How to play the stronger dollar [Quarterly Perspectives] - J.P. Morgan Asset Management

How to play the stronger dollar [Quarterly Perspectives]

Contributor Global Markets Insights Strategy Team

Some recent developments in global markets could be temporary, but there is widespread consensus that a stronger US dollar is here to stay. Traditionally, emerging markets (EM) have not responded well to a rising greenback. However, these are not normal times for global markets or for US monetary policy. It is worth considering whether the lessons of the past will hold true today, and what a stronger dollar will mean for investments.

Why is the dollar rising?

There are three key reasons for the dollar rise:

  • Divergent economic performance: the US economy looks to have grown at a healthy rate of 3% in the second half of 2014 and is particularly strong when compared to the loss in economic momentum in the eurozone, Japan and China in 2014.
  • Expected monetary policy divergence in 2015: the US Federal Reserve is expected to raise interest rates, unlike either the European Central Bank or the Bank of Japan who are pursuing expansionary monetary policies.
  • Reduced US borrowing from the rest of the world: America’s current account deficit has fallen sharply in recent years, largely as a result of its growing energy independence. Barely a third of the energy that the US consumed last year was imported, down from 60% in 2005.

What does it mean for investors?

Historically, EM equity prices have had a strong negative correlation with the dollar. This is because a rising dollar has tended to go along with lower commodity prices and capital outflows from emerging economies. There is also the currency translation effect that lowers the dollar value of EM earnings.

This time around things may be different. The last period of strengthening of the US dollar ended in 2002. Since then, some emerging economies have reduced their exposure to commodities and increased their exposure to manufacturing industries. Economies with strong links to the US consumer could stand to benefit from stronger US growth.

In developed markets, a rising US dollar has often been a boon as it puts downward pressure on interest rates and inflation in the US, helping to prolong the upside of the economic cycle. The potential for further weakening in the euro should be a major tailwind for European earnings, particularly when coupled with the falling oil price.

Investment Implications

  • The dollar will likely continue to strengthen in 2015, benefiting European and US investors.
  • A strong dollar, weak commodity prices and higher US rates pose risks to EM assets.
  • However, many developing economies have stronger fundamentals than in past periods of dollar strength.
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