Can the US dollar keep smiling? - Remaining front and centre

Having gained the status as the world’s premier reserve currency following the Bretton Woods Agreement in 1944, the US dollar remains the most prominent global currency today. According to the International Monetary Fund (IMF), the dollar makes up 59% of all central bank foreign exchange reserves, with the euro lagging behind in second place at 21%. In addition, almost 40% of all global debt is issued in US dollars, while it accounts for 40% of all global SWIFT (Society for Worldwide International Financial Telecommunications) payments.

The dollar also plays a significant role for global investors. An investment in a diversified global equity index like the MSCI World, due to the size of the United States (U.S.) equity market, means that over 60% of your investment’s exposure will be in U.S companies. By investing in any global financial asset, an investor becomes subject to two separate sources of return – the return of the underlying asset and the return of the asset’s base currency relative to the investor’s base currency.

In the short-term, currency fluctuations can have a significant impact on investment returns – adding to the underlying asset’s returns in some years, while reducing returns in other years. However, in the longer-term, the impact from currency fluctuations become less significant as the growth of equity returns outpaces currency fluctuations (see Figure 1).

Figure 1: Impact of currency fluctuations on global equity returns

A justified smile

In 2021 and during the first half of 2022 the US dollar has reigned supreme, increasing by 6.9% and -7.8% versus the euro, and -1.0% and -10.0% versus sterling. The dollar reached its highest level in 20 years in May versus a basket of currencies of its main trading partners. The moves, although extreme, appear to have been largely justified to us. At one side of the dollar’s smile, it tends to benefit in an environment where US interest rates, or expectations for future interest rates, move ahead of its peers. This has been particularly notable in comparison to Europe and Japan where a divergence in monetary policy has developed.

Figure 2: A deteriorating global economic growth outlook

Although the divergence in monetary policy has likely peaked as central banks like the European Central Bank (ECB) begin to play catch up, the US dollar continues to be propped up at the other side of its smile. It has a tendency to outperform when global economic growth is deteriorating, which has been the case since the second half of 2021 (see figure 2). Despite the fact that the US growth outlook has not been immune to the global slowdown, the dollar has displayed a greater level of resilience than the more cyclical currencies such as the euro and sterling in this environment.

What to expect from here

With supportive drivers remaining broadly in place, a sharp fall from grace for the world’s reserve currency is not anticipated. At the same time, the dollar has had a particularly strong run and is expensive on a number of valuation metrics. In a scenario where global economic growth receives a boost from China re-emerging from a COVID-19 induced lockdown and tensions between Russia and Ukraine dissipate later this year, the dollar’s broad smile might be reduced to a grin.

The extent to which currencies such as the euro and sterling can stage a recovery versus the dollar is up for debate. A key question for the euro currency will be the ECB’s ability to implement the anticipated number of interest rate increases. The futures market is currently pricing in a deposit rate of +1.3% by June 2023.

The ECB has an unenviable task of deciding how to act, faced with record high inflation driven predominantly by energy costs, at a time when its economic outlook remains uncertain. They also need dexterity to set an appropriate interest rate for nineteen separate countries, while keeping a close eye on government bond spreads of the more vulnerable ones. Despite the challenges, the euro is likely to receive a boost when European interest rates move out of negative territory for the first time since 2014.

At the time of writing, the Bank of England also find itself in a precarious position. The context of interest rate hikes is important for currencies – raising rates against a backdrop of a sharply slowing economy is likely to limit the support provided to sterling. Monetary Policy Committee members are opting for a gradual approach to higher rates. In the market, short positions have been growing against sterling as an increasing number of investors bet against the pound. With sterling down 10% versus the dollar this year, some degree of the negative backdrop has already been priced in.

Davy’s approach

At Davy, we invest in a global universe of financial assets through our discretionary managed portfolios, so currency fluctuations play a part in determining the returns achieved for our clients. Given the volatile nature of currencies and the difficulty in forecasting short-term moves, we generally refrain from implementing tactical views on currencies in portfolios, in the knowledge that over the long-term the impact of currency fluctuations reduces in significance. Having said that, given the current elevated levels of the US dollar, we are mindful of adding additional US dollar exposure in discretionary managed portfolios at this time.