From the end of 2016 to mid-February 2018 the US dollar index fell by more than 14%, in large part the result of broad-based global economic acceleration. The US dollar has traditionally served as a funding currency for international investment and when the global economy grows in unison the US dollar tends to fall as investors deploy capital around the world. A pleasant recent side-effect of this phenomenon was that emerging market equities and bonds were well-supported, since the weaker dollar kept domestic inflation under control and eased pressure on US dollar-denominated debts. The IMF crowned this happily benign era during its recent World Economic Outlook forum by declaring triumphantly “The global economic upswing has become broader and stronger.” But it was precisely at that point that the growth narrative began to unravel. Economic data in the eurozone, the UK, South Korea and Japan has shown signs of weakness while in the US the concern is quite the opposite; namely that a fully employed economy with a projected growth rate of 2.8% for 2018 would start to see inflationary pressures rise.
US economy starts to show signs of divergence from the rest of the world
The result has been a sharp appreciation of the US dollar against its peers. This has already unsettled key emerging markets such as Argentina, Indonesia and Turkey. High levels of US dollar denominated debt are one reason for the equities and bonds of these economies to have been particularly affected but the other reason is both less obvious and far more ominous. This is the trend towards ‘dollarization’ in recent years, whereby imports and exports are increasingly priced in US dollars, leaving both open economies and world trade especially sensitive to any dollar appreciation.
The potential implications of a stronger US dollar for investment portfolios are arguably more significant today than they have been in the past. Emerging markets, which have been particularly in favour among fund managers for the last couple of years, have always been vulnerable to a stronger US dollar. However, dollarization means that any further strengthening will impact global economic growth via impeded world trade in a more direct way than say, the threat of tariffs, which tend to affect only specified goods and services.
With the risks associated with a stronger US dollar clearly higher now than before, investors must coolly assess whether the recent strengthening is likely to persist. Interest rate differentials have been cited as a key driver of recent dollar strength, with US 10-year yields rising above the 3% level in contrast to much lower yields in Europe, the UK and Japan. This is naturally drawing capital back to the US where a decent risk-free rate is starting to get noticed by investors who have been piling into domestic bond ETFs.
However, the important point is that the US Federal Reserve under Chairman Jerome Powell appears far more reactive to economic data and inflation compared with his predecessor’s regime which tended to deterministically extrapolate from unemployment a higher path of inflation and therefore interest rates. In other words, if inflation fails to materialise then higher interest rates will be avoided. Furthermore, while there has been significant fiscal and spending stimulus in the US, consumers remain cautious and relatively indebted. And the payoff from higher levels of corporate investment may take quite some time to work its way into the data.
Investors will probably need to wait for more evidence before forming a definitive view on global economic divergence and a correspondingly stronger US dollar but there is much they can do to risk-manage their portfolios in the meantime. Crucially, they should not panic-sell out of high conviction positions in response to perceived US dollar risk. The fundamental case for emerging markets, for example, remains compelling given the associated secular growth story. That has not changed and investors need to extend their time horizons rather than reduce their emerging market equity and bond exposures, not least because timing the re-entry points is notoriously hard. The focus instead should be on how to dampen near-term volatility.
In equities, for example, a key point to address is how emerging markets are being accessed. Active stock selection has been much maligned in recent years but it remains particularly compelling in less liquid markets with lower governance standards. Dollarization will surely make active management obligatory since avoiding the pitfalls is likely to become just as important as harnessing the opportunities. Tactically increasing US dollar exposure can also make the valid ring-fencing of long term emerging market equity and bond positions less painful, while a broader basket of currency shorts could ensure that a more generalised dollar-induced global growth and earnings slowdown is mitigated.
Although the greenback may well fade again in the ensuing weeks, this recent episode should serve as a preliminary warning to investors that any future dollar strength is likely to have far more profound consequences for the global economy and capital markets than in previous years. Whether we are on the cusp of a multi-year dollar resurgence or not, investors would be advised to carefully consider how they can sufficiently dollar-proof their portfolios without compromising their long term strategic positioning.