Why Investors Should Keep an Eye on the Dollar

Looking through the recent election-induced stock market volatility, investors should instead focus on fundamentals

Nordea 7 November, 2016 | 3:02PM
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Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Witold Bahrke, senior strategist at Nordea Asset Management, explains how the value of the dollar can impact a wide variety of assets. 

Political risks are on the forefront of investors’ minds this week as we face up to the US election. But these short-term concerns tend to distract from the underlying fundamental problems. Looking through the recent election-induced stock market volatility, investors should consider what might derail markets from a more fundamental perspective.

Either commodities weaken or the US dollar must weaken

In our view, the renewed US dollar strength could be one such risk. It could turn out to be one of the key risk factor for markets as we approach year end, especially since some of the better performing parts of the markets seem out of sync relative to the dollar strength. A Clinton victory will not reduce these risks in a meaningful way.

A Weak Dollar and Strong QE

When the US dollar began to weaken last year, it laid the groundwork for a strong performance in equity markets in the first half of 2016, as a weaker dollar means looser financial conditions to support risk assets. Since May however, we have seen renewed US dollar strength, fuelled by a rising probability of a Federal Reserve interest rate hike in December.

Before election nervousness crept into markets last week, the dollar was up 7% since the lows in May. Now, we see two key risks that have the potential to disrupt markets: weaker commodity prices and the resurfacing of China currency risks. Both factors are side effects of a stronger dollar.

A Strong Dollar and Weak Commodity Prices

Firstly, a strong dollar normally means weaker commodities, as most commodities are denominated in dollars. Therefore, a strong dollar makes them more expensive, weakening overall demand. But so far, commodity prices have done quite well since the summer – with oil prices weakening only recently.

The strength in commodities over the recent months has contributed to what some people call a ‘regime shift’ in equities, with cyclical sectors starting to outperform. However, we think the combination of a strong dollar and strong commodities is unsustainable – something has to give in a meaningful way: either commodities weaken or the US dollar must weaken.

The US dollar tends to lead the commodity market, indicating that there are considerable downside risks to commodities caused by the dollar strength we already have seen. Going forward, these downside risks are unlikely to fade in any meaningful way, rather the opposite. Either, because the Fed will hike or because a renewed weakening of the economy will create growth scares, ultimately supporting the US dollar through its safe-haven merits.

On balance, there is a high probability commodities will weaken further from here. This would reverse the so called regime shift tendencies we have seen since summer in the equity markets, where investors have been allocating away from defensive sectors towards more cyclical sectors. It would also put renewed pressure on the commodity producing part of the emerging market universe. In other words, a strong dollar is a latent threat to some of the most popular trades in the market.

A Strong Dollar and a Weak Renminbi

Secondly, the flip-side of the strong dollar has been a weaker Chinese currency, currently trading at the lowest level since 2010. This makes Chinese products cheaper. Still being the global manufacturing hub, this helps Chinese exports, but it also means higher deflationary pressures globally, which would put a lid on the current reflation debate and clearly pose a downside risk for risk assets and emerging markets in particular. Also, it increases the risk of capital outflows in China, contributing to rising financial risks as such.

The bottom line is that if the dollar continues to strengthen, we might see a lot of the risks that spooked markets in 2015 re-emerge, albeit in smaller scale, as the pace of the dollar strengthening is more muted so far. If dollar strengthening does not take a pause, a 2015 deja-vu has the potential to spoil any year-end party in financial markets.

What of the US Election?

The US election deserves to be mentioned in this context: both candidates advocate higher fiscal spending, leading to higher interest rates, contributing to a stronger dollar as well. To say the least, a strong dollar would make some incredibly popular trades much less popular. It might even keep the Fed from hiking in December, as a stronger US dollar means tighter financial conditions, basically doing the tightening job for the Fed. Keep an eye on the dollar elephant in the room.

The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Nordea  Nordea is a financial services group in the Nordic and Baltic region. Nordea offers online banking and insurance as well as information to investors. 

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