The Dollar isn’t the Peso anymore

Richard Bernstein

May 2013 The Dollar isn’t the Peso anymore Many years ago, we wrote a report called “The US Peso”. At the time, investors were generally quite bullish on the US dollar based on the strength of the funds flows into the US to buy US technology stocks and the advantages a strong dollar offered US consumers. We felt that such euphoria was misplaced, and that the US dollar was likely to weaken over the ensuing years. Today’s sentiment seems totally reversed. Whereas the consensus a decade ago was that a strong US dollar was infallible, investors today generally believe that the dollar will significantly depreciate. Current sentiment seems to ignore that the dollar troughed years ago, and has been appreciating. Despite the popular belief, the dollar isn’t the peso anymore. The US dollar troughed five years ago – that’s right, five years ago. Human psychology suggests that long-held beliefs are rarely displaced quickly. That certainly describes investors’ sentiment toward the US dollar. Despite that the tradable dollar index troughed five years ago, investors largely still believe that the dollar is a relatively weak currency. Chart 1 shows the tradable dollar index (DXY). We prefer to use this measure of the dollar’s value because it is based on investors’ forecasts of the future rather than on the historical data which economists generally use. Most investors seem unaware that the DXY index actually troughed in the spring of 2008. Chart 1:

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Charts 2 and 3 show the trade-weighted dollar and the real broad trade-weighted dollar, both of which are widely used by economists. Both measures show that the dollar troughed roughly two years ago. The DXY led these economic measures because the DXY is forward-looking, whereas the economic versions are based on coincident economic and currency data. Chart 3:

Dec-12

Dec-11

Dec-10

Dec-09

Dec-13

Dec-12

70

Dec-11

60 Dec-10

80

Dec-09

70

Dec-08

90

Dec-07

80

Dec-06

100

Dec-05

90

Dec-08

(Dec 05-Apr. 13)

Dec-07

(Dec. 05 - Apr. 13)

Dec-06

US Real Broad TradeWeighted Dollar

Dec-05

US TradeWeighted Dollar

Dec-13

Chart 2:

Source: Richard Bernstein Advisors LLC, Federal Reserve Board, Bloomberg

What about the Fed? Dollar bears often suggest that the Fed is “printing money” (not really an accurate description), and that inflation is around the corner. First, one should remember that printing money does not cause inflation despite that the phrase has become popular. Rather, it is printing money and using it to create credit that is a root cause for abnormal inflation. There might well be a lot of money-printing going on, but if those funds are not circulated through the real economy via credit creation, then it is extraordinarily difficult for inflation to spiral out of control. One has to put the current fears of inflation in proper prospective. Investors are habitually worried about inflation, and forecasted inflation is typically much higher than actual inflation. Chart 4 compares the year-to-year percent change in the CPI with the Conference Board’s survey of inflation expectations twelve months hence. With rare exception, inflation forecasts are typically too high. The recent gap between forecast and actual inflation has been among the widest in history.

Richard Bernstein Advisors LLC 120 West 45th Street 19th Floor New York, NY 10036 212-692-4000 www.RBAdvisors.com

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS

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Chart 4:

Inflation vs. Inflation Expectations Dec. 1987 - Apr. 2013

8.0% 6.0% 4.0%

2.0% 0.0% -2.0%

CPI Y/Y % Conf. Board Inflation Expectation NTM (12 mos. Lead) 1987 1989 1990 1991 1992 1993 1994 1996 1997 1998 1999 2000 2001 2003 2004 2005 2006 2007 2008 2010 2011 2012 2013 2014

-4.0%

Source: Richard Bernstein Advisors LLC, BLS, The Conference Board

Chart 5 compares current rates of money growth and inflation around the world. Several points seem worth considering: 1) The US’s current 7% M2 growth is equal to the long-term average. The notion that US money growth is out-of-control is very inaccurate. 2) The fears that investors have about US money growth and inflation might be better focused on the emerging markets. Some of the major emerging markets have the highest rates of money growth and inflation in the world (when excluding frontier markets). 3) Despite the high inflation rates in some of the emerging markets, central banks in those countries are easing monetary policies or considering easing. It is hard for us to see how it is bearish for the US dollar when high inflation countries’ central banks are easing.

Richard Bernstein Advisors LLC 120 West 45th Street 19th Floor New York, NY 10036 212-692-4000 www.RBAdvisors.com

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS

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Chart 5:

Global Growth in Money Supply* vs. Inflation Rate (latest available as of 4/30/2013) 11% India

Country Key: Purple= Emerging mkts Blue= Developed mkts Orange= BRIC mkts

CPI Y/Y %

9%

Egypt

7%

Turkey

Russia

Brazil Indonesia

South Africa

5% Mexico

Hong Kong

Philippines

Singapore UK

3% Austria Finland

Spain Italy Germany Belgium France Ireland Portugal

1%

Australia

Hungary

Czech Rep. US South Korea Poland Canada Norway Taiwan New Zealand Denmark

Thailand Malaysia

Sweden

Switzerland

Japan

-1% 0%

2%

4%

China Colombia

6%

8%

10%

12%

14%

16%

18%

Money Supply Y/Y % Change Source: Richard Bernstein Advisors LLC, Bloomberg *Money Supply defined as M2 (or M3, if M2 not available, or IMF Currency Issued by Monetary Authority in National Currency, for EMU countries).

