Buy the US dollar stepping back from the short-term noise; one of the more impressive performances in recent months has been that of the US dollar, according to the BofA Merrill Lynch report.
“No longer correlated with volatility, the US dollar has thrived as risk appetite has surged, yet another indication that the “Era of Deleveraging” is behind us. The reasons for the dollar’s appreciation are mostly positive and suggest to us it may be embarking on a strong secular uptrend.
“Note, on a trade-weighted basis the US dollar is almost 30% lower in value than it was back in 1975. By contrast, the value of the Japanese yen is more than 3 times higher. We see two reasons for this. First, the market sees a better relative growth story in the US, driven by the revival in real estate, the manufacturing renaissance (US exports have almost doubled in the past 6 years) and the energy independence theme. This story faces fiscal challenges in coming months, as noted by Economist Ethan Harris, but looking further out the US looks in a better competitive position. The second and perhaps more important message from the dollar is the success of the Great Rebalancing theme. Specifically, Asia is no longer running large current account surpluses and the US running huge current account deficits. Indeed, no longer is Asia deemed the world’s producer and the US the world’s consumer. The Asian future is shifting toward consumption, while the US future is shifting toward production,” the report added.
Buy volatility on the surface all is sweet. Market volatility has been conspicuous in its absence, while risky assets such as equities and commodities are handsomely outperforming bonds year-to-date. Tail risks have faded from view, both the macro and policy makers seem to be behaving themselves and the great rotation is all the rage, we are seeing more equity inflows this week.
“With the backdrop seemingly a steady one of high liquidity and low (but positive) growth we continue to think the right asset allocation is long stocks and short bonds in 2013. But under the surface all is a little less sweet, in our view. We remain convinced that sooner rather than later a pullback is likely across risk assets, and indeed would healthy for the longer-term reflation story. We see three reasons for a pullback: first, positioning is too complacent,” the report added.
The BofAML Global Financial Stress Index is at a multi-year low, while the new BofAML Bull & Bear index, which measures market sentiment, is at a multi-year high. Second, policy makers are hinting that the point of maximum liquidity is behind us. The monetary policy minutes of both the Fed and the Bank of England indicated this week that the era of QE is slowly coming to an end. And Walmart hinted that fiscal austerity has some bite in the US. Third, price action within markets has become more defensive. The two best performing US equity sectors year-to-date are Staples and Health Care. Credit markets have stalled. And while the reflation story in Japan still looks like one of the bull stories of 2013, note that one barometer of local belief in Japanese domestic demand, small cap stocks, just dropped 20%.
“The Q2 will likely be the “show me” quarter maintains our bullish, reflationary outlook for asset prices this year. But reflationary policies have had a much bigger positive impact on investor sentiment than economic activity in recent months. 2Q is likely to be the “showme” quarter, where policy makers must prove that they can stimulate the economy. If successful, then we expect a negative reaction from rates and liquidity. If unsuccessful, then EPS expectations are likely to reverse. Buy volatility ahead of the “show me” quarter.