One of the more interesting global macro market trends right now is the direction of the U.S. Dollar and its impact on other markets.
The chart below is the U.S. Dollar trend year-to-date vs. the Emerging Market Index ETF. Emerging Markets are newly industrialized countries whose economies have not yet reached developed status. As the U.S. Dollar index has gained around 5% in 2018, Emerging Markets have trended down over -7%.
At the bottom of the chart, I included the correlation coefficient of the trends between the U.S. Dollar and Emerging Markets. A high correlation value is +1, non-correlated is 0, and a completely negative correlation is -1. The value of -0.90 is a negative correlation relationship between them. As the Dollar is trending up, Emerging Markets is trending down. We don’t need a correlation coefficient equation to determine that since it’s clear by looking at their price trends, the value shows just how negative the relationship has been.
Since Emerging Markets are growing countries, you can probably see how changing trends in currency rates can have an impact on them. For example, countries like China, South Korea, and Thailand are Emerging Markets. If those countries are selling their products to Americans who buy them in U.S. Dollars, a rising Dollar relative to their currency makes their things more expensive for Americans.
Correlation is the relationship or connection between two or more things. In investment management, we use it to measure the degree to which two or more securities move in relation to each other. Correlation is probably one of the most misused equations because professional investors seem to rely on it too much.
Correlation isn’t necessarily causation.
Correlations are ever evolving – they change over time.
One of the most dangerous investment management mistakes is to assume markets that are supposed to trend independently will always be negatively correlated. A grand example is the failure of diversification among markets that are supposed to trend independent to each other to provide downside risk management in a bear market.
In the chart below, we show the % off high U.S. stocks, Emerging Markets, Developed Countries, and Commodities since June 1999. It shows the drawdowns of these markets from their % off price highs. The October 2007 to March 2009 “Financial Crisis” wasn’t the only time expected non-correlations failed. In the “Tech Wreck” from 2000 to 2003 we also observed international stocks, real estate, and commodities all declined together.
Back to the U.S. Dollar…
An observation is to see something. The action or process of observing something carefully in order to gain information.
Insight is the understanding of a specific cause and effect within a specific context.
What is driving the Dollar up?
Ultimately, supply and demand drives the price trend of everything.
- If there is enough buying enthusiasm – price goes up.
- If selling pressure overwhelms buying demand – prices fall.
Beyond this simple economic principle, I believe we have certain key drivers of global market returns. It’s things like the direction of interest rates and inflation. For example, with the Fed raising our interest rates in America, our Dollars have a higher yield for foreign investors. If foreign investors were only earning .50% on their Dollars a year ago and now it’s 1.5%, that may motivate them to buy more Dollars.
Because supply and demand ultimately drives the price trend, I focus on the direction and change of direction of price trends themselves. Correlations are only a secondary observation for me. In fact, though the year-to-date correlation between Emerging Markets and the Dollar is negative, I show below these correlations do indeed change over time. However, though it’s oscillating in degree, we observe there is generally a negative correlation between the Dollar and Emerging Markets – it stays below .50.
Below we see that an index ETF of Developed Countries like Japan, the United Kingdom, France, and Germany are also demonstrating a negative correlation with the Dollar, but not as much as Emerging Markets. The iShares MSCI EAFE ETF (EFA) is down about -3% year-to-date with a correlation of -63.
Another asset class that typically shows a negative trend vs. the Dollar is commodities. The commodities index correlation was negative up until May and has since become more connected.
Just like price trends, correlations change and evolve over time. Investors shouldn’t expect them to remain intact when they historically show us they don’t.
It’s interesting to observe how markets interact with each other, but their relationships change because there are different return drivers impacting them.
This is why I don’t constrain myself to beliefs that require fixed causations or correlations. I prefer to be more flexible and unconstrained so I can adapt to changing conditions.
Everything is impermanent – nothing lasts forever.
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The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.