Reading the dollar and risk assetsContributor John Bilton
Three central considerations drive asset markets – growth, liquidity and tail risk
At the start of January we said the path of the dollar would be the defining influence on asset allocation in 2016.
We thought stretched valuation, after a blistering three-year dollar rally, and a gradual closing of the growth differential between the US and the rest of the world would leave the US currency with only modest upside, effectively mitigating what has been a headwind for sentiment and providing relief to companies that have borrowed in USD.
Although we see scope for a more virtuous end to the dollar strength cycle playing out later in 2016, the recent reversal in the dollar – one of the sharpest drops in 20 years – is more concerning. It is worrying because the weakness is not a symptom of growth broadening out from America to the rest of the world, but instead of pockets of economic stress around the world starting to affect the US.
Exactly how worried should we be? Though US and European equities rallied in recent days, US stocks and credit markets have been trading as if the US economy is holed below the water line. While we echo the near-term caution, it is too soon to conclude that the economy is heading for a contraction. Nevertheless, the path of the dollar will again be critical as the level of US growth is likely insufficient to reassure asset markets in the near term.
Growth, liquidity and tail risk
Three central considerations tend to drive asset markets – growth, liquidity and tail risk. Taking the first of our primary considerations – growth – it’s fair to say that recent US data are underwhelming. Nevertheless, the all-important labor market remains resilient. The domestic consumer and housing account for 70% of the US economy and while manufacturing and external sectors are weak, these alone are unlikely to shunt the US economy into recession.
We think US rates will slowly normalize but only as economic data and financial conditions allow. Reinforcement of the very gradual and data-dependent path of US policy would in turn reduce upside risk to the dollar in the near term.
This brings us to the second consideration – liquidity. The Fed is acutely aware that despite its domestic mandate, it is de facto the world’s central bank. Not surprisingly, the liftoff from zero interest rate policy has led to a tightening of global financial conditions, coincidentally compounded by the slump in commodity prices and shift in Chinese policy. Collapsing energy prices had a direct impact on financial conditions via wider credit spreads and weaker earnings.
Despite the Fed’s faith in the US economy, the tightening of global financial conditions could force it into a more accommodative stance than some board members would prefer. While tighter financial conditions may imply a scramble for dollars and other “safe” assets, the consequent delay to Fed policy has an offsetting impact.
Finally, and inevitably, a sluggish path of growth and poor liquidity places greater emphasis on tail risks, which markets are struggling to calibrate. The net result is an upward marking of risk premia, and a downward marking of growth expectations. As such, we see limited scope for a sharp or extended rebound in stocks in the near term, but rather a nervous period of consolidation.
However, there are two more encouraging conclusions: first, the US economy is relatively isolated from global risks – growth may be low, but so too is recession risk. Secondly, the Fed remains data dependent and as such rate hikes are likely to be delayed, in turn taking some of the steam out of the dollar.
Look for the US currency to act as a sort of balancing mechanism in the meantime. Both the US and the global economies would struggle to absorb another year of significant dollar strength, but stabilization will ultimately take some of the pressure off.
With sentiment damaged, valuations fair, and growth lackluster we would not bet on stocks seeing meaningful upside momentum just yet. But without the headwind of excessive dollar strength, there may well be a more positive backdrop for the world economy as the year progresses.
Past performance is no guarantee of future results.