Disentangling the dollar outlook from US growth
- 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
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 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
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
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.
Since our first segregated currency overlay mandate funded in 1989, J.P. Morgan Currency Group has grown to manage a total of USD 420 billion (as of 30 September 2020) in bespoke currency strategies. Our clients include governments, pension funds, insurance clients and fund providers. Based in London, the team consists of 18 people dedicated exclusively to currency management with an average of over 15 years of investment experience.
We offer a range of hedging solutions for managing currency risk as well as a tailored optimal hedge ratio analysis:
- Passive currency hedging serves to reduce the currency volatility from underlying international assets. It is a simple, low cost solution designed to achieve the correct balance between minimising tracking error, effectively controlling transaction costs and efficiently managing cash flows.
- Dynamic “intelligent” currency hedging aims to reduce currency volatility from the underlying international assets and add longterm value over the strategic benchmark. A proprietary valuation framework is used to assess whether a currency looks cheap or expensive relative to the base currency and the hedging strategy is adjusted accordingly.
- Active “alpha” currency overlay offers passive currency hedging, if required, combined with an active investment process to deliver excess returns relative to the currency benchmark. Our approach is to build a global currency portfolio combining the output of fundamental models and incorporating the qualitative views of our strategy team.