In the world of currencies, the US dollar has asserted its dominance through the course of 2022. The mighty greenback has cast aside all and sundry with its strength and attractiveness for several reasons. First, the pace of the Federal Reserve’s interest rate policy has been steadily rising higher and faster than market expectations for the bulk of this year, meaning cash investors can hold dollars and actually receive something (interest) in return at levels that haven’t been seen since the early days of the financial crisis. With the US Federal Reserve promising more rate rises to come, this will only improve, helping to draw funds away from lesser currencies.
In a year of high market volatility and heightened geopolitical risk, not only driven by the war in Ukraine but also by the potential for the world to be moving to an increasingly bifurcated US/Western/ democratic world versus a China/Russia/autocratic divide, the safety of being the world’s reserve currency affords the US dollar a privilege enjoyed by no other currency (arguably up until this year, you could also include the Japanese yen to a lesser extent). This flight to safety element has helped underpin support for the dollar through the year.
There is also a sense that the US remains the master of its own destiny in terms of trying to combat its own inflation problem, particularly compared to Europe. Rather than being driven by an external energy shock, such as the inflationary spiral being driven by gas supply issues in Europe, the US inflation problem broadly stems from an overly loose monetary policy that went on too long alongside a large stimulus package stemming from pandemic support, which still underpins the strength of US household finances to the tune of excess savings accumulated since the pandemic of $1.9 trillion, according to JP Morgan.
US dollar strength is not just against an increasingly beleaguered sterling but across a broad number of currencies. The US Dollar Index shows the dollar’s strength versus a basket of foreign currencies (dominated by the euro, but also measured against the Japanese yen, Canadian dollar, Swedish krona and Swiss franc) and this sees the US dollar at levels not seen since the beginning of the millennium. The dollar pushing higher is not only embedding higher import commodity costs, thereby perpetuating an inflationary pulse, but in the near-term is likely to be supported by the draw of safety as recessionary risks mount (and geo-political risk remains elevated) amidst an ever-improving interest environment for holding the dollar.
A Concerning Pounding
When Larry Summers (former US Treasury Secretary) says the UK is acting like an emerging market and the pound hits an almost 40 year lows versus the US dollar on the currency markets, you can conclude that global asset allocators are taking a pretty dim view on UK assets. The newly led British government in its “non-budget, Budget”, has delivered a sweeping array of tax cuts (c£45 bn of fiscal stimulus) and has additionally offered a massive backstop to households (estimated at £100bn +) to support them against rising energy costs this winter. The immediate market reaction has seen sterling fall and expectations for an even stronger set of interest rate rises being priced in.
The ramifications from not only the fall in the value of sterling, but also the sharp re-pricing of UK government bond yields is pervasive. During the course of the Conservative Party election, which started with the resignation of Boris Johnson on the 7th July, the UK 10-year government bond yield has risen from c2.2% to 4.2%, as I write. This market reaction is not ‘normal’ and should serve as a warning to governments elsewhere that the bond market is alive and well and does not like governments with unfunded spending commitments. Governments elsewhere planning spending under the guise of ‘Modern Monetary Theory’ (which argues unlimited spending can be financed by sovereigns that retain control of their own currency without any consequences) may be putting their MMT textbooks back on the shelf.
Sterling falls make UK assets look even more attractive to non-sterling investors, particularly US based investors who will see globally focused companies trading at cheap valuations. After years where UK plc has been shunned in the post-EU referendum fallout, a now cheap currency will be drawing more and more attention from overseas investors.
Buy the dollar, sell the roller coaster?
On a long-term measure, sterling pushing towards parity with the dollar suggests that it is under-valued. In the near term there remain good reasons for the strength of the US dollar to be maintained, both its reserve currency status and better interest rate profile make it a sensible harbour in a coming storm. On the other hand, those with a longer-term outlook may see sterling as suffering a perfect storm of events that have drawn it to a place of outright value.
…but it’s not all bad news…
A silver lining of sorts. For UK investors when they hold funds that invest in overseas assets, they receive not only the return on the underlying asset but also the return between the currency of that overseas asset and pound sterling. A strong overseas currency versus sterling, delivers a boost to returns, whereas a strong pound serves as a drag. For example, at the time of writing with a few days left of September, a US based investor is seeing the S&P 500 deliver a negative return of over -25% in 2022, whereas a UK investor benefits from a strong dollar/weak sterling, so the same index in GBP terms is ‘only’ down around -3%. Holding overseas currency in portfolios, particularly the US dollar helps serve as a risk control in difficult market environments and we have typically used unhedged share classes as a result. As we stand, the weakness of sterling may be sustained in the near-term, but on any longer-term time frame, the selling of the pound is probably overdone.