Falling USD, US economic development at a crossroads, soft or hard landing?

Chart of the week

The chart shows the USD dollar index (DXY, dark blue) and the purchasing managers' index in the USA (light blue). The line of the USD index is shifted 6 months to the right.

The chart shows the high correlation of the USD with the performance of the economy.

Why this is important

Last week, the USD fell dramatically against the EUR. Many investors are wondering if they should hedge their USD exposure. The chart above demonstrates why this usually doesn't make sense. A lower USD drives the economy in the US. A lower USD is followed by a more dynamically developing economy. The lower USD makes products made in the US cheaper and more competitive. The loss of investors in the currency is usually absorbed by better business activity of the companies within six months.

US economic development at a crossroads

The chart shows the development of the money supply (red) and the development of the broad stock index in the U.S.A., the S&P 500 since March 2020. Approximately 1/3 of the money provided by central banks usually flows into the stock market. When the money supply is reduced, the money usually also flows out of the stock market and falling prices follow.

In the year, however, this relationship shows no effect. Although the money supply is falling, technology stocks in particular are soaring to unimagined heights.

The chart shows two surveys. One among private investors (AAII, American Association of Individual Investors) and one among large institutional investors (FMS, Fund Manager Survey).

As a rule, both investor groups tick in roughly the same way. Currently, however, an unprecedented discrepancy is emerging. For the above-mentioned reasons of declining central bank liquidity, institutional investors are worried and have massively reduced their risks. The situation is completely different for private investors. There is no stopping them. They are even using loans to buy all shares that have something to do with artificial intelligence.

Who is right now? The private investors or the institutional investors?

Let's take a look at the past. It would be more or less the first time that the private investors got it right.

But the chart also shows that it paid off in the long run if you started investing when the institutional investors were so negative.

The chart shows the different development of cyclical and non-cyclical stocks in the USA and Europe.  
Cyclical shares are shares whose earnings and prices normally develop in line with the economic cycle. These are, for example, stocks from the automotive, chemical or mechanical engineering industries.

Non-cyclical companies, are those whose sales and profits are steadily independent of external factors such as economic trends. These include companies from the food, consumer goods or insurance sectors.

In the chart above, higher values mean a better return for cyclical stocks compared to non-cyclical ones.

What is particularly interesting here is the large divergence between Europe and the USA. Especially cyclical stocks in the US seem to be very favorably valued compared to Europe.

Soft or hard landing?

Central banks around the world have tried to fight inflation by raising interest rates. However, by raising interest rates, they are deliberately slowing down economic development. It usually takes 6-12 months for an interest rate hike to have its effect. Therefore, it is difficult for central banks to determine whether they have already raised interest rates enough or whether more is needed.

If the central banks get it just right, the economy will cool down only slightly and recover quickly. This is called soft landing. But if the central banks overdo it with the interest rate hikes and slow down the economy too much, a recession follows. That would then be a hard landing.

The chart shows a Bank of America survey of large institutional asset managers. The majority of them expect a soft landing. This confidence has increased in recent months. The pessimists who believe in a hard landing are losing more and more ground.

This is mainly due to the only slight decline in corporate earnings, but also to the well performing labor market.

The chart shows the development on the US labor market. It shows the percentage change in new claims for unemployment benefits in the US. Many investors had expected these to increase this year. But so far they have fallen, reflecting the still strong state of the US economy. The regularly published figures in the US on new applications for unemployment benefits are therefore currently one of the most important economic figures to pay attention to.

The stock market is sometimes not easy to understand. Currently, higher unemployment figures, or more applications for unemployment benefits will drive the stock market up, although this is bad for economic development. Because then it would become clear that wages would not continue to rise and inflation would also decrease from the side. There would then be no need for further interest rate hikes by the central banks.

The chart shows where the major institutional investors see the greatest dangers. By far the greatest risk at present is that the central banks will raise interest rates too tightly, thereby triggering a severe recession.