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MARKET
INSIGHTS
AUTHORS
Stephanie Flanders
Chief Market Strategist
for the UK & Europe
Alex Dryden
Market Analyst
Tai Hui
Chief Market Strategist Asia
Market Bulletin
Nove mber 11 , 2014
Should investors fear a rising dollar?
Some recent developments in global markets could be temporary, but there is a
widespread consensus that a stronger US dollar is here to stay. Emerging market (EM)
economies have traditionally had much to fear from a rising greenback, while for
developed countries it has often been a boon, helping to prolong the upside of the
economic cycle by putting downward pressure on interest rates and inflation in the US.
However, these are not normal times for world markets or for US monetary policy.
It is worth asking whether these past lessons of history are likely to hold true today,
and worth considering the implications of a stronger dollar for investors. There’s one
key conclusion: in currency markets, as in life, it’s not just what you do that matters, but
the way that you do it. Investors need not fear a further rise in the dollar if it occurs in
a fairly orderly manner, particularly if it keeps US monetary policy looser for longer.
But a more dramatic strengthening could pose more risks to investors in global markets.
Why is the dollar rising?
Currencies are notoriously hard to predict, but from an economic standpoint, it should
come as no surprise to see the dollar strengthen over the past two years. Several key
factors are pushing the currency up:
• Relative growth. After a 4.6% surge in real GDP in the 2Q14, the US economy appears
to have grown by a healthy 3% in 3Q14. This is particularly strong relative to
economic data from the eurozone, Japan and China, which have all seen a significant
loss of momentum during the course of 3Q14.
• Relative monetary policy and bond yields. As a result of this economic divergence, we
expect the Federal Reserve (Fed) to increase interest rates in 2015, unlike either the
European Central Bank (ECB) or the Bank of Japan. This suggests that both short- and
long-term interest rates will be higher in the US than in other places for some time to
come, resulting in greater inflows of investor capital and continuing support for a
stronger dollar.
• Rising US energy independence, as a result of shale energy production. In 2013, the US
imported just 6.6 million barrels of oil—or 35% of its total energy consumption. In
2005, some 60% of oil consumed was imported from overseas. This trend has had a
dramatic effect in shrinking America’s current account deficit which is likely to
continue for some time. In theory, a lower US current account deficit reduces the
global supply of dollars and raises the price.
INSIGHTS
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Market
There is clearly significant support for a strengthening dollar in
the coming months. However, it is important to keep the latest
gains in perspective. As shown by Exhibit 1, the size and length
of the latest moves are relatively small from a historical
perspective. It is not uncommon for a cycle of appreciation (or
depreciation) to last for several years and cause movements of
20—30% in the value of the US dollar. So, we have a while to go
before we can really talk about a new era of dollar strength.
EXHIBIT 1: THE RISE AND FALL OF THE US DOLLAR
US Dollar TWI
EXHIBIT 2:US GDP GROWTH VERSUS US DOLLAR INDEX:
THE US DOLLAR SMILE
US GDP growth versus USD index
110
100
US dollar index
MARKET
90
80
130
1985: Plaza Accord
125
70
120
115
110
105
100
95
90
-5
1978-85:
+52.7%
1973-78:
-21.8%
-3
-2
-1
0
1
2
3
4 % 5
USD GDP growth (y/y)
1985-95:
-34.6%
Source: Bloomberg, J.P. Morgan Asset Management. Data as at 22 October 2014.
1987: Louvre
Accord
2002-11:
- 28.6%
1995-02:
+34.2%
85
80
-4
'73 '75 '77 '79 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13
Source: FactSet, J.P. Morgan Asset Management. Data as at 22 October 2014.
This will be a benign development for investors in developed
markets—including the US—if it is simply the result of the US
growing faster than the rest of the world. But it is more worrisome
if it is driven more by fears elsewhere. What we don’t want is for
the dollar to become a “one-way bet” for investors who think they
can expect to earn not just higher returns on US financial assets,
but the added benefit of a stronger currency to boot.
In such an environment, EM economies are likely to see major
capital outflows, and the US central bank might also struggle to
push down long-term interest rates, even when policy rates go
up. Neither development would be very healthy for global
investors, or for the global economy.
The “dollar smile” in Exhibit 2 helps to make this point.
Essentially, it shows that the US dollar will tend to outperform in
both high relative growth environments where investors favour
US assets or low global growth environments, where risk
aversion sees selling of foreign stocks and demand for Treasuries.
We hope we are in the first environment, not the second. But in a
world of persistent and widespread disinflationary pressures, the
risks of the more negative scenario are clearly there.
2 | Market Bulletin | Should investors fear a rising dollar?
Economic implications of a stronger dollar
By itself, dollar strength is usually associated with a tightening
in domestic economic conditions: the Organization of Economic
Co-operation and Development’s (OECD) rule of thumb is that
10% appreciation in the trade-weighted dollar cuts 0.5
percentage points from GDP growth and 0.3 percentage points
from CPI inflation in the first year. But that doesn’t account for
the positive effect of lower oil prices, which have accompanied
the recent appreciation in the dollar.
