How to invest for renewed dollar strength
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Just as many more people were starting to talk about the impact of the US dollar’s sharp appreciation, the currency reversed course and weakened by almost 5 per cent. While it has been relatively rangebound since then, the prospect of renewed dollar strength now confronts investors with a basic question: should they bet on its beneficial influence on global rebalancing or guard against financial breakage?
Two factors drove the dollar’s earlier surge: superior US economic performance, in absolute terms and relative to many other countries; and the prospects of tighter monetary policy.
Buying dollars became not just the consensus trade in financial markets but also a particularly crowded one that inevitably became vulnerable to a sharp technical pull back. The catalyst came in the form of a bout of weaker US data that culminated in a disappointing March jobs report, along with a more dovish-sounding Federal Reserve.
Having gone through a period of technical consolidation, the dollar now seems set for a new phase of strengthening. As noted last week by New York Fed President Bill Dudley, the patch of weaker data is likely to be a transient one. While it might have pushed back the first interest rate rise, it has not materially changed policy prospects. It is likely the Fed will move in September and embark on what Mr Dudley describes as a relatively shallow path of rate rises over time.
Advocates of global rebalancing would view dollar appreciation as helping European and Japanese economies struggling with sluggish economies and the threat of price deflation. It would also benefit emerging countries that have stumbled in re-orienting their growth engines away from dependence on external markets.
Yet this path to a better global economy is far from assured. US companies’ revenues would be undermined by lower dollar proceeds and more intense foreign competition. Meanwhile, having fallen short of “lift off”, the US economy remains too delicate to tolerate a much larger transfer of growth impetus to foreigners. Then there are the historical precedents of a strong dollar breaking things elsewhere.
In the past, the major systemic risks emanated from overexposed sovereigns with excessive dollar-denominated debt, large currency mismatches, and/or fixed exchange rate regimes. While these issues are not totally absent today — and Switzerland’s dramatic exit in January from its partial euro peg is a reminder — it is the corporate sector that poses the biggest risk.
Renewed dollar strengthening would damp US corporate profits, undermining equity markets that are over-reliant on central bank support and the redeployment of idle cash into share buybacks, dividends and mergers and acquisitions. Vulnerability would also come from companies in emerging countries that have gone on a borrowing binge that has left them exposed to currency and debt maturity mismatches.
Fortunately, in many of these cases, the first line of defence would come from the sovereign balance sheets. As such, big global contagion risks would be limited to just a few particularly vulnerable spots in the emerging world.
The implications of all this for investors are clear. In positioning for renewed dollar strength, it may be best to resist the temptation of big trades. A superior approach would be to maintain larger cash balances while also exploiting relative price movements and highly differentiated positioning within asset classes.
That means combining exposures that favour the dollar versus other major currencies (particularly the euro) with hedged European versus US equities positioning and, on the government bond side, US bonds versus German Bunds.
The emerging market segment of portfolios would be repositioned in favour of countries with high international reserves and limited dollar-denominated debt. This would all come with selective private market investments.
For those retail investors unable to pursue such positioning, their focus would be on accumulating larger cash cushions, providing them with the ability to exploit the high likelihood of market-wide overshoots. After all, we should never forget the growing phenomenon of limited liquidity provision during periods of greater market volatility. And volatility is what awaits markets.
Mohamed El-Erian is chief economic adviser to Allianz and chair of President Obama’s Global Development Council