The consequences of a weak dollar
An article by Max Holzer
Head Relative Return
The US currency is trading at virtually the same level now as it was some three years ago when Trump emerged victorious in the November 2016 election. That cannot be to Trump's liking. While in office, the vocal advocate of a weaker greenback has failed in his attempts to drive down the value of his country's currency. And that's despite him launching broadsides against the Federal Reserve, its chair Jerome Powell and his predecessor Janet Yellen, and making ceaseless calls for rate cuts.
Trump's ideal scenario: interest rates at zero
So far, the US President, who would love to see US key interest rates at zero per cent or in negative territory, has failed to set the Fed on an ultra-expansionary course. Indeed the central bank has instead sought to assert its independence. However, there are several indications that suggest the dollar will depreciate against the euro, not least the greater tolerance of inflation on the part of the Fed, which appears willing to accept a brief overshooting of its inflation target. The positioning in the capital markets and the rising budget deficit also point towards a period of sustained weakness for the greenback. All this is feeding into the prediction by Union Investment's experts that the euro will rise to US$ 1.18 by the end of next year.
Investors will no doubt be asking themselves what this might mean for the capital markets. And the answer is a number of different things. This is because, even despite Trump's efforts to dial back globalisation, the US dollar is, and will remain, the world's leading currency. It is the most important reserve currency, it dominates the capital markets and it shapes the flow of goods.
The Dollar dominates
Three reasons why the greenback is so powerful
As the currency of the biggest economy in the world, the US dollar underpins the world's real economy. This means that any rise or fall in its value can influence the flow of goods in a way that no other currency can match. This in turn impacts on companies' profitability, the business prospects of entire industries and even the solvency of individual countries.
Virtually all internationally traded commodities are priced in US dollars. Every purchase and sale of metal, foodstuffs and energy is therefore partly affected by the value of the US currency – and these trades themselves can affect the dollar exchange rate.
The dollar area is one of (if not the) biggest investment region anywhere on the planet. The numbers speak for themselves: A quarter of all bonds issued worldwide are denominated in US dollars (in concrete terms, that's nearly 106,000 out of a total of around 420,000). Roughly half of the world's total market capitalisation in equities is traded via US stock exchanges. If you want to do business on these exchanges, there's no getting away from the greenback.
A weak dollar would impact on the individual asset classes in very different ways. Commodities, for example, are traded in US dollars, so a weaker greenback would generally be supportive of commodity prices, particularly if the demand was driven by industry.
This is the case for oil. Investors from other currency regions are able to position themselves more attractively in a weak-dollar market, relatively speaking, and this lifts the price of crude. So a weak greenback would be good news for the oil price. But the global economy looks set to deliver slower rates of growth for the foreseeable future, which would reduce demand and act as a brake on the price. The price of gold, on the other hand, is heavily influenced by investor demand and real interest rates. This has been clearly reflected in the sharp price rises seen over recent months. But as demand from investors appears to be sated for now, it's quite possible that this trend has already come to an end.
How the US dollar drives the markets
Good news for emerging markets
We also believe that the outlook for bonds from the emerging markets over the next twelve months is favourable overall. The currency effect for international investors is waning, which means the high current returns being delivered in the local currency sector are becoming more important. It also helps that there have been at least some signs of rapprochement in the US-China trade dispute of late. We expect the market for emerging market bonds denominated in local currency to have returned a little over 8 per cent by the end of 2020. However, caution is advised in the selection of individual paper. The news from Chile and Argentina has recently offered a stark reminder that careful analysis of the political risks is just as important as an evaluation of a country's ability to service its debt.
Equities, meanwhile, will be pulled in both directions. For US corporates, the faltering dollar is, on the face of it, a plus. A weak currency at home is particularly helpful for companies that generate a lot of their revenue outside the US. Depreciation of the dollar gives them an advantage over rivals that use a comparatively stronger currency. US firms are thus able to consolidate their market position and drive out unwanted competition. And this is precisely why a weak dollar holds such appeal for President Trump.
Tough times for the DAX
For European stocks, the consequences of a weak greenback would be the exact opposite of what has just been described. European companies can no longer expect to become ever more competitive simply because the euro is weak relative to the US dollar. Far from it, in fact. In the sectors where European firms are coming up against US rivals, the exchange rate is now playing into the hands of the US companies. This is particularly true of companies from export-driven economies such as Germany, and has generally curbed the upside potential of the DAX this year.
In summary, the further the world's leading currency falls, the more massive the implications will be for the capital markets. In the equity markets, the balance of power between the US and Europe is being reconfigured. For the emerging markets, one of the downside factors of recent years is now out of the picture. And commodities are getting cheaper for anyone whose primary currency is not the dollar.
Unless otherwise noted, all information and illustrations are as at 05 November 2019