As Exhibit 3 shows, there has been a strong correlation this year
between movements in the dollar and movements in mediumterm US inflation expectations, which have come down sharply
in response to not just the stronger dollar, but declining
commodity prices.
Lower energy prices act like a tax cut for US households and
businesses, boosting their real incomes. They also make it easier
for the Fed to keep interest rates lower for longer, all other
things equal, and long rates are also likely to be pushed down by
bond investors coming into the US looking for higher returns.
Taking those factors into account, we believe that the
strengthening in the currency will be a net positive for the US
economy, even if it makes life a bit more complicated for the Fed.
That suggests a broadly benign impact on US stocks as well,
though some sectors are likely to fare better than others (see
Investment implications on page 3).
EXHIBIT 3: THE US DOLLAR AND INFLATION EXPECTATIONS
3.1
76
US dollar broad TWI
%
3.0
78
2.9
80
2.8
82
2.7
84
2.6
US 5y/5y inflation expectations
86
2.5
88
Dec-13 Jan-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14
Source: Bloomberg, J.P. Morgan Asset Management. Data as at 22 October 2014.
For the eurozone, the net result of a stronger dollar—and a weaker
euro—is likely to be strongly positive, since it should help to boost
nominal GDP. The ECB reckons that a 10% change in the value of
the currency generates a 0.4—0.5 percentage point change in
inflation. Therefore a weakening US dollar has been acting against
the central bank in the period of euro strengthening. We might
now hope to see that act in reverse, though the fall in the price
of oil might lessen the effect, in the short run.
As Exhibit 4 shows, falling food and energy prices have played
a big role in the dramatic fall in eurozone inflation in the past 18
months. But longer term, lower energy costs will also act like a
significant tax cut for European households and firms—rather
more than in the US, given Europe’s greater dependence on
imported energy.
The macroeconomic impact of a stronger dollar is more
complicated for EM economies, which are at a very different
stage in their economic cycle than the developed world. At first
glance, a stronger dollar looks positive for these economies too,
by giving them a competitive boost in US markets and slowing
the path to tighter US monetary policy. But a stronger dollar
could also aggravate inflation problems in some parts of the
emerging world, and suck foreign capital out of emerging
markets, back to the US—leading to serious market volatility
and difficult challenges for policy makers.
In the late 1990s, this dynamic helped produce the Asian
financial crisis. But most EM economies are in a much stronger
position than they were then, when large external imbalances
had been built up during the period of relatively cheap global
liquidity, and many had committed themselves to unsustainable
exchange rate pegs. These days, the amount of foreign currency
debt is considerably lower, fundamentals are stronger—in most
cases—and many have an exchange rate that is free to depreciate
and act as a safety valve, as occurred during the “taper tantrum”
of 2013. With the eurozone now set to run a current account
surplus for the foreseeable future, the outflow of capital from
emerging markets might also be mitigated this time around by
inflows from Europe, as European investors look for more
profitable places to park their excess savings.
For all these reasons, we believe the net result of a stronger dollar
for emerging markets is going to be difficult to predict and depend
heavily on individual country circumstances. But it is safe to say
that nearly all of these countries are likely to see some volatility
in their domestic markets as these different forces play out.
EXHIBIT 4: THE IMPACT OF FALLING FOOD & ENERGY PRICES ON THE DROP
IN EUROZONE INFLATION
Since January 2013
2.5
0.3
%
0.0
%
2.0
-0.3
1.5
-0.6
-0.9
1.0
Food (lhs)
Energy (lhs)
Industrial goods (lhs)
Services (lhs)
-1.2
-1.5
0.5
CPI (rhs)
-1.8
0.0
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Source: Eurostat, FactSet, J.P. Morgan Asset Management.
Data as at 22 October 2014.
J.P. Morgan Asset Management | 3
MARKET
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Market
INSIGHTS
Investment implications
Emerging markets
US markets
EM equity prices have historically had a very strong negative
correlation with the trade weighted dollar. This is because a
strong dollar has tended to go along with weaker commodity
prices and capital outflows from emerging markets. There is also
a currency translation effect, which lowers the dollar value of EM
earnings. But now, especially, it is important for investors to
note that not all of emerging markets will react in the same way
to a strengthening US dollar. It is also possible that EM assets as
a whole will have a slightly easier ride during this strengthening
cycle, because energy and basic materials now represent a
smaller proportion of the index than in some previous periods of
dollar strength.
A strengthening US dollar is likely to have an adverse impact on
US equities in the short term. It is estimated that in 2013 S&P
500 companies were holding over US$1.9 trillion in overseas
investments, the value of which is likely to erode rapidly as the
US dollar strengthens. However, from a revenue point of view the
S&P 500 as a whole is well positioned to cope with the impact of
a rising US dollar, as companies source only 40% of their
revenues from overseas. But when considering the issue on a
sector-by-sector basis, investors may see some weakness. The US
technology sector sources approximately 60% of their revenues
from overseas leaving companies exposed to the negative impact
of a stronger dollar. In contrast domestically orientated sectors
such as financials are positioned to benefit from the positive side
effects of a stronger dollar.
