Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Felix Martin, an economist at Liontrust Asset Management discusses the threat of a strengthening dollar on investors’ portfolios.
The US – finally – is back. Strong growth, falling unemployment, rising confidence and a buoyant stock market all say so. The rest of the world, meanwhile, seems stuck in the doldrums.
Should this divergent dynamic concern investors? In principle, no: robust performance from the world’s largest economy should be unequivocal good news. In practice, however, the consequences of global de-synchronisation can be painful. The problem is the price of the dollar – because it is the currency not just of America, but of the world.
An increasingly healthy American economy implies that the era of cheap US currency is over. Interest rates will rise, and the dollar will continue to strengthen. And while increasingly expensive money might be just right for an accelerating US, it may be the last thing that the rest of the world needs.
History teaches that a reinvigorated US dollar exposes those whose balance sheets were built on the belief that cheap money would last forever. It acts like a depth charge, exploding deep below the surface of the ocean. First, the minnows float to the surface; then the bigger fish; and finally, one or two real whales.
The minnows have popped up already. Emerging market equities, bonds and currencies were quick to crack when the Fed first broached tightening back in mid-2013. The adjustment has been brutal, and perhaps a bit too indiscriminate. Many emerging markets are indeed net dollar debtors and so vulnerable to more expensive dollar financing – but some are net external creditors. With so many other asset classes yet to react, some of these more robust sovereign balance sheets - Russia springs to mind - now represent a rare pocket of value.
The bigger fish will be closer to the core of the US economy. High yield corporate bonds, for example, represent the part of the corporate sector most dependent on cheap debt. As such, they have rewarded investors handsomely over the past half-decade of ultra-low interest rates. Now, however, credit spreads are paper-thin; covenant quality is deteriorating; and liquidity is frighteningly low. In the course of the last three US downturns – 1987-1991, 1998-2001 and 2007-09 – US high yield corporate bonds saw price drops of 45%, 35% and 50%. Current valuations leave little room for error – and history suggests that losses in the event of a mistake may be painful.
What about the whales? They are the most difficult to spot, swimming as they do deepest below the surface – but to my mind three candidates stand out.
The first is the Asian dollar bloc. When the dollar was weak, it made much sense for the mercantilist economies of East Asia to track the dollar closely. But if the dollar continues to strengthen – and the Japanese yen, a major competitor, continues to weaken – the rationale for competitive devaluations may become irresistible. The most important member of this group, of course, is China – and the consequences of a policy-driven devaluation by the world’s second-largest economy would be profound.
A second potential whale is the pound sterling. At nearly 6% of GDP, the UK’s current account deficit has grown to alarming proportions. For now, this gigantic imbalance in our external payments is easily financed. But if the world’s reserve currency gets more expensive, that may change – and quickly. If history is any guide, a steep depreciation of sterling to reflect the new reality is likely to be the result.
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