The US dollar has started the year strongly, appreciating by 3.5% against the euro. In the near term the US currency may yet strengthen further, but we don’t expect the trend to last.
A number of factors have helped support the greenback. First, the coronavirus outbreak has created uncertainty over the extent and timing of an economic rebound in the wake of the phase 1 US-China trade deal. The US dollar tends to benefit from safe haven flows when faced with such risk events, while weak global growth would mean a poor year for export-oriented economies like Europe, and Japan. Second, facing lower expected returns, many asset allocators are increasing their strategic allocation toward equities relative to bonds to hit their return targets. This supports the dollar given the high weighting of the US market in global equity market capitalization. Third, macroeconomic data in the Eurozone has disappointed relative to US economic releases.
With the increased spread of coronavirus outside China we can’t exclude further greenback appreciation in the short term, but we see several factors that should weaken the dollar against the euro by the end of the year:
- Our base case is that the coronavirus will be largely controlled by the end of March in China and that the negative economic impact will be mostly confined to 1Q. We expect a sharp rebound in Chinese growth from 2Q onward based on pent-up demand and monetary and fiscal stimulus. We are monitoring the economic impact outside China, but still consider that adverse effects would likely be confined to one quarter. As global trade recovers later in the year, this rebound is likely to favor heavily export-oriented markets like the Eurozone over more domestic-driven markets like the US, and we expect a narrowing of the growth differential between the two regions.
- The hunt for yield has hurt the euro and supported the USD. But the two-year yield differential in favor of the US relative to Europe has narrowed by more than 150 basis points (bps) since peaking at 354bps in November 2018. The US still has a healthy yield advantage, but if volatility rebounds from current record low levels, and expectations of further dollar strength recede, carry trades will look less attractive. For example, if the euro were merely to regain its losses so far this year against the dollar, this would be equivalent to wiping out almost two years of USD carry.
- Eurozone financial conditions remain ultra-easy. This should eventually provide a boost to the Eurozone economy, supporting growth and meaning the ECB can avoid easing its policy stance further.
- The efficacy of negative rates is back in focus now that Sweden has ended its five-year experiment and raised rates to zero. European Central Bank (ECB) president Christine Lagarde has promised to look at the side-effects of negative rates as part of the bank’s strategic review of monetary policy. At present we see nothing to change our view that rates will stay lower for longer. But the point of peak ECB dovishness on rates may be past.
- We believe that markets are not yet pricing in the risks around the US election sufficiently. Greater investor concern about the election could lead to outflows from the US, a negative for the USD. • Our portfolio model, which compares current bond and equity market capitalizations with 20-year historical averages, suggests that USD allocations in global portfolios have never been as high as today, while EUR, GBP and JPY are all heavily underweighted relative to history.
- Our models that compare G10 GDP growth with currency valuation suggest that the euro's valuation is in line with the low growth in the Eurozone. But purchasing power parity (PPP) suggests that the USD is overvalued, with fair value currently at 1.30.
Overall, we believe that this combination of factors will weaken the dollar as the year progresses, and we maintain our end-year forecast for EURUSD of 1.19. We think that further downside for EURUSD remains limited for two reasons. First, the euro is already very cheap, and second, if the negative impact outside China increases, the Federal Reserve has room to cut rates, and is ready to ease at signs of trouble.
Although the dollar may not begin weakening immediately, in response to potential dollar weakness over the course of the year, investors should consider undertaking a number of portfolio actions today.
- European and Swiss investors who have sought relief from low or negative yields by owning USD assets should now consider other means of boosting yield, including buying dividend stocks in Europe, or undertaking option selling strategies. To manage currency risks, the same investors should also consider reallocating back from USD bonds toward EUR or CHF bonds.
- US based investors who have benefitted from US dollar strength through high allocations to US assets should now begin to think about the potential portfolio benefits of global diversification. Global diversification lowers portfolio volatility and would be additionally valuable from a US investor perspective if the dollar stops strengthening.
- Within equities, we continue to overweight emerging market stocks, which are attractively valued relative to developed markets and are likely to see higher levels of earnings growth this year and in years ahead. Dollar weakness would provide an additional tailwind to emerging market stocks. Read more about what's happening in your part of the world in our regional views.
Read more about what's happening in your part of the world in our regional views.
The US dollar has started the year strongly. Further near-term strength is possible as the coronavirus outbreak continues to spread. But our base case is that the virus is brought under control and that economic growth rebounds in the second half of the year, favoring export-oriented regions like the Eurozone. If volatility rebounds from current record low levels, and expectations of further dollar strength recede, carry trades will also look less attractive. European and Swiss investors should consider reallocating back from USD bonds toward EUR or CHF bonds and US based investors should consider diversifying.