Posted on 21st Aug 2020
For better or for worse, 2020 remains very much a US dollar story, with the currency at first whipsawing markets back in March as DXY spiked to 102 during the dollar funding squeeze and as of today having come down to a 92 handle. Speaking of which, the stock market sell-off we saw in March gets compared to other historical shocks like the GFC in 2008, but in reality - and as I have remarked here a few times - it was really a dollar story.
That is perhaps most easily illustrated from the perspective of another G10 currency versus the dollar: the Japanese yen. Traditionally seen as a safe haven asset, as markets sold off in 2008 the yen strengthened and saw high and increasing (negative) correlation with interest rates and the S&P500. Meanwhile its corelation with the US dollar declined as the dollar strengthened simultaneously. Fast forward to 2020 and we have a market in which its correlation with the US dollar has been persistently high while correlations with the S&P500 and interest rates have been weaker than normal.
If you look at the technicals over the very long term, the dollar seems to trend downwards. In the mid 1980s until 1990s we made a roundtrip from 84 to 165 back to 79. From there we spiked back up to 120 in 2001, down to 71 in 2008, back up to 103 in 2016 and we now seem to be in a multi-year bounce of those highs despite DXY in March just about touching the ceiling again. Could we be on the way to 60-70 again? It's at least a possibility based on my reading of the charts. Fundamentally speaking, together with excessive monetary debasement by the Fed and huge deficits this would not be an outcome that I find hard to believe. As someone else put it: if the US were an emerging market, any responsible investor would have divested years ago.
Speaking of emerging markets, a weaker dollar brightens their prospects significantly (emerging market stocks have a negative correlation of -0.35 with the dollar compared to only -0.24 for the S&P 500) and I expect this to be one of the key asset classes to perform well over the next decade or so. You will have to be country specific though, as the major EM ETFs are essentially a China play at this point given their outsized China exposure. My framework for picking emerging markets is simplistic but essentially relies on picking countries with better than average or improving indicators (current account, budget deficit, inflation under control, etc.) while I like to diversify their overall commodity sensitivity. Emerging market exposures that I currently like include Russia, India, Indonesia, Thailand and to a lesser extent Brazil.
Beyond that, opportunities in traditional markets are few and far between. Treasuries and credit are a dead trade as the central banks stuck the knife in and turned it five times. For now JPY and EUR may be rallying against a weaker dollar, but at some point I suspect they may go down in unison against emerging market currencies (the turnaround trade at the moment markets realise that developed market central bank antics have been far worse than their EM peers). Gold, TIPS and commodities and the broader inflation trade have room to run in the years ahead if inflation and monetary uncertainty truly picks up but will struggle for now. Shining light remains Bitcoin and the entire alternative financial ecosystem that's being built around it. Not having any exposure to crypto at this point is pure lunacy, in our view.
Finally, a quick note on our model portfolios. Our overall model portfolio is up +1.5% so far in August after delivering +15% in July. Meanwhile our traditional portfolio is flattish at +0.2%, while the crypto portfolio is up another +17%. In the traditional and regular model portfolios we remain pretty much long everything with the exception of EM equity where we have been in neutral stance for the better part of August. An interesting aspect of our model portfolios is the risk adjustment mechanism: assets are capped at a risk contribution of approximately 12% to total portfolio risk. That means that in our traditional model portfolio, oil had an allocation of no greater than 3-4% until July, but recently that has grown to some 11% as volatility receded.