A Contrarian View on the Dollar

The parabolic rally in the US dollar that kicked off last summer has been arguably the most important trend for investors over the past year. In currency markets, there seems to be a nearly insatiable demand for US dollars

In currency markets, there seems to be a nearly insatiable demand for US dollars. Many investors believe dollar-euro parity is a foregone conclusion, while the yen is languishing at multiyear lows against the world’s foremost reserve currency. The dollar’s strength has knock-on effects in financial markets and economies across the globe, but creates particular headaches for US investors in foreign assets. When the US dollar strengthens against its currency rivals, it has a negative impact on international stocks and bonds that are converted back to dollars.

figure 1: EURO-US DOLLAR EXCHANGE RATE

Source: Bloomberg, data 03/31/2014 to 03/31/2015

There is overwhelming bullish sentiment on the dollar amid expectations the US economy is strong enough for the Federal Reserve (Fed) to finally take off the training wheels and begin to lift rates. This at a time when other central banks such as the European Central Bank and Bank of Japan are rolling out fresh Quantitative Easing (QE) programs.
According to the consensus, the sky’s the limit for the dollar. Yet, as is my habit in these Uncommon Sense columns, I wonder if the conventional wisdom is wrong and how investors could be impacted if that’s indeed the case. If the dollar’s strength pauses or even reverses, it would give some much-needed relief to US investors in international stocks.

TRONG DOLLAR SLAMS FOREIGN STOCK INVESTORS

More US investors are buying international stocks than ever before, and I would argue that’s a good thing as they shed their “home-country bias” and include more of the global equity opportunity set in diversified portfolios. After all, international equities comprise more than 50% of the world’s equity market capitalization. But up until the last few years, they often represented a tiny portion of equity assets held by US investors.
Investors have discovered the diversification benefits, access to higher economic growth rates, sensible relative valuations and greater dividend income that international stocks can potentially offer. Not surprisingly, as the demand for international stocks has grown, the choices available to investors have increased considerably.
Amid this broader movement to international stocks, packaged strategies that hedge out the movement of foreign currencies have exploded in popularity recently, particularly currency-hedged exchange-traded funds (ETFs). These hot-selling ETFs seek to protect against a rising US dollar hurting local-currency investment gains by using currency forward contracts, which are rolled monthly.
Just how hot are currency-hedged ETFs? One out of every three new dollars invested in US-listed ETFs in the first quarter went to currency-hedged ETFs as the category hauled in more than $20 billion of inflows. According to ETF.com, four of the 10 most popular ETFs in the first quarter were currency-hedged.

It seems that currency-hedged ETFs have been go-to vehicles for playing the QE themes in Japan and Europe, where central banks are pursuing aggressive stimulus programs that may bolster risk assets in their respective countries. However, equity investors are looking for some protection as these policies could continue to put downward pressure on the euro and the yen at a time when the Fed is expected to begin to raise interest rates later this year.

figure 2 – MARKET VALUE OF US HOLDINGS OF FOREIGN SECURITIES

Source: US Department of the Treasury

BIGGEST RALLY SINCE BRETTON WOODS
The inflows of currency-hedged ETFs is indicative of investor bullishness on the dollar. Divergent monetary policies, interest rate differentials and growth trajectories among the world’s leading economies have led many investors to conclude that the US dollar has begun a multiyear uptrend. This has become a popular investment theme in 2015. Aksia’s hedge fund manager survey revealed that 86% of managers polled expect the US dollar to be the top performing currency in 2015, as shown in Figure 2.
This broad-based faith in dollar strength is supported by promising US economic growth, higher yields relative to our main trading partners, external balances that are in reasonably good shape, cheap currency valuation on a real effective exchange rate basis and deliberate currency devaluations in the rest of the world. As a result, foreign flows into US financial assets hit a record last year while traders’ speculative long positions in the US dollar reached new all-time highs.
How extreme has this move in the dollar been? The US dollar has appreciated on a trade-weighted basis faster in the past eight months than during any similar period since the end of Bretton Woods, the fixed exchange rate regime that held sway over global currency markets from 1945 through 1971.

WHY THE DOLLAR RALLY MAY TAKE A BREATHER
I believe predicting currency fluctuations is a fool’s errand, but we do see incredibly lopsided sentiment on the US dollar after its strong run. When everyone is expecting something to happen, the consensus is often wrong. So, is now a good time to begin hedging on hedging? The US dollar index is up 23% from its 2011 low, which, interestingly, coincided with the Standard & Poor’s rating downgrade of US credit. Can this US dollar strength endure, as it did in the 1980s and 1990s?
The two big late-20th century upward moves in the dollar came in times of robust US economic growth and relatively tight monetary policy. Neither condition exists today. Estimates for first quarter Gross Domestic Product (GDP) were significantly reduced due to severe winter weather in the Northeast, port shutdowns amid dockworker strikes on the West Coast, and mixed economic data. A weak March jobs report combined with benign inflation and lackluster wage growth has many a market pundit calling for the Fed to remain lower for longer.

figure 3: HEDGE FUNDS HOT ON THE DOLLAR WHAT WILL BE THE TOP PERFORMING CURRENCY OF 2015?

Source: Aksia Hedge Fund Survey 2015

The dollar has climbed consistently higher since 2011, and I am now skeptical of the widely held view that it will appreciate significantly from current levels. The recent, strong run-up in the currency’s value is a cyclical phenomenon, not a secular upturn, and as it starts to play itself out I am concerned some investors may get caught chasing performance.
It’s important to remember that currency hedging can taketh away as well as giveth. If you’re in a currency-hedged ETF and the dollar starts moving in the other direction against that particular currency, that could actually start eating into returns. While I am more inclined to believe the current USD/EUR trajectory could continue, I see some other final innings looming up a bit faster. For example, the State Street Global Advisors currency team recently came out with a strong non-consensus long-term bullish call on the yen. Depending on your time frame, moves to capitalize on Abenomics, QE and improving Japanese economic data may be better left unhedged.
The US economy can withstand the removal of emergency monetary policy at this point. However, the uncharacteristic divergence between jobs growth and inflation expectations complicates the way forward. The global macro environment today is overwhelmed with deflationary trends. As a result, US monetary policy is unlikely to tighten at a similar pace as it did during the last two cyclical bull markets in the dollar. If inflationary expectations decelerate, or in the event of any negative economic growth surprises, the Fed will be forced to adopt a more relaxed attitude toward policy normalization than is even currently anticipated by the markets. This would likely keep the US dollar well-anchored.
Meanwhile, QE in Europe and Japan combined with some potential economic tailwinds could bolster positions in international small cap stocks, dividend growers, cyclicals, real estate investment trusts (REITs) and credit. These are exactly the types of investments that performed well post-QE in the US. Currency-hedged—or not—they may offer investors further opportunity to diversify outside the US.

Michael Arone, CFA – Chief Investment Strategist – State Street Global Advisors