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On the Horizon: Preparing for a Weaker Dollar Era

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By ROBERT M. DALY/Glenmede

Profound shifts in the macro economic, competitive and political environment are converging to create a potentially long-lasting period of weakness for the world’s reserve currency. While many analysts and investors have been debating the potential for a short-term crash of the U.S. dollar (USD), in our view investors should be considering how to prepare for the possibility of a long-term period of dollar weakness.

Recent Depreciation Highlights that Issues are Likely to Linger

After bouncing back from an early March low caused by COVID-19 concerns, the U.S. Dollar Index (DXY) has resumed its slide, dipping approximately ten percent from its mid-March peak and moving toward two-year lows. An analysis of the drivers for this decline shows a multitude of reasons for this trend, including macro conditions, monetary and fiscal policy, trading fundamentals and a structural shift in how the dollar works within the global investment framework. When examining the major U.S. dollar pairs[1], we see four key issues behind the shift in the dollar’s valuation:

Source: Bloomberg. Click chart to enlarge.

1. The 2008 Dollar Shortage no Longer Exists

A myriad of issues makes it hard to argue that the U.S. dollar shortage continues to be an issue, as detailed in a recent GaveKal research report (GaveKal Research: “The US Dollar Starts to Break Down” July 22, 2020). In 2008, the U.S. dollar was the world’s overarching currency, and the United States was one of the only major economies with positive interest rates. During that time, the U.S. current account deficit was between 4-6 percent of gross domestic product. Plus, foreign-domiciled U.S. dollar debt was a legitimate concern during the great recession. In contrast, today interest rates are hovering near the zero lower bound, the current account deficit is widening, and U.S. money supply (M2) is growing at 24.5 percent per year. Additionally, the U.S. Federal Reserve has also opened up swap lines with 14 other central banks. GaveKal Research: “The US Dollar Starts to Break Down” July 22, 2020).

Source: Bloomberg, Bank of Canada, Bank of England and European Central Bank. Click chart to enlarge. 

2. Competition Across the Globe 

A credible alternative to the U.S. dollar may be emerging as the European Union appears to be regaining strength, making it attractive to investors again. In a demonstration of solidarity that Alexander Hamilton would envy, EU members’ decision to jointly issue up to 750 billion euros for the EU’s historic stimulus plan signals reassuring unity for the euro. However, the real question will be whether the European experiment provides a lasting stable fiscal foundation. Overall, we believe the EU developments can change how reserve managers and asset allocators think about their options around the world.

Source: Bloomberg. Click chart to enlarge.

3. Interest Rate Divergence Between China and the United States

China is not monetizing the COVID-19 crisis, while the United States pursues a policy of debt monetization. This difference in monetary policy has the potential to create a stark divergence in long-term interest rates between the countries.

4. The Unpredictable U.S. Political Backdrop

A chaotic U.S. political environment is making a very uncertain construct for the dollar. A divided government, a seeming inability to effectively address the COVID-19 pandemic, tax implications from the stimulus packages, election-year political dynamics and heightened Sino-U.S. tensions are just some of the concerns complicating monetary policy.

In short, we are now in a period of ample liquidity provisioned by the major world’s central banks combined with an uncertain U.S. domestic situation. The investment environment has changed markedly and in ways that are likely to continue for quite some time. 

Broader Implications for Investors

Given these significant and potentially long-term shifts, investors have a number of potential considerations as they map their asset allocation and investing strategies:

1. Inflation Dynamics

The decline in real interest rates against nominal rates completely bounded by the U.S. Federal Reserve has caused U.S. breakevens to rise significantly. While this would suggest a deflationary environment, there is real concern that persistent debt build up coupled with a depreciation in the dollar could create a higher likelihood of inflation as we move into 2021. According to Goldman Sachs (Gold Views: In search of a new reserve currency), the United States’ expanded balance sheet and vast money creation could heighten fears about the value of the dollar. The outcome likely would then be higher inflation but at a surmountable level. We are do not currently projecting anything similar to a 1970s scenario.

2. Gold and Metals

Gold can be a very good hedge in portfolios specifically against inflation. We believe that with real interest rates at all-time lows, an appropriate allocation to gold, as well as other metals such as silver, could make sense for investors.

3. Emerging Markets

A weaker dollar is good for external global growth. We believe that the current dollar dynamic may be a predictor of better returns in emerging markets.

Thinking More Broadly for the Longer Term

The current dynamics may lead to a very different investment environment than we have seen recently. Monetary trends today are supportive to treasury inflation-protected securities, metals such as gold and silver, and emerging markets. Going forward, investors may need to consider a more global construct, looking well beyond the U.S. domestic focus that has dominated the past decade.

