Dollar - Down but not out - Look at longer-run

 

The dollar has reversed two years of gains against advanced economies, but the moves are more muted compared to the broad dollar index and emerging markets. The speed of the decline is a concern, yet the dollar is still within a long-term range after a substantial gain. The question is whether the dollar is declining because there is less confidence in the US economy and financial system. It is a signal of US weakness, and that is a problem. 

The dollar remains the reserve currency, primarily due to its role as a medium of exchange; however, the store of value argument is problematic.

Conditional betas solve a classic problem

Beta is time-varying. There is no dispute about this. The traditional approach to addressing this problem is to utilize a rolling window to adjust beta over time; however, this method does not account for the changing environment. It just increases the use of new information.

A new paper, "Conditional Betas: A Non-Standard Approach," attempts to find a new method to account for changing beta. It compares the quality of beta forecasts with one of the leading alternatives of windsorizing the data for beta. The overall effect of a simple machine learning approach is very positive. Results are strong and only based on past price data. This is worth further exploration. 

I cannot tell you how frustrating it is to see a hedge balanced trade fall apart because the beta estimate is wrong. Market neutral is no longer market neutral. This may not seem like a significant issue for long-only managers, but for a long/short portfolio, it is a substantial problem.

Gold as a safe asset - an alternative to debt.

 

One of the topics that has received attention in microfinance research is the discussion of what constitutes a safe asset and whether it is in short supply. 

During a crisis, there is an increased demand for safe assets that are information-insensitive and serve as a means to protect wealth. A simple example of a safe asset is the US Treasury bill. When there is high uncertainty, investors tend to sell risky assets and shift to safer ones. However, if there is a shortage of these safe assets, the price will be bid up, placing downward pressure on interest rates. 

Nevertheless, there is the assumption that the supposed safe asset will really be safe. That is, the risk or market uncertainty cannot come from the producer of the safe asset. If there is an increase in risk from the safe asset, it will lose its convenience yield, and it will no longer be uncorrelated with risky assets. 

In this case, there will be a demand for alternative safe assets. One alternative is gold. Gold is often uncorrelated with risky assets during times of stress. It is negatively correlated with volatility and uncertainty, and it often protects against higher inflation that impacts the real value of debt-safe assets. It is information-insensitive, and it can be used as collateral. 

Many have suggested that gold is in a bubble, but that narrative shifts if you view gold as a safe asset substitute. If the US debt is less secure, then there will be a stronger demand for gold, which will push its value higher. If the relative safety shifts to gold and away from debt, then there will be stronger upward pressure on gold. The price increase has been significant, but it will be sustained if the safety feature continues to drive demand.

Performance at that the half year mark - nothing expected

We have lived through uncertainty, a war, trade battles, and various events that should have pushed markets lower; yet, we are at the highs in the core US market indices. This does not feel expected or normal.

One of my favorite exercises is to play out scenarios - what would you have expected to happen if a particular event occurred, and then examine the reality. No one would have expected the current outcome. This sharpens your intuition and also tests expected relationships.

We are now in a place where US stock indices are touching all-time highs, with breadth widening beyond the large-cap tech sector. The markets have looked through uncertainty. Some of that uncertainty has been resolved, but that does not alter the underlying view that we are in an environment with a wide range of views. Of course, investors focus on downside uncertainty. There is also upside uncertainty, or a positive reaction to the unexpected.

There is still a rotation effect toward international stocks; however, this bias toward the US is closing. High bet stocks and momentum have been the key drivers. In general, all the worst-case scenarios have proven false. The overheated rhetoric has subsided, and the world seems calmer. The doom reporting of the last six months may not be realized.