My colleague Bill Hall coined the phrase: “the Five D’s” as a catchy way of illustrating the economic condition that investors must navigate.
Bill is fond of pointing out that understanding the Five D’s is critical for investment success in today’s environment, and the biggest D of all is Deflation … with a capital D!
Economies in Europe and Japan are experiencing the most headwinds from the Five D’s because they are:
Up to their eyeballs in debt …
Running chronic government deficits, with no end in sight …
Suffering from poor demographics due to aging populations …
Consumers and business are struggling to de-lever their balance sheets by paying down debt. And the inevitable result is …
Persistent DEFLATION characterized by slumping prices and record low yields.
Case in point: This week the European Central Bank (ECB) launched an ambitious one-trillion-euro quantitative easing program of its own in a desperate bid to escape Europe’s deflation and boost its economy.
In a measure of just how desperate the ECB’s QE plan is, central banks dare buying European government bonds this week with negative yields. In other words, the investment is guaranteed to lose money!
ECB policymakers have not yet agreed on how to share losses from buying bonds with negative yields, but stay tuned because this could get interesting.
Perhaps we should add another D to Bill’s list of concerns for investors: Dollar — as in the strength of the U.S. dollar.
The buck has been on an absolute tear over the past year, with the U.S. Dollar Index up a stunning 24 percent against a basket of foreign currencies.
The largest currency in this index is the euro, and with Europe struggling more than any other region to escape the clutches of the Five D’s, it’s no surprise that the dollar just reached a 12-year high against the euro. In fact, many pundits in the financial press are predicting dollar-euro parity is close at hand.
A stronger currency is generally a good thing, but only up to a point.
The strong U.S. economy is seen as an oasis of prosperity in a deflationary world, but as a result, it’s growing more likely the Fed’s first interest rate hike in nearly a decade could come sooner rather than later.
Generally, a country with higher interest rates tends to attract more global capital from investors in search of a higher yield. The text-book result would be an even stronger dollar.
|If you’re impressed with the dollar’s rally so far, you ain’t seen nothing yet.|
In other words, if you’re impressed with — or perhaps surprised by — the greenback’s rally so far … you ain’t seen nothing yet.
Where a stronger dollar becomes a problem is when U.S. multi-national companies convert overseas sales back into a stronger dollar, earnings decline.
About half of S&P 500 profits are generated internationally, and many large-cap blue chip stocks like Procter & Gamble (PG), Philip Morris (PM), Coca-Cola (KO), and Intel (INTC) have substantial foreign sales.
In fact, analysts are already taking a sharp knife to S&P 500 profit estimates. Earnings forecasts that were already lackluster to begin with are getting slashed into negative territory. According to FactSet research, first- and second-quarter earnings are expected to decline 4.6 percent and 1.5 percent, respectively.
By contrast, at the start of this year, profits were expected to grow 3.8 percent and 5.0 percent in the first two quarters of 2015. So investors can add a potential profit-recession to their growing list of concerns.
The silver-lining in this playbook is to seek out small-cap stocks that generate the majority of their profits domestically. Since the American consumer is benefiting from a substantial tax-cut thanks to lower energy costs, small-cap stocks in the consumer discretionary sector look like an attractive choice.
Other domestic-oriented small cap stocks in the energy, technology and health care sectors should likewise benefit. My colleague Mandeep Rai, editor of Top Stocks Under $10, is busy uncovering small-cap gems in these sectors right now and you can find the full list here.