Tags: dollar | assets | allocation | investing

When the Current Dollar Bull Run Ends, Will It Impact Asset Allocations?

When the Current Dollar Bull Run Ends, Will It Impact Asset Allocations?
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Thursday, 09 August 2018 11:44 AM Current | Bio | Archive

The current dollar bull run is now about 7 years underway, which makes it longer than the dollar bull runs of the 80s and the 90s.

So, the day the dollar run turns around, will it impact investors’ asset allocations?

Measured in dollars, the S&P500 has outperformed the MSCI EAFE Index, which measures the equity market performance of developed markets outside of the U.S. and Canada, by roughly 100 percent since the end of the last U.S. recession in 2009.

Would a new U.S. recession stop the relative outperformance of the S&P500?

As a thought experiment (!) and not a forecast, let’s assume a U.S. recession starts in H2 of 2019.

So, based on the past 3 or even past 5 U.S. recessions, we see that a U.S recession is by itself not a reason to change asset allocation.

When looking at the post-Bretton Woods era of floating exchange rates, the dollar usually gains during U.S. recessions.

12 months into a new U.S. recession, the trade-weighted dollar has risen by an average of 6 percent, and by 10 percent two years after the onset of a recession. Only once, in 2001, was the dollar weaker by about 4 percent after 24 months. Thus, a generally stronger dollar usually helps U.S. markets outperform also in recessions.

Moreover, a stronger dollar generally tightens financial conditions outside of the U.S. This is counter-intuitive (!). In text-book economics a weaker currency is good news because of a larger growth contribution from net exports as competitiveness has improved.

However, this effect is dominated by financial effects. For example, firms who have borrowed in dollars see debt-burdens grow in local currency, which weakens the appetite to invest. The financial sector also becomes less keen to lend.

Thus, as the dollar tends to gain during U.S. recessions, it not only underpins the return of the S&P500 but also weakens the return elsewhere due to a negative impact on activity. Hence the direction of dollar is quite important for asset allocation decisions.

The past two major bull moves of the dollar in the early 80s and the late 90s lasted for 6.4 and 6.8 years respectively. Measured by the trough to peak in the dollar, the S&P500 outperformed the MSCI EAFE index by 10 percent and by more than 100 percent in these two periods.

During the two periods where the dollar showed a long weakening trend, the S&P500 instead underperformed the MSCI EAFE index by 15 percent (1985 to 1995) and 25 percent (2002 to 2011).

So, the dollar run has now lasted longer than both the bull run in the 80s and in the 90s.

If the dollar has peaked or is about to peak, you are likely to get outperformance in assets outside of the U.S.

I expect the dollar to peak in H2, 2018.

Emerging Markets – Turkish Lira’s Continuous Depreciation

When yesterday (Wednesday), during high level talks in Washington between U.S. and Turkish officials, the Turkish delegation that met with U.S. Deputy Secretary John Sullivan refused to commit to releasing Andrew Brunson, an evangelical North Carolina pastor who ran a small Protestant church in Turkey for more than two decades, and who was detained in October 2016 and eventually accused of terrorism and espionage, charges that could send him to Turkish prison for 35 years. The Trump administration has dismissed the case as groundless, and Mr. Brunson has denied the charges.

Mr. Bronson’s freedom has become a “cause célèbre” for evangelical Christians in the U.S.

These latest developments raise now the odds that the U.S. will double down on their sanctions on Turkey and adds to the domestic challenges like for example the Turkish authorities’ inability to put a lid on inflation that plague Turkish lira-denominated assets.

The Turkish lira plunged more than 3 percent to 5.4318 per dollar, taking this year’s losses to almost 30 percent while the yield on 10-year Turkish bonds jumped 60 basis points to 19.67 percent. Also, the one-month lira-dollar risk reversals, the premium traders pay for options to sell the local currency over those to buy, climbed above 5 percentage points for the first time since 2011.

By the way, the Turkish lira has weakened about 8 percent since U.S. measures were announced, which is piling pressure on the Turkish central bank to raise rates and prevent a further acceleration in runaway prices, potentially at an unscheduled meeting. The next central bank meeting is scheduled for September 13.

One thing is for sure, there is no solution in sight yet.

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The current dollar bull run is now about 7 years underway, which makes it longer than the dollar bull runs of the 80s and the 90s.So, the day the dollar run turns around, will it impact investors' asset allocations?Measured in dollars, the S&P500 has outperformed the MSCI...
dollar, assets, allocation, investing
Thursday, 09 August 2018 11:44 AM
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