The U.S. dollar (USD) has been on a downtrend since March. The USD index has lost 9% since March and its depreciation has been particularly rapid against European currencies. Many investors are asking whether this is the start of a multi-year trend and what they should do?
We believe the USD has been on a downtrend for several reasons. Its valuation has been high in recent years. The U.S. economy is also running a sizable trade deficit and going through a sharp surge in fiscal deficit. These structural factors are typically negative for a currency. However, despite these structural issues, the USD has been able to stay strong until now.
There are some new factors that remove the support for a bullish USD. U.S. economic outperformance relative to the eurozone and Japan is no longer guaranteed given the damage from the COVID-19 pandemic. The European Union’s (EU) EUR 750billion recovery fund is also giving investors more confidence that there is greater unity within the EU to overcome economic crises.
As a result of narrowing of economic performance, USD interest rates are also converging to other developed economies’ interest rates. The 10-year U.S. Treasury yield fell from 1.9% at the start of 2020 to 0.55%. The Federal Reserve (Fed) is committed to the current monetary policy, both in policy rates and asset purchases, until the economy makes a decisive turnaround. The narrowing of interest rate spreads means the USD is less appealing and investors would look to make deposits in other currencies.
Finally, the USD has historically been a safe haven currency. In the past years, the U.S.-China trade tension and the pandemic have prompted bouts of risk aversion. More upbeat risk sentiment has helped to push the dollar weaker.
In the longer run, the USD is still vulnerable to depreciation since it is difficult to see the Fed unwind its loose monetary policy much earlier than other developed market central banks. Investors would also pay attention to the potential for the U.S. economy to grow after the pandemic and also after the presidential election. How Washington handles its fiscal debt will be closely monitored as well, since the USD is also the most important reserve currency and the sustainability of its fiscal position could potentially impact investor confidence in the long run.
Yet, in the near term, the USD could go through some consolidation since there are growing worries of another wave of infections in Europe and Asia. Investors’ risk appetite could weaken once more.
Exhibit 1: Asia ex-japan equities: performance drivers
Source: FactSet, MSCI, J.P. Morgan Asset Management; (Left) J.P. Morgan Economic Research; (Top right) MSCI; (Bottom right) U.S. Federal Reserve.
AxJ = Asia ex-Japan; DM = Developed markets. *REER is the real effective exchange rate. Past performance is not a reliable indicator of current and future results.
Guide to the Markets – Asia. Data reflect most recently available as of 30/06/20.
Investment implications
The USD depreciation is an important factor in driving asset class performance, but not the only factor. Hence, investors should not be timing their allocation purely on the strength or weakness of the greenback.
A weak USD typically is good for risk assets, given this usually happens when risk appetite is strong and the global economy is in expansion. This is a particularly positive environment for emerging market and Asian assets, both in fixed income and equities. A weak USD helps to reduce currency risks when investing in emerging markets and Asia. Their central banks can also focus on delivering growth instead of keeping interest rates high to defend their currencies.
As the bottom right chart above shows, periods of USD weakness typically coincides with Asian equities outperformance relative to developed markets. While strong Asian currencies may undermine exporters’ profit margin, this should be offset by stronger demand globally. Moreover, a stronger currency would help to reduce imported costs and potentially benefit companies serving domestic demand with imported components. In addition to the outlook of the USD, Asian equities’ valuations, as measured by price-to-book ratio, are in line with long-term average and consistent with constructive 12-month forward return.
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