EXHIBIT 6: COMMODITY SECTOR WEIGHT IN THE MSCI EMERGING
MARKETS INDEX
Commodity sector weight in MSCI EM
40
%
European markets
35
The prospect of a weaker euro should be a major tailwind for
European earnings, particularly when coupled with falling oil
prices. There are questions marks over the impact that a weaker
euro may have on boosting growth within the region however,
recent estimates such that a 10% drop in the euro’s tradeweighted index will boost earnings, on average, by more than
8%. European equities have a broad global exposure with 45% of
earnings coming from outside of Europe—20% of that from the
US. A weaker euro would give a much needed boost to European
equities, which have experienced falling earnings, on a year-onyear basis, for the best part of three years.
EXHIBIT 5: STOXX 600 EARNINGS AND PERFORMANCE
Index level, analyst estimates of the next 12 months of earnings
30
€
28
STOXX 600 index level 380
360
STOXX 600 profits
340
26
320
24
300
280
22
260
20
240
18
220
200
16
14
180
'07
'09
'10
'11
'12
'13
Source: STOXX, FactSet, J.P. Morgan Asset Management.
Data as at 30 September 2014.
4 | Market Bulletin | Should investors fear a rising dollar?
'14
160
30
Average: 26%
25
20
15
Sep 2014: 18%
'94
'97
'99
'01
'03
'05
'07
'09
'11
'13
Source: MSCI, FactSet, J.P. Morgan Asset Management. Commodities includes
energy and materials. Data as at 22 October 2014.
On a 10-year time horizon, our analysis suggests that emerging
economies in EMEA have a -0.31 correlation with the US dollar,
compared to the MSCI Emerging Markets Index, which has a -0.82
correlation. Based on our analysis, Latin American emerging
markets are likely to fare less well, having a -0.86 correlation.
But even there, we are likely to see exceptions (see the case of
Mexico, on page 5).
MARKET
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INSIGHTS
Conclusions
EXHIBIT 7: THE CORRELATION OF EM ECONOMIES WITH THE US DOLLAR
• Overall, a rising dollar would be a net positive for European
assets, supporting export earnings for companies exporting
to the US and helping the ECB prevent deflation.
10-year correlations
5-year correlations
US TWI
MSCI EM
Latam EM
Asia EM
EMEA EM
US TWI
1.00
-0.82
-0.86
-0.85
-0.31
MSCI EM
-0.49
1.00
0.95
0.99
0.70
Latam EM
-0.21
0.50
1.00
0.94
0.58
Asia EM
-0.48
0.99
0.39
1.00
0.62
EMEA EM
-0.68
0.70
0.60
0.66
1.00
• A strong dollar does pose greater risks to EM investors. The
negative correlation between EM equity prices and the US
dollar trade-weighted index is very strong indeed. But most
EM economies are better placed to withstand a change in
global conditions than they were during the last period of
sustained dollar strength, in the late 1990s. There would also
be a silver lining to the strong dollar, for countries dependent
on foreign borrowing, if it helps the Fed keep interest rates
lower for longer.
Source: MSCI, FactSet, J.P. Morgan Asset Management. 10-year correlations are
from October 2004 to October 2014. 5-year correlations are from October 2009
to October 2014.
Overall, a significant strengthening of the dollar could provide a
bumpy ride for emerging markets in the months and years ahead.
But differentiation is the name of the game. As shown in Exhibit 8,
some emerging markets with economies linked to global supply
economies—and especially the US consumer—are likely to fare
better during this period. And some, such as Mexico could fare
very well indeed.
EXHIBIT 8: EM ECONOMIES’ EXPOSURE TO US VIA TRADE
Emerging market economies exposure to US via trade
10
Mexico
Gross merchandise trade to US,
% of GDP, 2013
8
Taiwan
6
0
Malaysia
Thailand
4
2
Saudi Arabia
China
Chile
Philippines
S. Africa India
Indonesia
Brazil
Hungary
Turkey Russia
1
3
5
7
9
Value-added exports to US, % of GDP, 2009
Source: OECD, FactSet, World Bank, IMF, Lombard Street Research,
J.P. Morgan Asset Management. Data as at 4 November 2014.
11
13
• A more nuanced approach suggests that countries in emerging
Europe could be better insulated than most from any negative
consequences, along with countries that are not heavily
dependent on commodities for their income. EM economies
that are closely linked to the US economy could well benefit—
notably Mexico.
• An important note of caution is that the rise in the dollar to
date has been relatively modest compared to past periods of
dollar strength. But if investors start to feel that the US is the
“only game in town”, the dollar could rise every bit as far as it
has in the past. That could have unpredictable and highly
destabilising consequences for global markets and revive fears
of asset bubbles in the US. This is not the most likely scenario,
but it cannot be ruled out if growth in the rest of the world
continues to disappoint.
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