The US dollar index, which measures the value of the dollar relative to a basket of six major foreign currencies, has increased over 5% since the beginning February. While this may not sound like a big move, it is actually quite significant for such a short period of time. The move into the US dollar reflects continued uncertainty in Europe (”flight to quality”) as well as the improving economic data we have received in the US over the past few weeks. Investors are especially encouraged by the recent housing data, which continues to suggest that this important sector of the economy is on the mend. Indeed, it appears that the US is becoming an even fancier house in a still-impoverished neighborhood.
Getting back to my point…The last time we saw a dollar strengthening of this magnitude was during the month of May, 2012. That month, too, was characterized by renewed fears about problems in Europe. There was widespread speculation that Greece might leave the European monetary union. Some also thought that a Greek exit would trigger a contagion, leading to other departures and the ultimate dissolution of the monetary union. In our March 23, 2012 Market Commentary, we wrote the following:
“Markets around the world continue to be volatile in response to concerns about the situation in Europe. As the value of “risky” assets has been falling in recent weeks, money continues to pour into the safety of the US dollar and US Treasuries. The US Dollar Index (ticker symbol DXY), which is a measure of the value of the dollar against a basket of six major currencies, is trading near a 20-month high. The yield on the 10-year Treasury note, which moves in the opposite direction as the bond’s price, is now close to a record low at 1.74%. Investors continue to display an insatiable appetite for an asset that will not yield enough to cover the expected rate of inflation, resulting in a loss of purchasing power. While this type of irrational investor behavior cannot go on forever, it does signal that investors are protecting against some very nasty tail risks. This European problem just won’t go away.”
While the recent flair-up involving Cyprus may not be as threatening as the Greek drama experienced last year in May, it also seems that investors have become somewhat desensitized to the issues across the pond. Prior to this year, sharp increases in the dollar index (reflecting European fears) were generally accompanied by a sharp rally in US Treasuries and the indiscriminant selling of stocks. This knee-jerk reaction to exogenous shocks came to be known as the “risk-off” trade because any security containing risk was shed in favor of those offering principal security.
This time around, however, investors don’t seem to be so alarmed. While the dollar has appreciated by a similar magnitude as last May, Treasury yields have fallen less than half as much, and stocks have actually appreciated in value. The chart below graphically displays the differing market reaction to the crises. From this chart, we can draw one of two conclusions: 1) either (and quite possibly) the European situation is not the threat it once was, or 2) investors have become much more risk-tolerant.
But there is a third possibility that makes more sense to us. It seems to me that there has been a change in investor perception about the inherent riskiness of stocks in this environment. In my view, investors have become emboldened to own stocks based on both improving economic data as well as the implied safety net of the Fed’s quantitative easing program. Therefore, crises that shake investor confidence do not necessarily lead to indiscriminant selling of US stocks anymore. At the same time, investors may be warming to the notion that the ownership of long-term bonds in a period of unprecedented money-printing entails its own amount of risk. A sharp rise in inflation, and therefore interest rates, could lead to substantial losses in bond portfolios. Stocks offer at least some protection against this scenario.
We will repeat what we said nearly a year ago when stocks swooned in reaction to renewed European problems: high-quality US blue chips stocks appear to be a sensible investment alternative in this environment. With interest rates as low as they are, the risks of owning stocks in high-quality companies with outstanding balance sheets may not be as high as the interest-rate risk associated with the ownership of long-term Treasury bonds. Perhaps investors are getting more comfortable with this notion. Having said that, stocks are not inexpensive anymore following a massive rally over the past four years. Careful research is as important as it’s been in quite a while.