04 Nov The unstoppable dollar is not going to last forever
As published by Business Day on 3 November, 2022
Investors shouldn’t pay it too much attention.
The dollar is running rampant this year and while it’s appreciation appears unstoppable that’s unlikely to be the case down the line. Currencies play a far smaller role in investment outcomes than end-investors often assume, and they should instead ensure their investments will compound in value no matter what the dollar is doing on the world stage.
The dollar’s rally is largely attributable to the huge upheaval we have seen in markets in the face of inflation rates that have risen to multi-decade highs and central banks’ consequent efforts to halt the unfolding cost of living crisis. Year to date the MSCI world is down 27% and the FTSE World Government Bond Index is down almost 23%.
Not every asset market has been a loser though. The US dollar has gained significant ground against a basket of other countries’ exchange rate – now up almost 9% on trade weighted basis this year.
Some of this strength can be attributed to the dollar’s status as the world’s reserve currency, meaning that it benefits from a flight to safety when market conditions are poor. But there have been other factors at play as well.
Chief among these is the fact that the US Federal Reserve has been more proactive in raising interest rates than central banks in other parts of the developed world. The Fed has raised interest rates 3% since their lows while the Bank of England has raised them by 2.05% and the European Central Bank by only by 1.25%. Japan has seen no base rate increases at all.
This means that holders of dollars are “having their cake and eating it as well”, as they are being richly rewarded for holding a safe-haven currency.
This also accounts for the fact that some emerging market currencies are doing better than some of their developed world peers. Interest rates in Brazil, and to a lesser extent South Africa, are now sitting at levels where they are offering far superior real (inflation-adjusted) yields to other emerging markets. As a result, the Brazilian Real has actually appreciated by 3% against the dollar this year.
A number of idiosyncratic factors are also at play. The Euro has been weak, mainly due to weak German industrial activity and the effects of the Russian invasion of Ukraine. The UK, already weakened from Brexit, is plagued by political uncertainty and the fallout from (now “former”) Chancellor of the Exchequer, Kwasi Kwarteng’s proposed mini budget.
But what does this all mean from a practical standpoint?
Firstly, a strong dollar benefits countries and industries that export to the US, as consumers there are able to purchase more of the goods or services they sell. This list includes China, Japan and Germany, which are the US’s biggest source of imports.
Secondly, a strong dollar coincides with weak commodity prices. This deeply impacts a commodity exporter, such as South Africa, largely negating the bounce in commodity prices that we saw at the beginning of the year due to the Ukraine invasion.
Lastly, a strong dollar means there are opportunities for contrarians to position portfolios for a weak dollar. While dollar strength could be with us for a while as many of the factors contributing to its strength look set to persist, we know that this is certain to change.
Ultimately, a strong dollar will lead to a decline in US competitiveness, which will tilt the macro-economic balance in favour of the rest of the world once again.
Position yourself accordingly and hedge where you can
Rather than fretting about the level of the currency, or speculating on its direction, most investors would be better served by hedging themselves against currency risk where they can. This means using dollar cost averaging to build positions in global businesses that are “natural hedges” because they generate earnings in multiple currencies.
Investors should not lose sight of the ultimate goal when investing, which is a portfolio that compounds its value through good times and bad – and currencies play a smaller part in this than is often supposed.