After weakening throughout most of 2020, the US dollar has a renewed bounce in its step. Which raises the big question: What is really driving the dollar’s value?
Most suggest differentials, not just in interest rates, but also in economic growth rates, and perhaps in the growth rates of central bank balance sheets as well. And given the large, chronic, and ever-rising US trade deficit superimposed upon the globe’s reserve currency, it’s clear that financial markets are contributing a relatively large share of US dollar demand.
For fixed income investors, even absent policy rate hikes anytime soon, current US yields are still more attractive than those in most of the rest of the world, providing the US dollar with a base of support. Yield-starved Japanese investors in particular have been strong buyers of US Treasuries following their March fiscal year-end. Team that with a Federal Reserve that is now positioning to leave the liquidity party first, and firming of the dollar is appearing sooner than rising interest rate differentials would suggest. Reopening-driven inflation has backed Chair Powell into a corner, forcing him to pull forward the end of quantitative easing (QE) as well as the beginning of policy rate rises. This pulling forward of the end of the monetary deluge coincided with a newly buoyant US dollar, even though the rising policy rate portion of that is still out in mid-2023.
Meanwhile, for equity investors, relative growth is what matters. Fueled by massive fiscal and monetary stimulus, the US economy has recovered so quickly that the potential for overheating is preoccupying investors’ calibrations. Some of these supply-driven bottlenecks and related price spikes arose from reluctance among workers who lost their jobs in the pandemic to return to the workforce. This tendency may begin to abate in September, when the reopening of schools and the expiration of many unemployment support programs could encourage many unemployed people to return to work. An unintended consequence of support programs, some of which pay recipients up to one-third more than the jobs they left behind, has been a desperate need for workers. If we see big employment gains in the fourth quarter, accelerating growth could be accompanied by declines in many prices. This could encourage equity-oriented investors while also giving the Fed more breathing room, discouraging US dollar yield-seeking investors.
The durability of US economic acceleration, at a time when Asia is decelerating, will also influence the dollar’s strength. The relatively high US vaccination rate, with 64% of those over 12 now vaccinated (according to the CDC), is positioning the country toward more sustainable growth, as would success in the next round of fiscal packages now working their way through Congress.
Finally, the central bank balance-sheet effect gave rise to a new differential. As countries initiated post-financial-crisis QE in 2009, whoever grew their balance sheet fastest saw their currency depreciate the most; the UK came first, followed shortly by the US. Soon after, all developed market central banks joined in, and with balance sheets surging simultaneously, this differential vanished. Now, over a decade later, QE still lives on, yet with the Fed now looking to stanch the liquidity deluge near year-end and the European Central Bank and Bank of Japan not yet even considering such a tapering. This reinvigorated differential is likely already reasserting itself – with policy rate differentials to follow in mid-2023, bringing a bigger bang to the US buck.
Conviction Score (CS) and Investment Views
The Conviction Scores shown below reflect the investment team’s views on how portfolios should be positioned for the next six to nine months. 1=bullish, 5=bearish, and the change from the prior month is indicated in parentheses.
Global Economy
Markus Schomer, CFA
Chief Economist,
Global Economic Strategy
CS 2.50 (unchanged)
Stance: Despite a cloudier horizon, we maintain our score and believe global GDP growth will remain well above average over the next 12 months.
Outlook: Near term, the global economic outlook remains dominated by the path of Covid-19. Medium-term worries include inflation’s impact on the US recovery, which may sap consumer spending in coming months; government transfers returning to normal perhaps in the fall, requiring households to rely on wage and investment income; and Fed tapering, which could be just talk, as Powell’s inclusive employment goal will make pulling the trigger difficult.
Risks: The biggest risks are expectations of central bank policy changes, which cause markets to flutter. Changes in futures rates and taper talk will likely drive up bond yields in coming months, while many emergency support programs are set to end this year. Hence, 2022 could see simultaneous fiscal and monetary policy reversals.
Rates
Henry Huang, CFA, FRM
Vice President, Portfolio
Manager, Research Analyst,
Securitized Products
CS 4.00 (unchanged)
The Fed has already raised short rates, offering 5 basis points (bps) for cash, up from zero, in reverse repo transactions, and 15 bps of interest, up from 10 bps, on excess reserves. As a result, T-bill rates have gone from negative to positive, although still below 5 bps for up to six months. The reason for this has been anybody’s guess. Only one forecast is unanimous: large volatile moves are possible this summer as investors take their first vacations in two years.
Credit
Steven Oh, CFA
Global Head of Credit and Fixed Income
CS 3.25 (+0.25)
Appetite for risk should continue into the second half, with spreads grinding even tighter. While far from defensive, we maintain our current risk posture and have become marginally more conservative, as central banks weigh pulling back from accommodation. Despite extremely strong fundamentals in the form of improving earnings, macro support, and plunging default rates, valuations in many segments remain very rich. Spreads are likely to tighten in inverse relationship with Treasury yields, resulting in an upside in line with coupon returns. Still, valuations have more room to tighten in below-investment-grade credits than in investment grade (IG); floating risk assets are relatively more attractive despite the steep short end of the curve.
