Since 2011, the U.S. dollar has been in a cyclical bull market that has touched most aspects of global portfolio positioning this decade. We can’t call an end to this cycle yet, but we know it’s coming, and investors need to think about how this affects their investments.
The dollar has been slowly falling in value since the era of free-floating exchange rates began in the 1970s. A huge economy like the U.S. can’t grow as quickly as smaller, up-and-coming nations, so its share of the global economy has been slowly shrinking as others catch up. This creates incremental demand for foreign currencies and puts pressure on the dollar.
This gradual downtrend has been punctuated by three separate multi-year cycles of dollar strength. We believe we’re close to the end of this third cycle, which suggests investors should consider reviewing their portfolios.
What does history tell us?
The current dollar bull cycle started in May 2011 as several broad measures of the currency and sentiment bottomed out. The most recent peak in the dollar in January 2017 marked a 43% move upwards over the course of nearly six years from the start of the cycle. This compares to the two previous up-cycles of 90% in five years and 41% in seven years, which ended in 1985 and 2002, respectively. This most recent bull market seems similar in scale and duration to the previous up-cycles.
What causes dollar bull cycles to lose steam?
There are several explanations for cyclical turning points in the dollar. Most relate to factors specific to individual currency pairs, but certain issues could be cited in the eventual demise of this dollar cycle.
1. Interest rate dynamics
The U.S. economy led developed nations in coming out of the global recession, and the U.S. Federal Reserve was the first central bank to start raising interest rates from record low levels. This supported the dollar when neighbouring currencies were contending with near-zero interest rates in their home markets. But in recent months central banks in Canada and Europe have hiked or considered unwinding quantitative easing programmes. Since the U.S. was the first to raise rates, the market might think it will be the first to stop, which could cap the dollar’s rise.
It’s hard to label a currency as overvalued just because certain items cost more. But fair-value measures such as purchasing power parity are useful for highlighting currencies at extremes of valuation. In the modern era of globalisation, it’s unusual for major currencies to trade more than 20% above or below their fair value, and these extremes tend to mark the turning points of dollar cycles. In May 2011 the dollar was 15% below fair value and in January 2017, the most recent peak, it was 18% above.
3. Political uncertainty
The markets crave certainty and currencies often reflect sentiment toward economic and fiscal policies. Policy paralysis can weaken a currency, and the current lack of political consensus and strains within the U.S. may act as a headwind to the dollar. Key near-term risks include delays to tax reform and increases in the federal debt ceiling.
Positioning for a peak dollar world
History provides a few pointers toward investment themes that might work in a dollar bear market.
Products priced in dollars tend to be more in demand during a dollar bear cycle. Oil and hard industrial commodities enjoy a demand tailwind when the dollar is weak as those commodities appear cheaper to non-U.S. buyers.
These tailwinds are most pronounced when industrial commodities are already in a bull market. Most commodities peaked by 2011–12 and have been under pressure since, but a weakening dollar may give prices a boost.
Equity markets outside of the U.S. also tend to do well when the dollar is weak. International stocks currently appear to be at the start of their own bull cycle, and a weakening dollar could add to their outperformance.
This year, money has flowed out of U.S. stocks and into international stocks. This has been driven by cheaper valuations and faster earnings growth outside of the U.S., but the pause in the dollar bull this year probably played its part too.
U.S. equity sectors
The picture is less clear for U.S. stocks in a dollar bear market. Large caps, particularly multinational companies, tend to perform relatively well as they have a higher proportion of profits generated outside the U.S., mostly in appreciating foreign currencies.
Energy and Materials companies tend to outperform when the dollar is weak, due to the currency tailwind enjoyed by commodities generally, and to perform poorly in a dollar bull market.
Outside of these sectors it’s a mixed bag, although Health Care and Technology returns tend to correlate positively with the dollar. That said, most tech companies have developed relatively high overseas revenue streams so the traditional pattern of tech sector weakness may not hold in the next cycle.
RBC Capital Markets analysts currently project a dollar peak in March 2018, while consensus forecasts imply we’ve already seen the high-water mark. We won’t know for sure until after the fact, but if history is a guide we’re probably close to the end of the dollar bull cycle. It is worth considering how to position portfolios in anticipation of a sea change in the dollar.