Reading the tea leaves of market movements

Jean Paul Lagarde, BridgeTower Media Newswires

A casual observer would be hard pressed not to notice the dramatic changes in market dynamics this year versus last. In a previous column I discussed the pickup in both daily prices swings (risk) and expected volatility (expected risk). However, in this column I would like to discuss other shifts in the market, particularly the turnaround in the U.S. dollar and attempt to explain the potential causes and ramifications.

One of these ramifications is simply relative stock index performance. In a rather stunning about face, the U.S. small cap Russell 2000 index, which underperformed the large cap S&P 500 by 6.3 percent in 2017, is now outperforming this year by 4.5 percent as of May 18. This fact alone should cause one to hunt for other major market shifts.

Among the major differences between small cap and large cap stocks are the sources of revenue. Small caps are decidedly domestic, with the majority of their sales being domestically oriented as they serve largely U.S. customers. This cannot be said for the S&P 500, whose index, comprised of the largest companies in America, generate over 40 percent of their revenues from foreign sources.

So, what is leading the Russell to outperform this year and not last?

One clue could be the strength of the global economy last year versus this year. 2017 could be characterized by what is known as a “globally synchronized economic expansion” which began late 2016. Most larger economies around the world were simultaneously expanding, and the rising tide lifted most markets, which certainly helped perpetuate the market calm mentioned above. The MSCI All World Index increased 21.6 percent in 2017.

In the U.S., growth in Gross Domestic Product continued to accelerate, consumers and businesses became increasingly confident, wages rose modestly and industrial production, factory orders, retail sales and many other import data sets were improving and exceeding expectations. Inflation and inflation expectations began picking up particularly in the back half of the year. The S&P 500 increased 19.4 percent in 2017.

In Europe the tone was similar, particularly in the first half of the year. The European Central Bank was not shy about discussing the removal of easy monetary policy through reductions in the central bank’s balance sheet and the eventual tightening of rates. Inflation in the eurozone was picking up, and bond yields were rising. Although the Euro Stoxx 50 stock index gained only 6.5 percent in 2017, Europe’s No. 1 economy, Germany, saw the DAX index increase 12.5 percent.

The same could be said for many countries around world, at least in terms of improving fundamentals.

The story began to unravel towards the end of 2017 and became more apparent in 2018 that economic data in many countries were beginning to slow, Europe and China being two major examples. In the case of Europe, the head of the European Central Bank, Mario Draghi, rather quickly pivoted from a relatively hawkish tone (willingness to raise rates/remove accommodation) to a more dovish tone (reluctance to raise rates), expressing that the central bank would be “data dependent” in determining the course of future policy.

The issue is that the U.S. Federal Reserve is facing what it thinks is the opposite problem - an ever-expanding economy, a tightening labor market and building inflation and inflation expectations. The Fed has become progressively louder with its intention of increasing interest rates, and the market is beginning to price them in. Fed Fund Futures are now signaling that markets expect the Fed will raise a total of four times this year, resulting in a Fed Funds range of 2.25 – 2.5 percent by year end.

With the ECB on hold and the Fed with the fire hose of higher rates in hand or at least close by, this creates the predicament of divergent monetary policy. While we observed bond yields across the Eurozone and the U.S. increase in 2017, the same is not the case in 2018. With economic data moderating in the EU, the ECB becoming more dovish, rates have fallen there while in the U.S. rates have continued to climb. Over the past three months, U.S. 10-year yields have risen 19.4 basis points (100 basis points = 1 percent), while German, French and U.K. 10-year yields have fallen 12.7, 12.3 and 8.3 basis points, respectively.

This divergence has led the euro currency to arrest what was a persistent ascent in 2017 while the dollar declined. 2018 marks a significant change, with the euro declining and the dollar appreciating – up 1.4 percent on the year and up 5.7 percent from the lows of early February.

A shift in the dollar can cause large ramifications for the global economies and financial markets.

Whether causal or merely coincidental, during periods of globally synchronous economic expansion, the dollar tends to devalue like we saw in 2017. The correlation between MSCI Emerging Market Index and the U.S. dollar shows a statistically significant relationship (-.40) since 2000 and a stronger negative relationship (-0.68) since 2008. An argument could be made that during times of global growth the “carry trade” tends to expand where some investors eschew dollar-based investments for foreign investments. These investments, often in emerging markets, typically offer a higher rate of return (and risk). This could explain, at least partially, why the dollar tends to be soft during these periods. In 2017 the dollar fell 9.9 percent while the MSCI Emerging Market Index climbed 34.4 percent.

Now that the dollar has begun heading higher in 2018, the fate of emerging markets is hanging on a wire. Many countries and corporations price their debt in dollars. As the dollar appreciates versus their local currency, the debt becomes increasingly more difficult to service since an increasing amount of local currency is needed to make the same payment in U.S. dollars.

Additionally, U.S. large cap companies that have high percentages of foreign revenues suffer through higher prices to foreign customers as the dollar appreciates, as well as foreign revenues and profits translating into fewer dollars as the dollar appreciates. Small cap stocks with their domestic exposures do not run into the same types of currency risk.

Markets are extremely complex. The combination of slowing economies abroad leading to divergent monetary policy, rate differentials and currency fluctuations can have significant ramifications to both our economy and our financial markets. One example is the turnaround in small cap stocks relative to their larger brethren and the sudden change of fortune for emerging markets.


Jean Paul Lagarde is portfolio manager and partner at Faubourg Private Wealth. All data sourced from Bloomberg. Securities offered through LPL Financial Member FINRA/SIPC. Investment advice offered through Level Four Advisory Services LLC, a registered investment adviser. Faubourg Private Wealth LLC and Level Four Advisory Services LLC are separate entities from LPL Financial.