The Dollar in a World of Worries
Published on May 2, 2022
David Kelly
Chief Global Strategist at J.P. Morgan Asset Management
In any given year, four big exogenous forces tend to have the most impact on portfolio returns, namely, earnings, interest rates, taxes and the dollar. While the tax environment appears to be stable, in all other respects, 2022 is shaping up to be a difficult year with slowing earnings growth and fast-rising interest rates. In addition, the dollar has risen significantly so far this year, as it did in 2021 and this is having negative impacts on both portfolio returns and economic growth. So it is worth addressing a few key questions:
First, how much has the dollar appreciated?
Second, why has it gone up?
Third, what does this mean for investing and the economy? and
Fourth, where is the dollar likely to go from here?
The Federal Reserve’s nominal broad trade-weighted dollar index tracks the value of the dollar against 26 different currencies, with currency weights being determined by each country or regions share of bilateral trade in goods and services. This index climbed by 3.6% in 2021 and, we estimate, is up a further 4.5% this year[1]. Moreover, the real broad trade-weighted dollar index, which adjusts for inflation, rose by 6.2% last year and, we estimate, a further 5.0% year-to-date[2], reflecting higher inflation in the U.S. than among our trading partners. Indeed, with this latest lurch upwards, the real value of the dollar is at its highest level since 2002 and just 1% short of its highest level since 1986[3].
So why has the dollar gone up? In the years following the financial crisis the most important reason was turmoil among our trading partners with the Eurozone experiencing a second recession due to the European debt crisis and Japan continually flirting with deflation and adopting a very easy monetary policy. The dollar then soared with the outbreak of the pandemic, serving its traditional safe-haven role, before relapsing as the global economy began to recover.
However, over the past year, the dollar has begun to surge again, reflecting a strong U.S. economic recovery and an increasingly hawkish tone from the Federal Reserve. In recent months, this move has been accentuated by overseas developments.
In particular, the euro has fallen against the dollar as investors have worried about the disproportionate effect of the war-induced spike in energy prices on the European economy. The yen has fallen as the Bank of Japan has resolutely stuck with its yield curve control policy in the face of a modest uptick in domestic inflation but a much a sharper climb in U.S. interest rates. And the yuan has fallen, as China struggles to achieve economic growth targets in the face of a number of pressures and most notably the increasingly disruptive impacts of trying to maintain a zero-Covid policy. Since the start of the year, the euro, yen and yuan are down 6.9%, 11.4% and 3.6% respectively against the U.S. dollar.
For investors, the dollar surge has, yet again, seen international stocks underperform their U.S. counterparts, at least in dollar terms. Through last Thursday, the S&P500 had a total return, including dividends, of -9.6% year-to-date while the MSCI all-world total return index ex-U.S. was down just 6.6% in local currency. However, translated into U.S. dollars the ex-U.S. index was down 12.3% year-to-date.
A higher dollar has also had negative impacts both on the real economy and on earnings.
Last week’s report on first-quarter GDP was dominated by trade weakness. While real GDP fell by 1.4%, changes in international trade reduced real GDP growth by 3.7%. In other words, if the trade gap had not widened, real GDP would have risen by 2.3% annualized.
Moreover, the reality is that the combination of strong U.S. consumer spending and a higher dollar have been eroding our trade position for years. In the first quarter, U.S. exports amounted to 11.2% of our GDP while imports equaled 16.0% of GDP. The trade gap, now 4.8% of GDP, has been climbing since the start of the pandemic and is now at its highest level since 2008.
Over the years, a high dollar and a chronic U.S. trade deficit have decimated the manufacturing sector. Despite talk of companies bringing manufacturing jobs back to the U.S., it is very hard to see a renaissance in U.S. manufacturing with the dollar at current levels. Moreover, the trade deficit represents a major leakage in the circular flow of income in the United States. With fiscal stimulus now essentially over and consumers working down their accumulated savings, our massive demand for imports is likely to cool domestic demand faster than many believe.
On the earnings front, roughly 30% of S&P500 revenues come from overseas and so far in the first-quarter earnings season, a 2.8% year-over-year increase in the value of the dollar has contributed to the lowest percentage of positive earnings surprises seen in seven quarters. Moreover, if the exchange rate were to remain unchanged for the rest of the quarter, it would be up roughly 6.7% year-over-year, applying a significant drag to both revenues and earnings going forward.
So where does the dollar go from here?
The most imponderable question, of course, is geopolitics and a worsening of the conflict in Ukraine or some other geopolitical issue could cause a renewed capital flight to the dollar. However, in other respects, economic forces should push the dollar lower.
Last week’s negative GDP print for the first quarter served as a reminder that the U.S. economy is downshifting to a lower pace of economic growth. Moreover, because this weakness occurred in a quarter with fast-growing employment, productivity slumped in the first quarter. Indeed, output per worker over the past two and a quarter years is now up just 1.4% annualized, compared to 0.9% in the prior decade. While this still implies a one-time upshift in productivity, it tends to undercut the idea that the pandemic has induced a higher growth path for productivity going forward. All of this suggests that the U.S. economic growth lead over our major trading partners should fade in the year ahead.
Second, while the Federal Reserve has been ratcheting up its hawkish rhetoric on interest rates in recent months, it will likely begin to recognize the danger of a too-aggressive monetary policy when fading fiscal stimulus and a high dollar are both already applying the brakes to the economy. While we expect the Fed to raise the federal funds rate by 0.50% this week and announce a program to reduce their balance sheet, Chairman Powell is likely, at some stage soon, to emphasize that the Fed would be willing to slow its tightening if inflation eases and economic growth shows signs of slowing too much.
Finally, the trade deficit itself will exert downward pressure on the dollar as it implies a net excess of those who have to sell dollars and buy foreign currency to complete trade transactions. This would, of course, be greatly amplified if U.S. investors are tempted to diversify their holdings by buying foreign financial assets.
The direction of the dollar is, as always, very difficult to forecast in the short run. However, in the long run, these economic forces should prevail, pushing the greenback down. This would enhance the return on international equities and this, combined with significantly lower valuations overseas, adds to the case for increasing international stock allocations in 2022 despite a world of worries.
[1] Extrapolating the Fed index from April 22nd to April 29th using the US dollar index, DXY, maintained by ICE.
[2] Extrapolating month-average numbers to month-end and April 29th, 2022 numbers using nominal index values.
[3] The current broad dollar indices, using weights based on goods and service trade are only available since 2006. However, approximate indices can be calculated back to 1973, by splicing onto this the previously calculated broad indices, based on goods trade only, re-benchmarked to January 2006=100.
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