In Brief

• US growth outperformance requires a nuanced interpretation for the US dollar.
  
  
• We continue to favour pro-cyclical currencies, typically of commodity producing economies, for their beta to strong global growth and also due to selected strong idiosyncratic domestic stories.
  
  
• We favour both the US dollar and the euro as funding currencies, while seeking to add value through actively managing the mix.
  
  

Growth and rates

Over the past few quarters our forecast that widening trade deficits would weigh on the US dollar has broadly been correct. The prospects for trade-related flows look set to remain a challenge for the dollar. By contrast, the growth outlook for the US economy is bright.

Further expansion of fiscal support combined with highly accommodative financial conditions is boosting growth forecasts for the US, well in excess of other developed economies (Exhibit 1). The US has also been among the global leaders in vaccinating its population, in sharp contrast to the efforts in much of Europe and the generally slower approach taken across Asia, where control of the virus has been a greater focus.

Exhibit 1: US and Eurozone relative growth forecasts

Source: J.P. Morgan Asset Management, Bloomberg; data as of 5 February 2021.

In more normal times, US growth forecasts exceeding 5% would see fixed income markets rapidly repricing expectations for interest rate rises. Yet, with significant slack in the labour market still present and the Federal Reserve happy to let the economy run hot to make up for past misses to the downside on inflation, the prospects for significant yield support for the dollar remain remote and real yields remain exceptionally low.

Equity flows

Equity flows could provide the dollar with support from the strong growth outlook, as the appetite for investors to buy into cheaper global stocks may finally recede after years of disappointment. However, the US market already represents a higher share of the MSCI World index than ever before, having risen slightly above the peak reached during the dot-com bubble in 1999 (Exhibit 2).

Therefore, the scope for US equity allocations to increase further may be limited. Nevertheless, equity flows represent the key risk to a bearish dollar outlook, so this is an area we are watching with interest, particularly as it is increasingly possible to track flows in real time.

Exhibit 2: MSCI US index share of msci world

Source: J.P. Morgan Asset Management, Bloomberg; data as of February 2021.

Trade flows

Over the last year we have placed a greater weight on real economy trade flows as a driver of currencies due to the prevalence of zero or negative interest rates in the developed economies, which are supressing unhedged fixed income flows. The prior decade of dollar strength was characterised by US outperformance relative to the rest of the world, both in terms of growth and asset price performance, with a stable overall trade position and improving narrow basic balance.

In the 2010s, the rapid growth in US energy production offset the typical feedback loop, where strong growth boosts imports and eventually causes currency strength to fade. The US is certainly in a better position than it was in the early 2000s, when a reflationary environment of rising resource prices exacerbated the current account deficit (Exhibit 3).

However, given the uncertainty around the investment environment under a Biden administration that is focused on climate change, and following a year when very low energy prices depressed investment in new capacity, we do not see the volume gains in US energy production being repeated. Therefore, the impact of boosting consumption through large fiscal deficits is likely to continue to draw in imports and keep US dollar currency fundamentals weak.

Exhibit 3: US trade balance, energy and non energy

Source: J.P. Morgan Asset Management, Bloomberg; data as of 31 December 2020.

Cyclical bias

We continue to favour exposure to the more pro-cyclical currencies of commodity producing countries. The reflationary environment and sustained high levels of infrastructure investment in China are supporting commodity prices, while there is a historical tendency for these currencies to appreciate when global growth is strong and improving. In the developed market commodity currencies we can find strong and improving domestic fundamentals, such as for the Australian dollar, while among the emerging market universe we see few signs of unhealthy imbalances and many improving domestic stories, such as the Chilean Peso and Mexican peso.

Strategically, we believe a balanced mix of funding in euros and dollars is likely to deliver the best risk-adjusted returns over the next few quarters, with the euro held back by the headwinds of negative policy rates and relatively less favourable Covid-19 infection and vaccination dynamics. An active approach to rebalancing the funding mix can enhance returns, while the offsetting positives and negatives for Europe and the US are likely to keep the euro reasonably rangebound against the dollar.

Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.

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