With the markets soaring and the U.S. dollar on a roll, investors are pondering what’s next for their asset allocation through the end of the year.
In a recent note to investors examining what lies ahead for the dollar, gold and currencies, portfolio manager Axel Merk of Merk Investments warns that the picture is not as rosy as it appears.
He notes that just as equity markets are at or near historic highs, measures of complacency are also testing record levels; the VIX index of implied stock market volatility is approaching its lowest point.
Moreover, 10-year U.S. Treasuries are yielding around 2.4%, again near record lows.
In this environment, Merk offers some reservations about the theory that with the U.S. pulling ahead, the dollar must win.
He says the U.S. recovery might not be as robust as it appears. Consider the following:
- The housing market remains vulnerable
- Many retailers have challenges
- Inventory stuffing may be happening at some tech firms
- Europe and parts of emerging markets are slowing down, threatening recovery
Furthermore, U.S. real interest rates are more negative than those of the eurozone and likely to become even more so given the Fed’s reticence in raising rates, Merk says.
He notes that no historical correlation exists between a rising interest rate environment and a stronger dollar because U.S. Treasuries might lose in value as rates rise, discouraging overseas investors from holding the dollar.
In Merk’s analysis, the Fed’s actions have resulted in what’s called a compression of risk premia — making risky assets appear less risky, causing everything from stocks to junk bonds to be more expensive.
This has prompted Merk Investments to caution investors about a potential crash, arguing that the U.S. “recovery is based on asset price inflation.” This means that if the Fed should pursue an “exit,” risk premia might expand once again, compromizing not only asset prices, but also the entire recovery.
The euro’s recent underperformance has to do with Europe’s sanctions vis-à-vis Russia, Merk writes, not with interest rate differentials or monetary policy.
For the currency to resume its ascent, he says, the Ukrainian crisis must be resolved — which is largely contingent on Russian President Vladimir Putin’s unreadable strategy in eastern Ukraine.
In the meantime, he says, expect the euro to bounce around “based on a mix of rumors and action coming out of Russian and Ukraine.”
Merk looks at why gold is down when geopolitical tensions are high and interest rates aren’t rising.
He notes even with recent drops in the price of gold, the metal is up more than 5.5% in dollar terms year-to-date.
Merk doesn’t like to buy gold because of geopolitical tensions, as such tensions usually tend to be short-lived. “We like gold long-term because we don’t think we can afford positive real interest rates,” and real interest rates may be negative for a long time.
For investors with a short- to medium-term perspective, he argues that the current holders of gold have reasonably “strong hands” as speculators in the metal have exited the market. These days, “those buying gold actually like gold.”
In contrast, buyers of many other assets, including S&P 500 stocks, buy the stock market simply to keep up, he says. “On the Nasdaq in particular we have started to see some excesses that are rather reminiscent of the dot-com bubble.”
As for the most desirable currency to invest in, Merk says that although the Swiss franc has recently outperformed the euro, the Swiss National Bank has imposed a ceiling on the franc versus the euro, and “betting against that might be an uphill battle.”
Instead, he suggests investors consider the Australian dollar, which has struggled in the face of the country’s tumbling mining sector and the threat of a Chinese hard landing. “That’s exactly where there is value to be found,” he wrote.
Year to date, the Australian dollar is the best-performing major currency.
Merk also notes that although the Chinese yuan is down year to date, it has lagged only the Brazilian real in the emerging market space over the past three months.
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