Central banks and governments around the world are once again engaged in a ‘currency devaluation’ contest. The US dollar has been on a sharp downward trend in recent weeks. This has had a significant impact on financial and real assets.
The chart below, which we borrowed from Hong Kong investor Puru Saxena and goes back all the way to 1980, suggests the dollar indeed is on a long-term downtrend.
The graph seems to tell us that the USD simply ‘wants’ to fall. This has important consequences for financial markets. Broadly speaking, we can say that a weak US dollar is more likely to lead to greater liquidity on the financial markets, and a stronger US dollar is more likely to lead to a tightening of liquidity.
When the USD is weak, investors sell USD to buy financial or real assets or to take on debts in another currency. Conversely, when it is strong, those debts must be repaid or the assets sold, and demands for dollars rises.
In recent months we have seen a sharp increase in two types of asset classes: long-duration assets (growth stocks) and real assets (especially precious metals). Real assets, with pronounced increases in gold and silver prices, are rising because real interest rates have fallen sharply. Gold reaches its all-time high and is likely to break through the $2,000 per ounce soon. The sentiment is very positive now, and that calls for caution or a correction.
FAMANGs
Growth stocks are also rising as the discount rate used to discount future cash flows back to the present (net present value) is close to zero. The value of future cash flows therefore rises more than current cash flows, which excessively benefits growth stocks.
Moreover, the business activities of these companies are not hampered by COVID-19, and often even benefit from it. The well-known technology giants, the FAMANG shares (Facebook, Amazon, Microsoft, Apple, Netflix and Google) of course also benefit from a weaker dollar. Many of these American shares are in foreign hands after all. With the exception of Google (Alphabet), these companies all published bumper profits on 30 July that far exceeded expectations. They are all benefiting from an increase in digitalisation and e-commerce, two trends that clearly accelerated during the lockdown.
Can we compare the FAMANGs with the Nifty Fifty stocks that were a hit in the 1970s? These were shares of quality companies with stable and growing cashflows that everyone wanted. It was a group of growth stocks such as Xerox, IBM, Polaroid, McDonald’s, Disney, Pfizer, Merck, Pepsi and Coca-Cola that meant a radical break with the value investing style which was very popular at the time.
At their peak in 1972, the Nifty Fifty were priced at 42x earnings, more than double the S&P500 average of 19. They were shares to ‘keep for life’, as you could read so often back then.
The Dow-Jones rose 15 % in 1972, but the rise began to narrow. The Nifty Fifty shares rose sharply while the smaller shares lagged behind, a very similar development as we’re seeing in the post-Covid recovery.
In 1973-1974, the Dow fell by 45%, however, one of the worst bear markets ever which was triggered by the oil crisis. From their peak, Coca-Cola dropped 69%, Xerox 71%, McDonald’s72 %, Disney 87% and Polaroid91 %. The peak of the Dow in January 1973 would not be reached again until nine years later.
Is it possible that the FAMANG shares would suffer the same fate? Possibly, of course, but then the interest rates weren’t at zero like today and the central banks didn’t launch huge stimulus programmes. And other NASDAQ stocks such as Livongo Health (x5 YTD), Datadog (x3) and Zoom Video Communications (x4) are doing even better than the FAMANGs.
Conclusion
The falling dollar and real interest rates are creating an explosive cocktail on financial markets. Valuation multiples are rising, especially for growth stocks. This creates a ‘winner takes all’ environment in which value shares lag behind enormously. But value rallies can come quickly and unexpectedly, once the economic recovery gets going.