How will the US dollar continue to influence asset markets?
30 September 2018
What has driven of the dollar’s strength this year, are the influences likely to persist and what are the potential implications for investment markets. Richard Larner, head of Research at Brooks Macdonald looks at the markets and takes a view.
Growth strengthened in the US in the first half of the year, while economic momentum slowed in most of the world’s other developed regions. We do not expect US economic growth to decelerate in the near term, as the US business cycle has been extended by the Trump administration’s tax reforms. However, the US economy’s strength should eventually begin to have a positive influence on economic activity outside the US.
Meanwhile, we see scope for China to boost its economy through the provision of economic stimulus. As such, there is potential for US-overseas growth differentials to narrow and this should ensure that further dollar appreciation is limited in the near term, even if US growth remains strong.
Inflation and monetary policy
The strong US economic backdrop is supporting growth in the country’s labour market, which continues to tighten.
At the same time, inflation has reached the Federal Reserve’s (Fed) target rate of 2%. Various forward-looking indicators point to building inflationary pressures and this has coerced the Fed to raise US interest rates.
However, we are yet to see compelling evidence that wage growth is set to accelerate in a persistent manner (even after August’s stronger-than-expected average hourly earnings data) and are cognisant that structural deflationary headwinds such as demographics, high debt levels and technological advances might continue to keep inflation contained around the world.
In line with this, recent rhetoric from key US policymakers has suggested that the Fed may temper its view on the pace of future rate hikes if wage growth remains contained.
We note that the Fed’s current forecasts for the progression of interest rates (two more hikes this year and three next year) are more hawkish than the markets (two more this year and between one and two next year), however the magnitude of this mispricing is much less than the average over the last five years.
Overseas, significant spare capacity remains within many of the world’s other major economies, most significantly Europe, and this is ensuring that inflation and interest rates in these regions have stayed low. Despite Japan’s low unemployment rate, the Bank of Japan continues to use monetary policy to keep the yen weak, in order to support the country’s large export sector. Overall, the views of both policymakers and investors remain that interest rates outside the US are set to stay low over the next 12 months.
Aside from rates, the Fed continues to slowly remove dollar liquidity from fixed income markets by reducing the size of its balance sheet, which will put some upward technical pressure on yields and provide some support to the dollar. However, current interest rate differentials are largely priced in to exchange rates and in the absence of an acceleration of US inflation, scope for monetary policy developments to drive significant further dollar strength is limited.
Generally speaking, political developments manifest themselves in currency markets and events on each side of the Atlantic will therefore affect the relative strength of the US dollar.
In the US, President Trump continues to push his ‘America First’ policy, which has involved the implementation of protectionist trade measures. This has been taken as dollar supportive by investors, given perceptions that the US’s large trade deficit puts it in a better position to ‘win’ any trade war (although we would note that any ‘win’ would be on a relative basis as a global trade war would likely damage all participants).
Meanwhile, Europe continues to be mired by various political headwinds, most pertinently the situation regarding Italy’s fiscal position and debt burden. This threatens to undermine European integration and, hence, the euro. In the UK, Brexit developments are the clear driver of sterling, which we expect to remain volatile until clarity on the post-Brexit environment is provided.
We therefore believe that political developments will remain dollar supportive through the remainder of the year. However, President Trump has repeatedly stated that he favours a weaker US dollar, as this would help US businesses’ international competitiveness. If he continues with this rhetoric, it should act as a headwind to further dollar strength.
Implications of a stronger dollar
The relative strength of the dollar has many implications for investment markets, both directly and indirectly. In recent history, the most publicised of these has been the adverse effect it has had on certain emerging markets, the worst afflicted generally being those with large exposure to dollar-denominated debt, low foreign exchange reserves and, therefore, a dependence on external financing. As the dollar has strengthened and yields have risen, it has become more expensive for entities within these to service their debts, to the point where some may become financially insolvent. When such situations develop, investors seek to withdraw their capital from the country in question, which puts its asset markets and currency under further pressure.