While we think about the dollar’s decline and the inflationary scenario that the market is worried about, we don’t perceive these as fundamentally problematic at this time. Real interest rates are the narrative. The driver pushing risk assets is the continued low interest real rate environment. As real interest rates continue to drop, and the dollar declines, risk assets persist as attractive opportunities.

Source: Bloomberg. Click chart to enlarge.

Glenmede Investment Management, LP, is an Associate Member of TEXPERS.The views expressed in this article are those of the author and not necessarily Glenmede Investment Management nor TEXPERS.

Sources:

[1] The major pairs are the four most heavily traded currency pairs in the forex market. The four major pairs are the EUR/USD, USD/JPY, GBP/USD, USD/CHF.

About the Author: 

Robert Daly is Director of Fixed Income for The Glenmede Trust Company, N.A. and Glenmede Investment Management LP. He is responsible for the management of over $4 billion of tax-exempt and taxable fixed income strategies for institutions, consultants and private clients. Daly works closely with a team of traders, portfolio managers, credit analysts and other professionals to broaden exposure to GIM’s fixed income suite. He also serves as a member of GTC’s Investment Policy Committee. 

Prior to joining Glenmede, Daly served as a Senior Portfolio Manager for U.S. and global fixed income strategies at BlackRock in New York. In this role, he was instrumental in establishing and managing a team responsible for asset allocation development, portfolio construction, risk budgeting and formulating investment process. Previously, Daly managed multi- sector and investment grade credit fixed income portfolios for institutional clients. 

Daly earned a Master of Business Administration degree in finance and accounting from Columbia University and his Bachelor of Arts degree in government from Dartmouth College.

BY STEFFEN REICHOLD, Stone Harbor Investment Partners

Sustainable investment assets globally reached $30.7 trillion at the start of 2018, an increase of nearly 35% in two years, according to the Global Sustainable Investment Alliance. And while the majority of these assets are invested in equity strategies, bond investors are actively participating in the growth of environmental, social and corporate governance, or ESG, investing through various approaches, including purchasing green, social and/or sustainable bonds, launching ESG funds, benchmarking against ESG indices, and embedding ESG factors into the overall investment framework. 

In our view, integration of ESG factors into the fixed income investment process is complementary with fundamental credit analysis and engagement activities with sovereign and corporate issuers. Importantly, active investor involvement can drive change and positively affect sovereign and corporate issuers by creating incentives for them to improve ESG performance and by supporting economic development through fixed income investments.

Of the primary ESG factors, governance is particularly important to bondholders due to the impact it can have on improving institutions and on the rule of law that supports economic development. From a bondholder’s view, the sovereign’s commitment to political stability and security, and the strength of the institutional framework that supports the financial sector are strong indicators for improving creditworthiness. Considerations that are particularly relevant with corporate issuers include management incentives to ensure that their actions do not disadvantage bondholders in favor of stockholders, the structure of the board of directors, and the nature of the shareholding structure, among other factors.

Social issues and environmental factors, while still relevant and important, are somewhat more narrowly applicable compared to the governance factor. For a bondholder, the ability to influence social issues (e.g., worker rights, fair pay and adequate living standards, etc.) is limited. However, where these social issues are inequitable, concerns about the stability of the country are raised, along with questions about the sovereign’s ability to service its debt. Environmental factors are crucial for sectors such as the extractive industries. Again, from a credit perspective, the ability to effectively manage environmental risks (e.g., lapses and accidents) is a key concern as the company’s approach could have significant economic implications for the company, thereby affecting its debt servicing capabilities, as well as causing potential fatalities.

Click graphic to enlarge.

Improvements in ESG scores, particularly as they apply to governance, are often connected to better returns as the market prices in the improved fundamental (and thus lower risk premium). Therefore, the incentives for both issuers and investors to take actions to positively impact ESG scores are clear: improved ESG factors tend to be associated with lower spreads and thus better returns, benefitting bondholders; and countries and corporations that experience improving ESG scores also tend to undergo economic development and reduce their borrowing costs.

Click graph to enlarge.

The increasing demand for fixed income ESG products have also led to the development of tools for investors. Morningstar introduced their Sustainability Rating, which measures how well the holdings in a portfolio are performing on ESG factors relative to a portfolio’s peer group. Fixed income ESG indices have also been developed to provide a comprehensive and efficient coverage of the investable universe. For the JP Morgan ESG index suite, weights are set by scalar as determined by ESG score. For fixed income asset managers, tools that aid in analysis of ESG factors and provide better transparency are critical in managing ESG strategies.

