Dollar weakness is far from certain: pick your poison accordingly
As the Fed unwinds previous rate hikes, don’t count on the dollar to move much.
I continue to believe international equities and fixed income may offer good value and diversification.
However, I find it somewhat disconcerting that a certain meme is taking hold in the market: international assets are attractive because the dollar will weaken meaningfully.
Put aside the portfolio construction issue of mixing factors – that is, one should disaggregate foreign exchange (fx) and equity risk -- the meme has more serious problems.
While I too expect some dollar weakness, thinking that the dollar will weaken meaningfully and that will foster potentially higher returns in international markets may prove to be misplaced.
The more likely outcome, in my view, is modest dollar weakness at best and at worst, no dollar strength.
This is far from splitting hairs or an academic exercise; your view on the dollar has a meaningful impact on the risk reward profile of various international assets.
First on the dollar: The reason I disagree with the weaker dollar thesis is that it is built on one of three drivers, none of which will be proven correct:
a) The Fed rate cut is the beginning of a sustained easing cycle, which has always resulted in a weaker dollar.
As I stated in my previous note “Good or Bad: It is all in the framing”, this is a faulty read on the current situation. The Fed is unlikely to initiate a sustained easing cycle with numerous interest rate cuts. An easing cycle like that is typically only undertaken when the US is near or in recession, which looks unlikely right now. Instead, the next few rate cuts are more about the Fed taking back some of the misplaced policy tightenings of 2017-18. By the end of 2019, the US economy will likely be growing close to 2% trend rate and 10-year Treasury Yields is likely to be closer to 2.5%, rather than the current 2% rate. This is certainly not the scenario in which the Fed must ease on a sustained basis.
b) The dollar is a countercyclical current that will weaken as the rest of the world strengthens.
Nothing could be further from reality. In my view, the growth rates outside the US are likely to be meaningfully weaker than their trend rates. That is true in Europe, Japan and even in most of Emerging Markets (EM). The dollar can’t weaken much because there is no countercycle to be had. In all likelihood, it is the revival of the US economy and better policy momentum by other Central Banks that stabilizes international growth rates that are still quite low and below the potential trend rates.
c) Trump is on the verge of starting a currency war by intervening to weaken the dollar substantially.
This is confusing tweets for policy initiatives. While it is true that Trump has been talking about the Fed, lower rates and even dollar strength, what he truly wants is US growth, which he will get in the second half of 2019. The need to support growth with dollar intervention will subside over the next few quarters naturally. Further, in a counter intuitive way, if the US intervenes to weaken the dollar, the global financial flows and asset prices would have a tough time dealing with it, which in turn may lead to additional dollar strength rather than weakness. Currency speculators will have a field day in that environment.
The bottom-line then is relatively simple: the dollar is unlikely to strengthen much but don’t count on a meaningful weakness and adjust your international asset selection accordingly.
What are the best choices you ask?
EM local currency bonds is the top of my list: A lack of global inflation ensures that the trend in EM rates is lower. You don’t need dollar weakness to support those returns.
EM equities remain attractive due to significantly better valuation and stabilizing growth outlooks.
European government bonds remains the worst assets. Yes, they could appreciate if the European Central Bank (ECB) eases aggressively. But a lot of it is already priced in and like the Fed, the ECB may not have to intervene as aggressively, as the European growth outlook smooths out on the back of EM growth stabilization.
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The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
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