Richard Bernstein Advisors LLC 120 West 45th Street 19th Floor New York, NY 10036 212-692-4000 www.RBAdvisors.com

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS

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The currency race to the bottom – bullish for the US dollar We have long thought that a global currency war was inevitable. Bubbles create capacity, and the global credit bubble created tremendous productive and financial capacity which may not be needed in the future. Currency devaluation has historically been one solution to such overcapacity. This is why some currency forecasters are bearish on the US dollar. However, those forecasts seem to ignore that other countries are, or soon may be, in worse shape than is the US. Corporate profits in many emerging markets continue to disappoint (roughly 60% of EM companies reported negative earnings surprises for 4Q12), and a devalued currency might increase competitiveness and boost corporate profits. Gold bulls believe that such currency wars are bullish for gold, and that might be true if one resides in one of the countries that might devalue its currency. However, this seems very bullish for the US dollar, and questions why a US dollar-based investor would consider gold. The global economy is not going to transact in gold. The global economy is going to transact in dollars. Thus, if currency wars develop, the US dollar will likely appreciate. Unanticipated risks: the negative convexity of EM local currency debt funds It may be somewhat ironic that investors are worried about the unintended consequences of the Fed’s policies, yet have little appreciation of the unintended risks associated with some investments that are currently quite popular. For example, there have been massive flows into emerging market local currency funds during the past year or so, but few investors seem to have considered the risks associated with these funds if the US dollar were to continue to appreciate. Emerging markets used to have to issue debt in US dollars in order to attract investors. By issuing debt in dollars, these countries took the full brunt of the imbedded currency risk. If the US dollar appreciated, the amount of local currency needed to pay the US dollar coupon would increase. If the US dollar appreciated too much, then the country might default on the bond because they couldn’t afford to pay a dollar-based coupon. The popularity of local currency debt has significantly altered that risk dynamic by shifting currency risk from the bond issuer to the investor. Because the bond was issued in local currency, the local currency needed to pay the coupon doesn’t change through time. Rather, the dollar-value of the coupon received changes. If the dollar appreciates, then the dollar value of the local currency coupon depreciates. However, if the dollar appreciates relative to a bond-issuing country’s currency, it generally implies that the issuing country is becoming relatively more risky. When countries become riskier, they generally must offer higher yields as a risk premium. Unfortunately, the yield of a local currency bond would go down because the investor absorbs the currency risk. Significant depreciation of the bond’s price would be the only way for the market to adjust to the new relative risk. Richard Bernstein Advisors LLC 120 West 45th Street 19th Floor New York, NY 10036 212-692-4000 www.RBAdvisors.com

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS

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This is called negative convexity, and the recent flows into emerging market debt funds (see chart 6) leads us to believe most investors do not fully understand the risks that an appreciating dollar can impart on those types of investments.

Chart 6:

$Mil

Year-to-Date Flow of Funds* (as of 3/31/13)

20,000 15,000 10,000 5,000 0

(10,000)

Foreign Large Blend Diversified Emerging Markets Intermediate-Term Bond Bank Loan Nontraditional Bond Short-Term Bond World Bond Multisector Bond Conservative Allocation Emerging Markets Bond Large Value World Allocation Mid-Cap Blend Real Estate Muni National Intermediate Small Blend Foreign Large Growth Moderate Allocaiton Ultrashort Bond Commodities Broad Basket Foreign Large Value Muni National Short Mid-Cap Value World Stock Healthg High Yield Bond High Yield Muni Small Value Mid-Cap Growth Small Growth Large Blend Muni National Long Inflation Protected Bond Large Growth Intermediate Government

(5,000)

Source: Richard Bernstein Advisors LLC, Morningstar® Includes the 35 Morningstar Categories with the highest Total Net Assets, ranked by Year-to-date Net Flow as of 3/31/13.

The dollar isn’t the peso anymore The US dollar troughed five years ago, yet it seems that most investors remain generally unaware. Our old joke about the “US peso” certainly is not appropriate anymore. Investors, however, seem mired in the 1998-2008 time period, and views regarding the dollar have not evolved despite the changes to the global economy. The massive flows into emerging market debt funds seem to support that contention. Our portfolios remain structured for a stronger dollar.

Richard Bernstein Advisors LLC 120 West 45th Street 19th Floor New York, NY 10036 212-692-4000 www.RBAdvisors.com

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS

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INDEX DESCRIPTIONS: The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website. The past performance of an index is not a guarantee of future results. Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indices are not actively managed and investors cannot invest directly in the indices. DXY Index: IntercontinentalExchange (ICE) US Dollar Index. The ICE US Dollar Index, indicating the general international value of the USD, averages the exchange rates between the USD and six major world currencies using rates supplied by some 500 banks. US Trade-Weighted Dollar: A weighted average of the foreign exchange value of the U.S. dollar against the currencies of a subset of currencies in the broad index that circulate widely outside the country of issue. The weights are derived from those in the broad index. Source: Federal Reserve Board US Real Broad Trade-Weighted Dollar: An Inflation-adjusted weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners. Source: Federal Reserve Board Consumer Price Index(CPI). The CPI of a country is a measure of the average change in prices over time of goods and services purchased by households.

© Copyright 2013 Richard Bernstein Advisors LLC. All rights reserved.

Richard Bernstein Advisors LLC 120 West 45th Street 19th Floor New York, NY 10036 212-692-4000 www.RBAdvisors.com

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