The Great Divergence: Strong Dollar Vs. The World

The Great Divergence: Strong Dollar Vs. The World

U.S. dollar strength and trade demands continue to ripple through asset and currency markets, with the Turkish lira the latest casualty.

The strong economic momentum and slow tightening of monetary policy in the U.S. this year have yet to be matched by the world’s other major economies. That divergence of fortunes has pushed down relative valuations in many asset classes, with the impact felt most keenly in Europe and emerging markets.  The situation is further complicated by the persistent strength of the U.S. dollar since late spring.  

 

Understanding the Dichotomy

Jeff Schulze, Chief Strategist, ClearBridge Investments

Global economies are so interconnected today that it makes sense to examine fundamentals in regions outside the U.S. as part of how we assess the health of the domestic market and economy. In conjunction with our ongoing U.S. recession research, we have developed a dedicated international roadmap that provides a high-level look at some of the factors impacting major economic regions around the globe.

Source: S&P, Moody’s, MSCI and Bloomberg. Data as of June 30, 2018.  North America P/E and EPS growth based on S&P 500 data; all others based on respective MSCI Country/Region Indexes. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 

This snapshot reveals a dichotomy between the U.S. and most of the rest of the world in terms of economic momentum and central bank policy. The U.S. was the first major market to recover from the global financial crisis. It also remains ahead of other regions in moving from accommodative monetary policy meant to spur growth to a more neutral policy stance that has included three consecutive years of interest rate increases. Europe, Japan and the rest of developed Asia, meanwhile, have retained easy monetary policy to keep their recoveries on track or avert recession. These actions have supported stable economic growth in Europe Ex-UK and accelerating growth in Asia Ex-Japan. Emerging markets are also experiencing stable growth while the UK and Japan have work to do to reverse decelerating growth trends.

 

The dichotomy in growth has shown up clearly in the currency markets, where the dollar’s relative value leapt higher in May, maintaining its strength throughout the summer.
 

Perspective on the Dollar

Robert Abad, Product Specialist, Western Asset

A key question asked by many clients today - aside from where bond yields are headed - is where we think the US dollar is headed. This is an important question as the returns of any fixed-income portfolio with developed or emerging markets (EMs) currency exposure will be inextricably linked to the gyrations of the world's major reserve currency. The Trump Administration's recent rhetoric advocates for a strong US dollar policy, but this has only served to further muddle the currency's outlook because it contrasts with the same Trump Administration's protectionist tilt, which  - at least historically - does not support the US dollar.

Periods of Fed tightening do not necessarily augur US dollar strength: While conventional wisdom suggests that Fed tightening cycles should strongly correlate with a strengthening US dollar, the actual record is mixed. For example, since December 2015, the US dollar has depreciated 4.5% while the Fed has hiked rates 125 basis points (bps). The same dynamic occurred during the 2004-2006 period when the US dollar depreciated 7% while the Fed hiked rates 425 bps. We believe investors need to be mindful that current Fed tightening is not happening in a vacuum, but rather against a backdrop of expected future short-term rates across the UK, Canada and the eurozone.

US fiscal policy is supportive of growth prospects, but its longer-term impact is uncertain: We expect the Tax Cuts and Jobs Act-which improves US corporate competitiveness relative to the rest of the world-combined with a recently approved increase in spending caps, to put positive upward pressure on GDP growth, which should be US dollar supportive. However, because the tax bill includes front-loaded timing gimmicks, we expect most of the growth benefits will occur in the first few years, possibly adding only 0.25% to 0.50% each year to GDP, then fade out.

Sharp, protectionist rhetoric muddles the near-term picture for the US dollar: Ernest Hemingway once wrote: "The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists." The Trump Administration's recent announcement of indiscriminate steel and aluminum tariffs, along with its aggressive posturing toward countries such as China, raises the odds of a global trade war and only serves to further cloud the US outlook in the eyes of the world. While textbook economics says that tariffs by themselves should work to strengthen the home currency, it is important to consider what the retaliation by the US' major trading partners might be. For instance, during the last episode of steel tariffs that occurred under the George W. Bush Administration in 2002, the US dollar declined versus other major currencies as the European Union imposed retaliatory tariffs and the World Trade Organization ruled the US steel tariffs were a violation of international trade rules. In instances such as these, policies that are perceived by the market to be US dollar negative could generate a self-reinforcing dynamic whereby reduced foreign investor demand for USD-denominated assets results in downward pressure on the currency.

 

While the dollar has surged in general, the impact has been heightened relative to China's currency, the renminbi, which has seen its value diminish by more than 6% since early May.
 

Global monetary policy

Tracy Chen, Portfolio Manager, Structured Credit, Brandywine Global

The ongoing uncertainty with respect to trade, technology competition, and the strategic rivalry between the U.S. and China has become the new normal. It is unavoidable due to the rise of China and its vastly different social system. The perception that the trade conflict can be easily resolved is probably naïve. One thing is certain: there are ebbs and flows with varying intensities. 

The big question for investors is the future direction of renminbi and China rates. The Federal Reserve (Fed) hiked rates in June, whereas the People’s Bank of China (PBoC) did not follow suit as it appears to be concerned with exogenous shocks from an incipient trade war. As the chart below shows, the narrowing gap between China onshore rates versus U.S. rates exerts downward pressure on the renminbi versus the dollar.

China’s renminbi has been strengthening against both the dollar and the basket of currencies (CFETS) since 2017 and reversed starting in April 2018 due to the acceleration of dollar strength as a result of China’s reserve requirement ratio (RRR) cut. The renminbi’s next move could depend on the dollar; if the dollar strengthens from here, the renminbi’s rally against the basket of currencies could decelerate. If the dollar weakens from here, the renminbi would have the luxury of moderate weakening to ease monetary conditions.

China’s foreign reserves declined slightly recently. Given the uncertainty of external trade negotiations and burgeoning corporate defaults, China will ensure domestic stability and support growth through moderate easing of monetary conditions or fiscal support. Markets expect that more RRR cuts could be on the horizon to relieve a potential liquidity squeeze or a slowdown due to external pressure. This relatively easy policy should portend better performance of Chinese assets, including equities and onshore bonds.

 

Renminbi Valuations

As of 6/8/2018

Source: Brandywine Global, Haver Analytics. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is only for distribution in those countries and to those recipients listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK & Switzerland) this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London, EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorised and regulated by the UK Financial Conduct Authority.

In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.

Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information Documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.