Currency
(USD Perspective)
Anders Faergemann
Managing Director, Senior
Sovereign Portfolio Manager,
Emerging Markets Fixed Income
CS 2.75 (unchanged)
A year from now, US real yields should be a dominant factor in the strength of the US dollar. Currently, foreign exchange markets are continuing to take their cue from US/Europe bond differentials. The reflation theme, which has driven US dollar weakness, appears exhausted. Except for oil, many commodity prices have fallen from May peaks. Now, supply chain bottlenecks are the main inflation driver. In EM, surging nominal GDP growth, rising GDP deflators, and sharp increases in tax revenue have been widely underestimated and underreported. In combination with rising current account surpluses and record FX reserves, many EM economies look very robust while their currencies are generally undervalued. The Brazilian real, Colombian peso, Chilean peso, and Mexican peso offer compelling value.
Emerging Markets
Fixed Income
Steve Cook
Managing Director, Co-Head of
Emerging Markets Fixed Income
USD EM (Sovereign and Corp.)
CS 2.50 (-0.25)
Local Markets (Sovereign)
CS 2.25 (-0.50)
We have adjusted our CS to be more positive based on the bright fundamental outlook, improving EM sovereign fiscal finances, declining corporate leverage, and greater institutional inflows due to the vigor of the post-pandemic rebound. At EM corporations, rising 2021 revenues, higher earnings, and conservative leadership should reduce net leverage to the lowest levels in a decade. Since the good news on so many fronts seems underreported, we may be able to gain an additional advantage through our country and security selections.
Multi-Asset
Peter Hu
Managing Director, Portfolio
Manager, Global Multi-Asset
CS 2.50 (unchanged)
While our score remains unchanged, we have been gliding our portfolio risk toward neutral as we see bottleneck-driven inflation possibly being greater and more persistent than many expect. Confident US consumers enjoy healthy balance sheets and corporate investment is surging, focusing on digitization and decarbonization. While inflation will eventually recede, the longer the overshoot lasts, the greater the risk that a wage/price spiral embeds itself.
Real Estate
Gregg Gilbert
Principal, Real Estate
The focus on ESG has intensified over the past six to 12 months. While environmental issues have long been a concern, as property and construction sectors account for about 40% of all carbon dioxide emissions globally, the industry is grappling with how to measure social and governance factors, which had been largely neglected. Currently, changing use patterns are exacerbating dramatic undersupply issues in logistics and institutional rented residential, senior living, and student housing, sectors that are attracting capital. Risks include a resumption of increases in construction material costs and inflation-related interest rate increases, which would cause substantial value erosion.
Global Equity
Chris Pettine, CFA
Senior Vice President,
Senior Research Analyst –
Global Equities
CS 3.00 (unchanged)
Companies remain confident in their outlooks, with labor and other cost increases viewed as manageable, and Street estimates are still trending upward, but to a lesser extent. As stock-specific volatility has increased, company-specific drivers are regaining importance in alpha generation. Markets are viewing inflation as transitory, as signs of de-bottlenecking emerge in problem areas including semiconductors, lumber, and shipping, which might begin to alleviate supply chain shortages and dampen raw material price increases. We maintain our CS at 3.00 and our balance across risk categories, acknowledging uncertainty over interest rates, inflation, and policy decisions.
Global Emerging
Markets Equity
Taras Shumelda
Portfolio Manager,
Global Equities
CS 2.50 (unchanged)
We maintain our 2.50 score, supported by positive earnings revisions and more attractive valuations. In China, all e-commerce names reported a margin squeeze in the first quarter and guided further downside in the second. Our portfolio is meaningfully underweight such exposures. Credit growth slowed further, and Consumer Price Index (CPI) stayed low despite a 13-year producer price index (PPI) high. In India, lockdowns may reduce disposable income, but most of our positions are companies poised to capitalize on the expected recovery. In Latin America, rising income and an expanding middle class support demand for products and services, particularly in the consumer, financial, and healthcare sectors. EMEA has been fundamentally stable and helped by higher natural resource prices and EU stimulus. As the reopening nears, expectations of better economic growth are rising.
Quantitative Research
Peter Fwu
Quantitative Strategist,
Quantitative Fixed Income
Our US Market Cycle Indicator (MCI) deteriorated a touch as a result of the 5-bp flatter yield curve. Option-adjusted spreads on BBB rated credits tightened 4 bps to 113 bps. The short ends of IG and HY looked rich in spread terms. In industry selection, we liked cyclical sectors including energy, basic industry, and banking versus defensive sectors such as utilities, consumer non-cyclicals, and communications. Rising yield forecasts have become more and more muted and this month flipped to slightly lower forecasts. Slope forecasts continued to point to flattening globally, except in Japan. The rates view expressed in our G10 model portfolio was overweight global duration, mostly as a result of curve positioning that favored the long end versus the belly of the curve. In duration, we are overweight in Europe (ex-Germany), neutral in North America, and underweight Japan.