Weathering a moderately stronger U.S. dollar

We see a modestly higher U.S. dollar ahead. Richard explains why and what this means for investors.

We see a mildly stronger U.S. dollar (USD) ahead. But we believe many of the asset classes that generally suffer when the USD appreciates—including commodities and most emerging market (EM) assets—will be more resilient this time around.

A key U.S. dollar index has depreciated roughly 7% so far this year. Some are betting on further declines; speculative short positioning is at three-and-a-half year highs in the futures market. We believe this positioning buildup led to an April break in the usual positive correlation between the USD and the U.S. yield premium over other developed markets. Yet we see the USD’s broad uptrend since mid-2014 slowly resuming as monetary policy divergence re-emerges. The Federal Reserve (Fed) is normalizing rates while the European Central Bank and Bank of Japan maintain easier policies, and the positive correlation between the USD and yield premium has returned. See the chart below.

54476_BII_COTW_110617_v4_blog

We see a stronger U.S. dollar as the Fed normalizes ahead of its developed market peers and U.S. economic growth shows upside potential. However, we expect the gains to be moderate over the short term, as Fed rate rises will likely be slower than in past cycles given relatively tame U.S. inflation. Our BlackRock Inflation GPS points to U.S. core inflation returning to 2% in six months’ time.

Commodities and EM assets have had an inverse correlation to the USD in many historical periods, falling when the USD is stronger and vice versa. But we don’t believe a mildly stronger dollar necessarily spells bad news this time around. This is because we see other factors driving these assets’ performance. Commodities have rallied and EM equities have outperformed their developed market counterparts over the past month despite a stronger USD. Local EM debt was an exception, with returns dragged down by local currency weakness. Supply-demand fundamentals can also trump the usual negative relationship between commodity prices and the dollar. Oil prices, for instance, neared a 27-month high last week on improving demand and expected supply cuts. Similarly, we see EM equities able to withstand a modestly higher USD amid improving economic conditions, earnings growth and investor sentiment.

We see a stronger USD versus the euro and yen supporting equities in the eurozone and Japan, given these stock markets’ export-oriented nature. The major risk to our view is a sharper dollar appreciation. U.S. tax reform is a wildcard here: Deficit-financed tax cuts could boost U.S. Treasury issuance and growth, leading to higher interest rates and a more rapid dollar rise.   Bottom line: We believe a modestly higher USD ahead supports the case for favoring eurozone and Japanese equities, and it does not change our preference for EM stocks. Within currencies, we favor the USD to the euro and yen amid monetary policy divergence. Read more market insights in my Weekly Commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

Listen to Kate Moore discuss the uncertain path forward for tax reform in Washington in our latest episode of our podcast, The Bid.

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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