Dollar Playbooks

There is surely very little dust to brush off the playbook which tells us what to do when the US dollar rises. With the US economy and its central bankers looking more ready for further interest rate rises than had only recently been suspected, it must be time to start selling commodities and emerging market assets again. As the dollar resumes its rise, the cost of US imported goods will fall too – the prospect of which is perhaps helping to stay the hand of those who have done so well out of the long end of the US Treasury curve over the last few years, even as inflationary pressures more convincingly return.

There is no need for commodities and the dollar to have a strong relationship. Although commodities are indeed invoiced in dollars (leading many to assume that if the US dollar rises, demand for commodities should fall) producers, speculators and consumers are perfectly capable of looking through this. There are certainly still countries with significant dollar denominated borrowings, such as Brazil, South Africa and Turkey, where the resumption of an uptrend in the Greenback will widen already existing mismatches between domestic income and foreign liabilities. For emerging markets in aggregate and Asia in particular, such fears are likely overdone. China, for one, has very little in the way of external borrowings and is moving increasingly towards a more market-directed exchange rate regime in any case.

For the relative underperformance of emerging market equities seen since 2010 - falling emerging market corporate return on equity, amidst softer external demand from the Chinese economy and an extended rout in commodity markets likely have little directly to do with the coincident surge in the US dollar. We keep an open mind with regards to what a rising dollar means for our asset allocation.                           

More generally, currencies can be a dangerous medium through which to try and understand the world economy and its capital markets – cause and effect become easily muddled. More often than not though, economic activity and risk appetite drive the moves in relative interest rates and currencies rather than the other way around. Of course, that is not to say that strong movements in currencies cannot have lasting and important effects, just that such moves are less easy to accurately diagnose and therefore act upon than commonly perceived. Our suspicion should also always be aroused by theories that manage to explain too much, alluring though such theories may be in a world awash with data, news flow and overconfident talking heads. As we regularly point out, the world is much messier and often less sophisticated than the theories and models that we financial professionals try to inflict on it. 

Right now emerging market equities look inexpensive and unloved. The last 10 years have seen the analyst community move from indiscriminate cheerleaders to equally indiscriminate critics, as so often seems to happen. We would not be mechanically deterred from adopting a more positive tactical posture by the behaviour of the US dollar, but will likely be waiting for corporate earnings to more visibly turn a corner. The recent bounce in commodity markets will likely be helpful here, but not necessarily instrumental.

For the dollar, we would argue that the potential for a repeat of the dramatic ascent, as seen in 2014/15, is lessened by the fact that we start from less obviously inexpensive levels. Alongside this, the gap between the US economy and the rest of the world has narrowed with Europe looking better set, China temporarily less precarious and commodity prices at levels that both consumers and producers can more or less live with. This may mean that the Federal Reserve may not be as alone in moving to a more normal monetary setting for as long as previously thought.