Why the dollar is sitting at the heart of allocation decisions
Henna Hemnani, assistant fund manager for the Miton’s multi-asset fund range, looks at the effect of a strong US dollar and what that means for global asset prices
In recent weeks we’ve seen a reversal in some year-long currency trends. Since mid-April the US dollar has been strong, sterling weak, and many emerging market currencies falling too. What does it mean for key global asset prices if these new trends persist?
We generally try and interpret any currency moves with caution, as history has shown that they’re extremely difficult to value. However, the US dollar is correlated to multiple asset classes, including emerging markets and commodities, so in many ways sits at the heart of asset allocation decisions. It’s therefore important for us to consider the wider implications should the US dollar continue to strengthen.
Generally speaking, a strong US dollar leads to tighter financial conditions in many parts of the world and is considered a headwind to global economic growth. Emerging markets, for example, have a material amount of their debt denominated in US dollars, so as the dollar rises the cost of their debt also rises. This inverse relationship between emerging markets and the dollar can be seen in the chart below, which shows recent dollar strength favouring developed markets over emerging markets.
The correlation between the US dollar and the relative performance of DM vs EM equities
Source: Bloomberg, 08/05/2017 – 09/05/2018
That said, we’re of the view that emerging markets aren’t a homogenous group, and that some countries have become less sensitive to global factors with foreign debt generally lower and more flexible exchange rates able to act as a shock absorber. We are directly invested and have no benchmark so can be very precise in our emerging markets exposure, avoiding regions most at risk, like Argentina.
Taking a closer look at what we own, the Hong Kong equities have their currency pegged to the US dollar, while India’s domestically driven growth story means it is fairly uncorrelated to the dollar. Our Latin American equities and emerging market bonds are most vulnerable here, particularly with their currencies selling off too, but these are only small positions that we’ve scaled this way to limit currency risk. Importantly, our exposure here is liquid. We have been trimming these positions and if this trend continues we will take a pragmatic approach and potentially have zero exposure here again.
Historically, oil, gold and other commodities have also had a negative correlation to the US dollar. As the US dollar rises, commodities become more expensive in other currencies, and demand falls. It’s interesting that despite the recent rally in the US dollar, capital continues to flow into oil. This suggests that the primary driver of oil has shifted, to geopolitics, or perhaps that market participants don’t expect the US dollar rally to persist. Either way, with a broadly positive macro backdrop we’re comfortable with our energy exposure at present.
Sterling has also traded in huge range over the past few weeks, dropping quite sharply as it approached the pre-Brexit level. If this trend continues it could trigger a dramatic asset allocation shift towards the UK. Despite ongoing political and economic uncertainty, the UK market is biased towards overseas earners and is therefore a big beneficiary of a weaker currency. The opportunity becomes even more attractive when you consider how much the UK has lagged global equity markets since June 2016. We have been fairly light in the UK for some time now but we have been building this position up again more recently.
We take a risk management approach to currencies, not return-seeking. This doesn’t just involve hedging first order effects, but it’s important to consider the wider implications of the primary trends, especially for instrumental currencies like the US dollar.
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