MorningWord 11/3/14: Global Cooling

by Dan November 3, 2014 9:36 am • Commentary

The health of the EuroZone’s economy could be the single largest risk to the continuation of the bull market in U.S. equities (with Chinese growth a close second).  There appears to be little in the way of good news in the last week, from poor manufacturing data to woefully under-capitalized banks and a currency that seems dead-set on re-testing 5 year lows.

Despite the U.S. Federal Reserve’s impact on the value of the U.S. dollar since the start of QE in 2008, there was a repeated insistence of a strong dollar policy by the central bank.  Interestingly as QE wore on and on, there seemed to be fewer central bankers who could make such claims with a straight face.

I think it is safe to say that the new found strength in the U.S. dollar vs the Euro and the Yen is far from a coincidence as the Fed ended QE and the BOJ and the ECB are left to carry the torch.  My friend and emerging market strategist Jay Pelosky, founder of J2Z Advisory which advises institutional investors on global asset allocation and portfolio strategy (who has all the chops to talk all things Macro), has been speaking/writing on the concept of a “lower-for-longer” global growth, most recently on Friday in a piece for Brazilian bank Itau (emphasis mine):

While the lower-for-longer growth world becomes accepted wisdom, the investment playbook for such a world seems less clear to many. It makes sense that equities bore the brunt of the recent selloff, given that fixed income and currencies had moved further and faster in discounting a low-growth world with no Fed-driven QE and the natural growth governors of a strong FX and high relative rates. Likewise, it makes sense that US equities rallied on the back of the third-quarter GDP print of 3.5% a day after the Fed stated that rates will remain low for a considerable period of time – the best of both worlds!

The good news about the lower-for-longer growth world is that it removes the risk of sharply higher interest rates, which remain the bête noire of financial assets and perhaps economic vitality. It does not preclude the likelihood of some slow, small rate increases at the front end as the Fed tries to build some ammunition for future crises. How investors respond to the potential for small, patient, Fed-led, good rate hikes at the short end, versus bad, sudden, sharp, market-driven rate hikes at the long end, will be important.

The risk to the low-growth world is a descent into flatline status ……..Should the global economy weaken sharply, earnings are likely to be affected and thus equities would come into the line of fire.

Jay and I are in agreement that the delicate levels of growth, the potentially decreasing positive real growth affects of easy monetary policy, and the recent strength of the dollar pose a great risk to U.S. equities. While it doesn’t seem at all evident at the moment (as the S&P500 is set to make a new all time high on the open, round tripping the nearly 10% decline from Sept 19th) on an ongoing basis, it seems that continued weak global economic data with continued dollar strength WITHOUT a meaningful pick up in the U.S. could be the worst of all outcomes for U.S. stocks.  The strong dollar would be a significant headwind to large U.S. multinational profits in the coming quarters. So expect to see continued levering up by companies to buyback shares at a time when U.S. companies remain hesitant to re-invest for a higher growth world that seems to be on the cusp of a re-set.

If we get past the midterms and closer to the holiday season without a hiccup, I suspect that there is little that will derail this train now that the S&P500 is back up nearly 10% on the year. But the higher we go with the U.S. Fed just talking, the greater the risk is in early 2015 of the same sort of sell off we saw in January/February 2014.