The most pertinent situation is that regarding Turkey. The pace of dollar liability growth in Turkey has been extremely rapid over the past ten years, with the amount of dollar-denominated debt issued having increased by a factor of three (to almost $150bn, according to the Bank for International Settlements). This situation was judged as manageable until global financial conditions tightened and political developments resulted in the US enacting sanctions against the country. These events caused investor sentiment towards the country to decline sharply and this manifested itself in a heavy depreciation of the Turkish lira, which makes it more expensive for entities to service dollar debts with lira revenues.
In turn, this is weighing on companies with significant exposure to the Turkish economy, most pertinently within the European financial sector. Spain’s Banco Bilbao Vizcaya Argentaria (BBVA) owns around 50% of Turkey’s Garanti Bank, Italy’s UniCredit owns approximately 40% of Yapi Kredi, and France’s BNP Paribas owns almost three quarters of Türk Ekonomi Bankasi (TEB). This situation will exacerbate the strain on a European banking sector which is already facing large headwinds.
As we saw during the Greek debt crisis, financial markets are sufficiently interwoven that concerns over debt serviceability in one sector or region can quickly spread to the broader market. Turkey has been an early casualty of the dollar’s rise, but there is clearly scope for markets to face broader, more intense pressure, given that some estimates of the amount of outstanding US dollar borrowing by non-US entities are higher than $2trn. Outside of Turkey, there have already been instances where stress is developing; for example, the Argentinian peso has suffered large losses due to concerns over its government’s weak financing position, while the currencies of larger emerging market economies such as India have declined as contagion fears have weakened sentiment towards the emerging market region as a whole. Nevertheless, contagion has so far been limited by the fact that most of the emerging market economies have adequate foreign exchange reserves to service their debt, at least in the near term. Further consequences of this year’s dollar strength have included widening credit spreads and lower commodity prices, while international companies earning dollar revenues have benefitted and those with dollar costs have suffered.
Overall, the trends underpinning the dollar’s strength this year are unlikely to abate in the near term, but headwinds have also emerged that could limit further dollar strength. The acceleration in US growth should eventually have a positive impact around the world and the US-foreign growth differential could therefore narrow in the near term. Over the longer term, we expect the US economy to face cyclical headwinds before other countries, which would swing the relative growth differential further away from the US. Further, we do not believe that the Fed will become more aggressive in tightening its monetary stance in the absence of a sustained acceleration in inflation, but we also see scope for US policymakers to surprise to the dovish side if wage growth fails to move consistently higher, as it has repeatedly done in recent years.
The trend of increased trade protectionism is likely to persist for some time, but President Trump has already stated that he could put tariffs on all of the US’s imports from China and he appears to be more willing to soften his stance towards other countries. We note the recent announcement of a trade deal with Mexico and the potential for a deal with Canada to be signed shortly, which would essentially reinitiate a form of the North American Free Trade Agreement (NAFTA). As such, we also see only limited scope for protectionism to drive further dollar appreciation.
Meanwhile the US dollar faces the structural headwind of the US trade deficit, the fact that it appears expensive in terms of valuation measures such as purchasing power parity, and efforts to undermine its position as the global reserve currency.
Some of the factors which have driven the dollar’s strength are likely to persist, at least in the near term, including strong US growth and the threat of trade protectionism. However, these factors are largely priced into foreign exchange markets and we therefore do not expect the dollar to strengthen much further over the remainder of the year in the absence of a major shock event driving a broad episode of risk aversion. Conversely, we expect it to depreciate over the longer term as other major currencies develop tailwinds of their own and as the aforementioned dollar supports weaken.
Given this, the potential for further dollar strength-driven fallout is limited in our view. This expectation underpins our recent decision to move tactically overweight the emerging markets region, which has suffered a sharp correction this year. Nevertheless, we remain selective within the emerging markets and are extremely cautious of initiating any positions in Turkish assets, given that economic and political uncertainty is likely to remain elevated.
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