Click graphic to enlarge.

The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Stone Harbor Investment Partners nor TEXPERS, and are subject to revision over time.

About the Author:

BY NIKOLAJ SCHMIDT, T. Rowe Price

Volatility returned to markets in mid‑May after trade talks between the U.S. and China appeared to stall. If the current dispute between the two biggest contributors to global gross domestic product becomes a full‑scale trade war, it will adversely impact not just the U.S. and China, but the entire world economy. Trade wars do not produce any winners in the long term.

Tariffs directly affect economies in two main ways: first, because they function as simple taxes on goods and, second, because they cause uncertainty, which impacts household and corporate decision‑making. Let’s look at each of these in turn.

Tariffs as Taxes

Although taxes on goods increase the tax revenues of governments, they also lead to a misallocation of resources, which drives the overall economy into an inefficient equilibrium. In economics jargon, this is known as the “deadweight loss” of taxation. Because tariffs raise the price of consumption, the purchasing power of households is reduced and fewer goods are bought. At the same time, households and companies try to substitute away from the tariffed goods, thereby ending up consuming a basket of goods that has been distorted by the tax. This new basket of goods represents an inferior choice to the consumer.

When President Donald Trump tweets that the U.S. will win the tariff war, he assumes that U.S. households and companies will substitute toward a domestically produced basket of goods and that this will indirectly create new American jobs. I’m skeptical. 

Although taxes on goods increase tax revenues, they also lead to a misallocation of resources.

In my view, it is more likely that U.S. households and companies will shift their consumption to goods produced in Vietnam or Mexico rather than back to American‑produced goods and that U.S. jobs which have been outsourced to China will not be repatriated before the production process has become entirely automated. American‑produced goods would be a viable alternative if either the U.S. was the most cost‑efficient producer after China (which it is not) or if the U.S. harbored the production facilities required to produce electronic gizmos it currently imports from China. In an unsettled trade regime, U.S. companies are unlikely to build onshore production facilities to cater to this potential demand.

Tariff Uncertainty

The second way that tariffs reduce consumption is by creating uncertainty, which causes households to postpone consumption and companies to defer capital expenditures. The impact of uncertainty on an economy is akin to monetary tightening (which is clearly not part of President Trump’s agenda). As the U.S. and China are the two biggest economies in the world, any uncertainty created by a prolonged trade war between the two will affect the global economy. The few countries that might benefit are those, such as Vietnam and Mexico, that can deliver substitutes for tariffed Chinese goods in a cost‑efficient manner.

The impact of uncertainty on an economy is akin to monetary tightening.

Trade wars do not just hit consumption, they also impact inflation, central bank policies, and exchange rates. As tariffs function largely like consumption tax hikes they are likely to cause headline inflation to rise initially, but just like any other form of fiscal tightening, they will eventually cause growth to slow. This will lead to an increase in output gaps, which reduce core inflationary pressures. As U.S. households and consumers substitute away from goods produced in China, China is likely to respond by trying to export its excess capacity to the rest of the non‑U.S. world. This is how the disinflationary shock of tariffs is transmitted across the globe.

The impact of tariffs on central bank policies will differ by region. For a developed economy central bank, the monetary policy implications of tariffs are straightforward: Tariffs lead to slower growth and lower core inflation pressures, so the appropriate monetary policy response is dovish. In emerging markets, however, rising uncertainty is more likely to trigger capital outflows, putting downward pressure on growth and upward pressure on inflation. To keep capital onshore, emerging market central banks may be forced to respond with monetary tightening.

How tariffs affect exchange rates is a complex function of demand elasticities. Usually, the country whose output gap is most adversely affected by tariffs is likely to see its currency depreciate the most. In the current environment, this would mean that emerging market currencies would depreciate versus the U.S. dollar and the U.S. dollar would lose ground against other major currencies.

Given the negative overall impacts of tariffs, it is tempting to conclude that sanity will prevail and that the U.S. and China will step back from the brink and walk away from a situation that will only serve to harm the economies of both countries. However, President Trump seeks to be reelected next year and may decide that the political gains from an outright fight with China outweigh the political cost of slower economic growth. Indeed, support for populist parties across the world continues to grow on the back of rising inequality and concerns about the impact of globalization. Tariffs may not be a good idea economically, but it is politics, not economics, that wins elections. Consequently, we are unlikely to see the back of tariffs anytime soon.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of T. Rowe Price nor TEXPERS, and are subject to revision over time.

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