Or is it the other way around? First, we've had a strong
one-month run in U.S. stocks, led by cyclicals, pushing the S&P
500 up 27 percent in April and finally turning it positive for
2009. Then, the NASDAQ is up over 13 percent since the beginning of
the year and the DOW is up 28.7percent, with both making most of
those gains in the last 39 trading days.
The biggest practical driver of this equity rise seems to be that
investor sentiment has shifted dramatically during the past eight
weeks. Mutual fund managers have trimmed cash positions. Hedge
funds have scrambled to cover short positions in financials.
Pension funds and endowments are underweight in equities in their
mixed asset portfolios. Money market mutual fund assets currently
total $3.3 trillion, or 44 percent of the value of the S&P 500.
Relative to history, these levels are extraordinarily high - by
over 15 percent. There seems to be an expectation of declining risk
aversion during the second half of 2009, as funds flow into common
stocks. Recent fund flows in equity and money market mutual funds,
coupled with a string of successful capital raises by U.S.
financial companies, also suggest that the cash pent up on the
sidelines is beginning to be deployed into the equity
Longer term, there are four big factors at play:
How does this translate into USD direction and
- Mortgage spreads have stabilized somewhat, providing a cushion
to home price deflation.
- Financial company positive earnings are pulling these stocks
sharply upward, with a direct effect on the major stock indices,
given that Bank of America, Citi and JP Morgan are elements of the
Dow Jones Industrial Average.
- Corporate access to credit has improved. The Federal Reserve
System's balance sheet has dropped by nearly $160 billion as it has
made no additional purchases of commercial paper; this source is
now squarely back in the realm of banks.
- Global stimulus packages are also a factor, even though only
China's is really working for people and businesses.
EURUSD, for example, started off the year at 1.4045. The USD
strengthened to a "high" of 1.2457 on March 4, but has steadily
lost some ground since, settling in at just over 1.34, effectively
a 5 percent gain since the beginning of the year. In essence, the
USD has outperformed the S&P 500 this year. So, is the buck
uptick a function of demand for U.S. equities or can it be
explained another way? My postulation is that global imbalances are
correcting swiftly and sharply, thus firming up the
The most prominent expression of this shift has been the very
significant decline in the U.S. trade deficit from around $60
billion monthly in mid 2008 to $26 billion in February. A large
chunk of the decline in imports can be attributed to one-off
factors, including the Chinese New Year effect, but the improvement
in exports is instead broad-based and is likely to extend going
forward. On a more long-term basis, the macro trend is toward a
more sustainable external balance in the U.S., which is a long term
positive factor for the USD.
More broadly, the average trade deficit from the six biggest
deficit economies (South Africa, New Zealand, Australia, Turkey,
Poland, Hungary and the U.S.) has shrunk to near zero from about 6
percent in mid 2008. On the other hand, the average trade surplus
from the six largest surplus economies (China, Russia, Sweden,
Switzerland, Brazil, Japan and Norway) has shrunk to about 3
percent from about 8 percent in mid 2008.
This is the largest shrinkage in trade imbalances since at least
1998. A small part of this adjustment is due to one-off factors (as
discussed above) and may reverse over the next few quarters.
However, it is likely that the macro shift towards lower global
imbalances may persist to a large extent and that is because they
are driven by three key fundamental forces.
- First, the external adjustment is partly attributable to lower
commodity prices. Commodity prices have corrected to mid 2005
levels on average. However, the gap between trade surpluses and
trade deficits has narrowed to levels not seen since in
- Second, the depreciation of currencies with current account
deficits relative to currencies with current account surpluses is
another significant factor. According to a Goldman Sachs research
model, the relative performance of current account surplus
currencies relative to current account deficits appreciated by 20
percent between mid 2008 and February 2009. This may seem like a
large shift, but if FX adjustments were the key driver of the
imbalances correction it would imply a very elastic response of the
global economy to exchange rates.
- Third, the difference in domestic demand is a very important
driver behind this shift. This is particularly so in China, India
and Brazil - the BIC of BRIC! This ultimately helps U.S. exporters
and potentially earnings improvement which in effect fuels US
equity interest and foreign direct investment.
The point of this story might be that the tail is wagging the dog,
in that balance shrinkage is freeing up capital for investment
purposes. That, aligned with money managers sitting on the
sidelines with capital bodes well for the U.S. stock market and
that in turns continues to fuel the USD uptick. Just watch for the
upcoming inflation to throw this whole theory out the window!