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[Contribution] What happens when the US Dollar weakens?

Manpreet Gill (Standard Chartered Bank)
Manpreet Gill (Standard Chartered Bank)

The Korea Herald is running a regular contribution series written by senior investment strategists at Standard Chartered Group Wealth Management. -- Ed.

The US dollar has started to decline in value over the past few months, with the benchmark US dollar Index down about 9 percent since its March 2020 peak. This naturally raises questions on whether this US dollar weakness can extend, and whether this has broader implications for investors.

We are of the view that there is room for the dollar to weaken further from here. This has significant implications for currency markets, of course, but we believe that weakness in the world’s dominant currency is likely to have a broader impact on equity and bond markets.

Dollar weakness to extend

Our bearish dollar view is based on key fundamental and technical drivers which, we believe, have started to weigh against the US currency. For one, interest rate differentials are no longer supportive for the US dollar. In fact, they arguably started moving against the currency well over a year ago. Since then, the Fed’s efforts to boost global dollar liquidity has likely raised supply to the point where it is no longer a constraint against a fall in the dollar’s value.

Secondly, there are increasing signs of the global economy gradually recovering from the immediate shock caused by the COVID-19-related lockdowns. A recovering global economy has historically led to a weaker dollar as its safe-haven status fades.

Thirdly, there is now an increasingly attractive alternative to the dollar as a global reserve currency -- namely the euro, thanks to the efforts of euro area policymakers to overcome their differences and agree on a combined, regionwide fiscal policy to revive growth in the world’s second-largest economic entity. This fundamental picture appears consistent with the signal from technical indicators, which also argue the US dollar is breaking lower.

Lessons from history

What happens when the dollar weakens? Historical data indicates periods of dollar weakness (of more than 5 percent) have been positive for risk assets on a 12-month horizon. Our analysis shows:

• Absolute returns from equities, corporate bonds, emerging market bonds and gold have been strong.

• Equities outperformed bonds in relative terms.

• Within equities, emerging markets and euro area led gains, in US dollar terms.

• In bonds, high yield and emerging market local currency bonds outperformed, though government bonds still outperformed a number of other bond asset classes.

• The euro and Japanese yen delivered strong returns, though they underperformed emerging market foreign exchange.

Are we set up for a repeat of this historical experience? Broadly, we believe the answer is yes on a 6-12 month horizon. We continue to expect corporate and emerging market bonds and equities to outperform cash and government bonds, led by the ongoing economic recovery, significant policy stimulus and low bond yields. While new US stimulus will be important, the agreement among euro area members on a combined European fiscal stimulus is arguably the most significant event over the past month. We believe it is a key step toward a more unified fiscal policy which could help revive long-term euro area and global growth potential.

Having said that, we do expect a few key differences with the historical record today.

First, we are slightly less bullish on broader emerging market assets than the historical experience would suggest, given today’s COVID-19 and related growth challenges are much greater for most emerging markets. In our assessment, Asia ex-Japan equities and emerging market US dollar government bonds are the two emerging market assets that offer the best risk/reward trade-off in today’s environment.

Second, within equities, we continue to expect US equities to outperform given the strength of policy stimulus and the expected earnings recovery. 

Third, within bonds, we are less confident about continued government bond outperformance. Falling bond yields in the post-2008 environment led to their good performance, but this becomes harder to repeat as bond yields fall closer to 0 percent.

Summer volatility

This constructive 12-month view notwithstanding, on shorter horizons of three months or less, we remain on watch for an equity market pullback (ie. a rise in equity volatility). From a seasonality point of view, equity volatility has tended to rise in August.

This is particularly important at a time when US-China relations appear to be deteriorating ahead of the US Presidential election in November. Meanwhile, new daily COVID-19 infections are unlikely to peak without a drug or vaccine, which still appears at least a few months away. Finally, our proprietary market diversity indicator is starting to look stretched for select bond and foreign exchange markets (though not yet for equities).

Taking advantage of volatility

In our assessment, any pullback is likely to be temporary and relatively contained in size. Given our constructive medium-term view, this means we would consider using any such pullback to add exposure to our preferred asset classes. Our historical analysis of market returns during dollar weakness is consistent with recent economic and market performance -- they both continue to support our positive 6-12 month view on developed market corporate high yield, emerging market and Asia US dollar bonds, a preference for US, Asia ex-Japan and euro area within equities and, more broadly, multi-asset income strategies.

Gold remains an attractive asset class in this context as an extended economic recovery means inflation expectations are likely to rise, placing further downside pressure on “real” (ie. net-of-inflation) bond yields, which is positive for gold.

By Manpreet Gill

Manpreet Gill is Head of Fixed Income, Currency & Commodities Strategy at Standard Chartered Private Bank. The views reflected in the article are his own. -- Ed.