Time to Be Vigilant About the Dollar

One week into the new year, it looks like a wider range of outcomes may be in store for the global economy and markets.

As I stated in our annual outlook for 2017, we still expect the current business cycle to continue, but the tails are getting fatter. In other words, while the base case is for growth to continue and global asset markets to continue to do well, the probability that the base case is not realized is higher than in previous years.

Why Our Base Case Is at Higher Risk than Before

This view isn’t just a matter of being the proverbial “two-handed economist” who can’t muster enough conviction about either scenario; it’s that there are indeed probable scenarios that could lead the global economy and asset markets away from our base case.

My lower conviction about our base case this year has nothing to do with severe but low-probability outcomes, such as an economic blow-up in China or a break-up of the European Union. Rather, the primary reasons for my lower conviction are more mundane and include the: 

1. potential for more aggressive interest rate hikes by the U.S. Federal Reserve (the Fed) than currently anticipated;
2. potential for conflicts in global trade; and
3. strength of the dollar.

There isn’t a whole lot of analysis to be done with the first two issues, as they are dependent on data or political developments that are tough to handicap accurately at the moment. We will just have to watch things develop and react to them throughout the year. Besides, in my judgment, these issues are more likely to surface during the second half of 2017.

However, the strength of the dollar is a bigger and more immediate concern.

All Eyes on the U.S. Dollar

Since the financial crisis of 2008, a strong dollar has usually been a harbinger of immediately forthcoming weakness in the U.S. and global economies. Why has this happened? A strong dollar has led to higher capital inflows than the U.S. economy could absorb because of slow credit growth.

However, as I noted in a previous blog, “Welcome to the world of persistent dollar strength,” in this go-around in 2017, it is quite probable that a strong dollar will not take down the U.S. economy. For this to happen, U.S. credit growth has to increase to absorb those incoming flows. The relevant question, then, is: which part of the U.S. economy will contribute to that growth in credit, especially in an environment of interest rates potentially climbing higher?

The household sector could generate slightly higher credit growth due to high consumer confidence, which would lead to re-leveraging. Yet higher mortgage rates will virtually ensure that any incremental credit growth, if such growth were to even occur, would be very modest.

Similarly, the corporate sector could generate slightly higher credit growth rates. However, since credit growth rate in the corporate sector has been quite high to begin with, the likelihood that the corporate sector will be carrying the “credit-growth baton” at this point in the cycle is quite small.

So, it comes down to the government sector. For the strength of the dollar to not affect the U.S. economy negatively, the U.S. federal deficit has to widen meaningfully and sustainably. On the basis of what we’ve been hearing from the incoming Trump administration, there is reason to be hopeful on this front.

With that said, as the new administration and Congress coalesce and put forward their legislative agenda, the markets would need to see a reasonably quick and well-defined timeline for the increased fiscal stimulus and deficit time line. Any significant delay, backloading or backsliding on that front will be an ominous development.

So yes, the dollar’s strength may not end up being the equalizer of global growth in this go-around if the Trump administration is quick to widen the fiscal deficit. It is vigilance—rather than complacency—that is warranted on this front.

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DISCLOSURE:

These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.