Will the US dollar remain as the world’s dominant and, by some measures, the most expensive currency?
In an increasingly charged geopolitical world, this question has become more and more part of the financial market discussion following several years of sizeable dollar strength. Speculation about a possible ‘Plaza Accord’-style agreement to weaken the dollar has added fuel to the fire.
Dollar’s dominance vs. Dollar’s value
We believe one way to answer these questions is to separate the structural dominance of the US dollar from the question about valuation, which is a more cyclical question.
The dollar continues to be the most dominant currency from both a trade and store-of-reserve perspective. While the dollar’s share has admittedly reduced in recent decades on both fronts, data from the Bank for International Settlements (BIS) shows the greenback’s share in payment for global trade remains significant, as does its share as a global central bank currency reserve.
To an extent, this is not surprising.
We have written before about how few other currencies offer the breadth and depth of investment opportunities as the dollar. Investors are attracted to the dollar to make riskier investments targeting higher returns (such as in equities and high yielding bonds) or park their money in relatively stable, high-quality assets (such as government bonds) to preserve capital.
Together with the free movement of capital offered by the US, these factors make the dollar the dominant currency in payments for trade and as a vehicle to hold reserves. We believe this dominance is unlikely to end soon.
This does not mean, however, that the dollar’s value will not go through cycles. This is where more significant movement over a multi-year horizon looks more plausible.
The chart above from the Bank for International Settlements illustrates one approach to dollar valuations. It shows the dollar is now increasingly expensive on this measure – almost as expensive as during its 1985 peak and significantly more expensive than its 2002 peak.
Currency valuations, by themselves, can tell us little about the 12-month outlook. On a multi-year horizon, though, it does suggest the dollar is more likely to moderate than continue moving towards ever higher valuations. Similar moderations in value were observed in the second-half of the 1980s and the 2000s.
A softer dollar is likely to help President Trump’s efforts to cut the US’ large trade deficit. In theory, a more moderately valued dollar would help rebalance the country’s trade balance by making imports more expensive and exports more competitive.
The internationally orchestrated devaluation of the dollar through the 1985 Plaza Accords followed a similar train of thought. Of course, at that time, the US mainly negotiated with a geopolitical ally, Japan to boost the value of the yen against the Dollar.
It is also plausible to argue that a shift in relative interest rate outlooks could lead to dollar moderation. This would typically play out via lower net-of-inflation yields in the US and higher yields elsewhere.
Does this all matter for investors?
Against this backdrop, many investors feel the need to ‘do something’. However, some context may help ensure any action (or lack thereof) is deliberate.
The most important takeaway for investment portfolios is that the ultimate currency exposure of your investment matters. For example, investing in the S&P500 index of US stocks means that you are already significantly exposed to non-US markets, given that about 40% of the underlying revenue exposure of the index companies is sourced from outside the US.
This creates a natural hedge. Similarly, many bonds may be denominated in dollars, but the underlying income could depend on non-USD sources (such as emerging market bonds).
Getting, and staying, invested in a diversified portfolio can often be one of the best mitigants against unexpected currency market volatility. This is something we can act on today.
One asset class that tends to have a more direct relationship with the dollar is Emerging Markets (EM). EM assets (equities, but also bonds and cash) have historically tended to do well when the dollar weakens, and vice versa.
Today, we favour a greater tilt towards US assets, given relatively strong US economic and earnings growth and trade and geopolitical uncertainty clouding the outlook of the rest of the world. However, in a scenario where the dollar weakens on a multi-year basis, EM assets are likely to do well.
That said, we are not there yet.
