An expert has warned share markets could crash in the coming quarter if one metric fails to stay in its favour.
Watermark Funds Management chief investment officer Justin Braitling told clients that the post-COVID "reflation trade may be maturing sooner than we previously thought".
"Is a bubble forming in shares?" he said in a memo.
"Price signals in bond and currency markets are key to reflation. The US dollar, along with bond prices, peaked in March of last year when the share market bottomed."
Braitling warned of dire consequences for share markets if the US dollar's descent turns around to a rebound.
"In recent weeks, the US dollar is looking like it may have bottomed for now," he said.
"If the low is in for the USD, we are likely to see a reversal in the reflation trade and a setback for equities and commodities in the near term. This is the first major red flag we have seen for the reflation settings in a year and should be monitored carefully."
A second quarter US dollar rally could be disaster
Braitling told clients that the coming quarter could see chaos for investors.
"Watch the USD – it holds the key," he said.
"Positioning is extreme, everyone is short the dollar, which means a Q2 rally and associated sell-offs in equities could be one of the big surprises for this year."
Oddly enough, the Australian dollar will remain strong through any movements in the greenback, as the local currency is heavily associated with commodity prices.
And that's also a headwind for ASX shares, as it makes Australian companies less competitive in a global market.
"If we are correct, the high for the AUD at 80 [US cents] is probably in for the medium term and equities could be in for a rough ride in Q2 2021."
What shares do Watermark hold in its portfolio?
Braitling said that while his team's game is to assess each stock on its merits, the macroeconomic shift in the post-pandemic world could not be ignored.
Therefore the Watermark Absolute Return Fund is currently holding:
- Value stocks with post-COVID tailwinds emerging
- Commodities shares: "We are bullish on commodities. There is both structural constraints in supply and heightened demand expected. This comes with a more favourable inflation/yield environment."
And the fund is currently avoiding:
- Expensive technology shares: "We still think tech is a brilliant and exciting sector. We are holding companies that will generate huge shareholder value regardless of what the yield environment holds, but tech that has simply seen valuation benefit from low rates should be avoided."
- Defensive income shares like infrastructure and utilities: "However, we look favourably on those that will benefit from reopening, such as airports."
