This week’s commentary is more of an update on views previously expressed rather than anything earth shatteringly new. That said, we do think that there are important developments afoot in the FX markets that have implications for all markets and the global economy.
As we all know, the US Dollar was on a tear from mid-2014 to early this year. The diverging monetary policies between the US and the rest of the World certainly helped. Indeed, triggers were reached whereby Dollar strength hurt emerging market economies and added fuel to the commodity bear market, which only added to the strength of the Dollar bull market. By late 2015, after stresses had been building in a number of financial markets, policymakers were becoming openly concerned about the Dollar’s strength.
In early 2016, the Federal Reserve gave up on their forecast of four rate rises this year and central bank stimulus managed to generate a large enough firewall to prevent further Dollar strength. As can be seen in chart 1 below, measured on both a narrow Dollar index (heavily weighted to the Euro) and a broad trade weighted index, the Dollar may well have simply been in a multi month consolidation this year. Indeed, this is very much our view.
As measured by the DXY (red line in chart 1), the consolidation has been ongoing for nearly 18 months now. On the broad trade weighted index, the uptrend has been more persistent, and the recent consolidation therefore appears to have been shorter. Both measures may well be in the process of turning higher, albeit in a sort of grinding process rather than dynamic process; so far at least.
Chart 1 – The performance of the US Dollar over the last three years
The main impediment to a strong Dollar in recent months has been the fact that the Fed has been more dovish than expected. Although the US economic data has been better than expected of late, this will not be enough to encourage the Fed to raise interest rates next week. We still believe that the current rate rise cycle is a one or two and done (i.e. either a rate rise later this year or not at all), something we talked about late last year (please let us know if you would like to see this report). No matter how shallow the rate normalisation process will be for the Fed, the direction of travel is still more hawkish than other central banks, and this modest divergence should help the Dollar in the months ahead. Indeed, the stronger the Dollar becomes, the less likely the need for a rate rise, and vice-versa.
Now, perhaps the global economy and financial markets can live with a mildly stronger Dollar, but at some point, further Dollar strength will begin to worry markets again. We are also watching the price of oil very carefully. Having said in recent months we expect a range of $30 to $50/$55, the recent failure in the low $50s is of interest and oil is now trading around $47. Chart 2 below shows the strong correlation between the Dollar and the price of oil in recent years. If this correlation holds and the Dollar strengthens as we think, then oil may be headed well below $40 which could easily begin to raise concerns amongst oil producers.
Chart 2 – The Dollar and the price of oil
When we think of oil producers, we are thinking of both US domestic producers and the OPEC producers. Below $40 oil price, concerns will rise again over reduced US capex and maybe even solvency for the shale sector. For OPEC, falling reserves (as budget deficits widen again) will be a real headwind for global assets.
As regards equities, chart 3 below shows the movement of the Dollar and the MSCI World Index ex. US. What is clear is that, in Dollar terms at least, global equities struggle in a strong Dollar environment. In particular, we would expect Emerging Market equities to underperform despite their obvious cheapness relative to the US equity market in particular.
Chart 3 – MSCI World Index ex. US and the Broad Trade Weighted Dollar Index
As for the US, a strong Dollar will again at some point impact both corporate earnings and the overall economy. As with the late 2015/16 period, by the time it gets to this stage, we should expect more global central bank easing which could again lead to a weaker Dollar and rebounding financial assets. However, before we get to that, a strong Dollar may begin to weigh on both financial markets and the economy, or at least act as a bit of a headwind.
So for us, the mildly appreciating Dollar remains the likely scenario, which at some point could easily lead to rising stress signals. If we are wrong on the Dollar, then risk assets should continue to grind higher as the most hated bull markets ever continue to frustrate the majority of investors. We like to keep our lives simple when we can, and we think that the single most important thing to watch in the weeks ahead is the performance of the Dollar.
Please get in touch if you would like to discuss the RMG FX Strategy UCITS fund. Some basic information can be seen HERE.
Stewart Richardson
Chief Investment Officer
