Growing up in New England, our sons had a privileged childhood as sports fans and particularly as football fans. Between 2001 and 2020, the New England Patriots, coached by Bill Belichick and with Tom Brady at quarterback, competed in nine super bowls and won six of them - a truly extraordinary performance in a league of 32 teams. It is all the more impressive because of the NFL’s efforts to make the league competitive. These include the salary cap, which forces all teams to spend roughly the same on their rosters, and the draft, which awards the top picks to the worst teams from the year before.
And yet the dynasty continued for almost two decades, with the Patriots winning many games that they should have lost due to their own confidence and their opponents doubts. And the supposedly eroding effects of low draft picks seemed to have little impact on the team, as relatively unknown players found a way to win.
And then, finally, it all came to end. Tom Brady moved on to Tampa Bay, a dearth of star receivers hamstrung the offence and, new quarterbacks, lacking Brady’s confidence, now found ways to lose games they should have won. A team that we had come to believe would always win has now had a losing season in three of the last four years.
In a similar way, many investors have come to believe that the U.S. dollar will always remain at a level that seems overvalued based on fundamentals. But it is only prudent to consider what might happen if this dollar strength turned to weakness.
The Week Ahead
Before examining this, however, let’s take a look on the economic data and events that could move markets in the week ahead:
Numbers due out this week include retail sales and inventories on Monday, and housing starts industrial production on Tuesday. These reports, combined with other numbers on housing and manufacturing, should fill some of the gaps on estimates of economic activity in the first quarter. Overall, it appears that first-quarter real GDP grew by between 1% and 3% annualized, representing only a modest slowdown from the 3.1% year-over-year pace seen over the course of 2023.
The first quarter earnings season will get into full swing this week with 39 S&P500 companies set to report. Corporate profits appear to have been solid with analysts expecting a 3.2% year-over-year gain in pro-forma earnings.
Meanwhile, last week’s CPI data was a little hotter than expected and this, combined with still very solid economic momentum, has undermined hopes for three rate cuts this year, starting in June. Futures markets are now pricing in just a 20% shot of a June rate cut and only a 68% shot of two rate cuts this year.
We continue to expect inflation to drift down slowly in an environment of solid gains in both economic activity and corporate profits. While this does suggest a healthy economy overall, it is not particularly good news for the bond market. It also is having the impact of further delaying a long overdue decline in the dollar.
This is important for investors, since a key catalyst in achieving better returns on international equities and international assets in general would be a resumption of the dollar decline. This being the case, it is worth reviewing the recent behavior of the dollar and why its decline has stalled out, how the strong dollar is impacting the economic environment, when the dollar decline could resume and, finally, what all of this means for investors.
The Long Dollar Rise
One easy way to see the broad trend in the exchange rate is to look at the U.S. dollar index or DXY, which is weighted index of the dollar’s value against the currencies of six major trading partners, namely, the euro, the Japanese yen, the British pound, the Canadian dollar, the Swiss franc and the Swedish krona.
The DXY increased very steadily from the spring of 2008, at the onset of the Great Financial Crisis, to the fall of 2022, in the aftermath of Russia’s invasion of Ukraine, rising by 60% in 14 1/2 years.
Part of this climb can be ascribed to impressive U.S. economic performance. Despite a battering from the Great Financial Crisis, the U.S. economy saw uninterrupted economic growth between June 2009 and February 2020, marking the longest economic expansion in American history. Moreover, while economic growth turned sharply negative in the pandemic, the recovery in the U.S. was remarkably strong. Corporate profit margins also rose over this period, encouraging foreign purchases of U.S. equities, while U.S. interest rates, although generally low, remained higher than in developed countries overseas.
However, the dollar’s strength could equally be ascribed to the weakness of our trading partners. In the DXY, the euro, the British pound and the Japanese yen have a combined weight of over 83%. In the aftermath of the Global Financial Crisis, Japan continued to languish in a near-deflation economy, the euro fell as a result of the European Debt Crisis and Britain abandoned its most important trading block. In addition to this, the US dollar, despite a pretty reckless fiscal policy, has always been seen as a safe-haven currency in times of crisis. Thus, the Great Financial Crisis, the tariff war, the Pandemic Recession and the Ukraine war were all seen as reasons for investors to hide in U.S. dollars.
The Impact of a Strong Dollar
The rising dollar has had some positive effects over the years in restraining inflation and encouraging inflows into U.S. financial assets, thereby boosting wealth and reducing financing costs for American corporations and the federal government.
However, it has had seriously negative consequences also.
First, the United States has now run a current account trade deficit for 32 straight years, as a yawning trade deficit in goods has dominated a surplus in services. In 2023, the current account deficit amounted to $818 billion or 3.0% of GDP.
On the surface, this seems like just an accounting entry. However, it reflects two very negative impacts of a too-high dollar.
First, the high dollar has decimated the manufacturing base of the U.S. economy. In 1991, the last year in which the U.S. ran a trade surplus, there were more than 17 million manufacturing workers in the United States, representing over 15% of total employment. Today that is down to less than 14 million or just over 8% of employment. This reduction in manufacturing jobs has eaten away at a key pathway by which Americans without a college degree could achieve a middle-class life style.
Second, it has increased our foreign obligations. At the end of 2023, foreign holdings of U.S. assets exceeded U.S. holdings of foreign assets by $19.8 trillion, up from $16.2 trillion just a year earlier. While some of this is foreign holdings of U.S. Treasuries, the biggest part is foreign holdings of U.S. equities. Over time this means that a large chunk of the profits and interest payments of U.S. corporations will be diverted overseas rather than funding consumption and investment in the U.S.
The Outlook for the Dollar
So where does the dollar go from here?
After peaking in September 2022, the dollar index fell by 11% in less than six months. This reflected the perception that the Fed was likely to wind down its monetary tightening, even as the ECB and Bank of England continued to tighten in the face of inflation and the Bank of Japan finally ended negative interest rates. It was also fed by a view that the U.S. economy was likely to slow and could very well enter recession in 2023.
As it turned out, the U.S. economy actually accelerated throughout 2023, postponing any Fed pivot, while growth languished and inflation fell in Europe and the UK. Meanwhile, although Japan has finally abandoned negative interest rates, its monetary tightening has been extremely cautious so far, leading to a further decline in the yen.
As a result of this, the dollar decline has stalled out, with the DXY now almost 5% higher than it was in February 2023.
Given current trends, it is hard to predict a near-term resumption of the dollar decline. However, over the next year, the U.S. economy should see slower growth and the Federal Reserve should reduce interest rates. Meanwhile, the Eurozone should see some pickup in consumption and fiscal spending while the Bank of Japan should get more serious about normalizing policy.
This could allow the dollar decline to resume, boosting the return on international investments. However, for U.S. investors, investing overseas in non-dollar denominated assets has as much to do with reducing risk as boosting returns.
U.S. equities trade at much higher P/E ratios than their counterparts in Europe or Japan and the gap is much more than can be explained by industry mix alone. While the U.S. economy is still growing, it is not invulnerable, and high and growing public debt, combined with political polarization are a threat to the U.S. economy, U.S. assets and the U.S. dollar.
For our own family as fans, the end of the Patriots dynasty has forced us to diversify into other sports and, I hesitate to admit, is some cases support the teams of other cities. For investors, who have long basked in the warm glow of the dollar dynasty, it also makes sense to diversify. In short, while the near-term outlook for the U.S. remains favorable, there are increasing reasons not to put all your financial eggs in a dollar-denominated basket.