We espouse two themes at Tailwinds Research. The first theme is that small cap stocks should be a piece of your portfolio and, when picking small caps, we look for companies that are developing disruptive technologies. Ideas that will change the world and stocks that are potential multi-year holdings with exponential return potential. Great ideas transcend markets and are not cyclical. These stocks have the potential to outperform during any and all market cycles.
For the rest of your investments, however, we have a very different mantra. It is our time-tested belief that markets are cyclical and that, for the larger, more established companies, global-macro trends will dominate investment returns over years. If you can see the big picture and not get caught up in the minutiae, trends are evident that will help generate substantial outperformance for those investors who look at their portfolios in a more holistic manner.
The chart above shows the US Dollar index for the last 43 years. There is an obvious trend here of lower highs. Additionally, it’s quite plain to see that the dollar had a run of very significant outperformance over the last 4 years. Outperformance that appears to have ended.
I’m not a chartist by nature; rather I use charts as a way of determining if my underlying fundamental thesis is correct or if I’m way off base. For example, I turned bearish on the USD last December, saying “The USD dollar stops its climb, as the strong US economy starts to bring emerging markets along with it.”
That was my economic thesis, and the charts are telling me that I’m on to something here as the dollar has dropped 7% so far this year; a move that appears to be accelerating…
The question at this time is the following,
“Is this a correction in the dollar’s upward trend, or is this the start of a major downtrend?”
From a technical standpoint, I look at the first chart and say to myself, this has all the makings of the beginning of a major downtrend. But, as I mentioned, I’m not a technician but an economist by training, and, therefore, will fall back on global macro themes as the key determiner of major trends.
To determine if the USD trend has shifted, it makes sense to understand what drove the strength in the first place. Quite simply, the years of 2010 through 2016 was a period of outperformance by the US’ economy relative to the rest of the developed world as a whole.
The chart above shows how the US was, on average, well ahead of Europe in terms of economic growth from 2010 through 2016. This strength enabled the US to stop their Quantitative Easing (QE) and start raising interest rates, while simultaneously the EU grew increasingly concerned about their economies and lowered rates dramatically.
Not coincidentally, these differing interest rate trends sparked a stronger dollar relative to the Euro; a trend that occurred globally and led to the years of outperformance by the USD.
Where do things stand at this time? Will the trend of US economic outperformance continue? Will US rates continue higher while the rest of the world lowers rates?
I believe that, outside the US, the major economies are at an inflection point. After years of underperformance, they appear to have stabilized. This is evidenced, in the European Union, by the relative GDP chart shown above. Since the end of 2015, the US isn’t outperforming the EU by very much, if at all, and the weaker economies in the EU have been shored up.
Now, I’m not about to say that the rest of the developed world will outperform the US economically going forward. The economy here is on strong footing and we have a number of things going for us.
But, what is more important to the US Dollar is relative interest rates. And, rates have stopped declining outside the US. Do you think Germany will have a .4% rate on their 10 year bond forever? It’s ridiculously low and will have to move higher over time. Rates in the EU are going to go higher.
And, other countries have similar situations. The days of flooding the market with cheap paper and printing cash will have to end. Japan has pegged their 10 year yield to zero. Really? Zero percent interest over 10 years? This is not possible to be maintained long term and I believe that their rates will have to reverse higher…it’s inevitable.
“The dollar has been suffering through one of its worst stretches in years, weighed down by scant inflation and doubts whether the Federal Reserve will raise rates anytime soon,” Wall Street Journal
Meanwhile, in the US, rate increases seem to have stalled. We have a bumbling president who likely can’t push through any of his policies and continued low inflation. He’s threatening war with North Korea, upsetting every trade partner and generally speaking diminishing the US’ standing internationally.
Meanwhile, the US’ economy is strong, but the Fed is more focused now on unwinding its large balance sheet, than raising rates. All of which means that, relative to the rest of the world, the US is unlikely to be raising rates at a faster pace, if at all.
The end result of all this is that the US Dollar’s decline appears not only to be justified, but on solid grounds to continue. The long-term chart of the dollar is not pretty at all, as it appears to be at major resistance. Moves in major markets, such as currencies, are very cyclical in nature and this appears to be the start of major downtrend. Expect it to continue until an official bear market (down 20% or more) in the US Dollar has been achieved.