Geopolitics and disparate global monetary policy have made for a muddy start to 2014, but at least one thing is clear- the US dollar is packing a powerful punch, reaching multi year highs and clinching its 11thconsecutive week of positive returns against a broad basket of currencies last week.
A currency’s performance is always relative, and the dollar’s position in currency markets today is reflective not only of broad- based softness in the rest of the world but also of a strengthening domestic picture. Invariably, dollar appreciation is an affirmation that the US economic recovery is on solid ground, and the currency should continue to benefit from the US’s expected relative growth outperformance versus peers.
Looking forward, relatively higher domestic interest rates vs. other developed markets will tend to attract capital seeking a higher return. The challenges confronting foreign markets are unlikely to be resolved quickly, creating a structural context for dollar strength. The European Central Bank (ECB), still embroiled in asset purchase programs, has been forced to move to negative deposit rates and in Japan, growth arrested by limited export recovery and sluggish improvement in real wages has kept policy highly accommodative. In fact, the International Monetary Fund’s (IMF) latest report shows that central banks are already strategically diversifying away from euro holdings, net reducing positions to the tune of $40 billion in the second quarter of 2014, while USD denominated reserves remained relatively constant. In emerging markets, weaker than expected net exports in the first half of 2014 sends a clear sign that a US- confined recovery is not enough to prevent the continued erosion of the EM growth “premium” relative to developed markets. China, everyone’s favorite EM bellwether, is presently relying on targeted stimulus to defend growth levels and relaxed mortgage lending to help prop up a cooling property sector. History also tells us that, for this country in particular, maintaining a relatively weak currency is at the core of engineering desirable growth.
Growth and interest rate dynamics aside, the dollar enjoys another advantage – it remains foremost the global reserve currency. Liquid dollar assets have been the primary purchase of choice, for example, for many EM countries adding to reserves (now for the 6th straight month). Punished severely for current account deficits during the 2013 “taper tantrum”, these countries have rebuilt reserves in part as an insurance policy in the face of rising funding costs, and in part to keep their domestic currency rates in check and exports supported.
How long can the dollar “gun show” last? From a valuation standpoint, the dollar still looks undervalued relative to many developed market peers on a purchasing power parity basis. Further, while in the recent past, periods of positive US growth have been stilted by headwinds like the fiscal cliff and euro sovereign crisis, the positive growth trend in the US seems more sustainable this time, and therefore supportive of USD outperformance over the medium term. In addition to supportive growth and interest rate dynamics, capital flow dynamics are improving. Outflows, historically a major impediment to USD strength, are slowing and may even reverse as net purchases of US equities by foreigners pick up. At the same time, historically high trade deficits thought to threaten the US’s position as a global financial leader, continue to narrow in large part as net oil imports continue to fall and oil self- sufficiency becomes a real possibility.
Broader investment implications of this stronger dollar environment will be largely dependent on the magnitude of the dollar’s move. Should the currency’s ascent remain gradual, potential beneficiaries will likely be currencies with strong links to US growth, and manufacturing countries whose export prices would look more attractive at the margin (Mexican Peso, Korean Won), while those with structural vulnerabilities or links to commodity markets like the Russian ruble, and currencies like the Euro and Yen, fall out as favored funding candidates.
We believe we are potentially part way through a sustained period of USD outperformance