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.
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.