By: Tavaga Research
Credit Suisse equity research division produced a report in August of 2020 outlining their research on the impact of the dollar bear market and the implications for the global equity markets. A dollar bear refers to investors becoming pessimistic about the USD expecting its value to depreciate.
Firstly, they suggested there would be a long-term bear market, and this would positively impact economic growth, inflation expectations, commodity prices, and gold prices.
Secondly, they analyzed the implications for different regions ranging from emerging markets to Europe. Finally, they considered how certain sectors and stocks could be impacted.
Why will the dollar continue to depreciate further?
Data indicated dollar depreciation that occurred in July 2020 was the biggest since September 2010. The expectation is for the dollar to decline further by the end of the year.
Historically, a seven-year bull market is followed by a long-term bear market. This year the dollar is down 9% from its peak in March compared to a normal bear market decline of 40-50% over six years.
- Looking at the Euro versus the Dollar, the fiscal position is much worse for the US since the Fed has decided on unrestricted quantitative easing (QE). As a result of this, the US budget deficit and debt to GDP ratio have significantly increased compared to the EU. By the end of 2021 US government’s debt to GDP is expected to be 43 percentage points higher than the EU, meaning the US will be emerging from the crisis with a much higher level of debt.
- Economists believe that the US Federal bank will not allow the bond yields to increase thus, the Fed could increase its balance sheet more than the ECB further weakening the dollar. You may be wondering how the government purchasing treasury bills aids the economy, the purchases increase the reserve for banks which leads to increased lending therefore consumers increase their spending stimulating the economy.
- Massive changes in the European policy indicated the euro could become more of a reserve currency. Foreign exchange reserves are assets denominated in a foreign currency owned by the central bank these can be currencies, bonds, policy response, and treasury bills. At the moment only 20% of FX reserves are in the euro with its GDP weight of 15%, in 2009 29% of global reserves consisted of the euro. Countries hold foreign exchange reserves in case their national currency depreciated suddenly in value then the central government agency has backup funds.
- The euro area is operating with a significantly larger current account surplus compared to the US. Last time the euro current account surplus was 5% greater than the US, the euro was 20% more expensive.
- The dollar is 14% greater than the purchasing power parity which is the basket of goods economists use to compare currencies of different countries
- The real rate differentials are no longer dollar supportive meaning the gap between the real rates of the US and the euro has decreased
- US net foreign debt has reached a new peak at 55% of GDP which indicated the US net investment position has hit -55% of GDP. Massive US debt is owned by foreign countries and this makes the US vulnerable when countries decide to demand repayments or greater interest payments
- Net speculative positions have decreased to their most negative level since 2012 indicating poor confidence in the dollar leading to its depreciation. On the other hand, the euro has been overbought leading its price rising to historical levels
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How are long term currency moves dealt with?
First, the Fed would intervene if the USD has depreciated too much negatively impacting the inflation target.
Second, the central bank may intervene by cutting rates if they feel the currency weakness is damaging the economy.
Normally three factors prevent a USD bear market:
- Extreme undervaluation
- Policy response
- A sharp adjustment in the current account
Concerning the dollar, it’s overvalued and policymakers are unlikely to implement policy change until the extremes are reached thus this leaves the current account adjustment.
The current account adjustment occurs due to the imports falling significantly negatively impacting US growth or due to currency moves leading to improvement in trade and current account balance. The issue with current account adjustment is that they can negatively impact shale oil prices and there is a time lag for imports and exports to adjust.
How will a dollar bear affect your investments?
- A weak dollar is beneficial for global economic growth since 80% of global trade and 62% of FX reserves are dollar-denominated. In addition to this, the US can tackle the inflationary consequences due to dollar depreciation while the currency of emerging markets strengthens leading to monetary easing
- A weaker dollar will lead to a rise in inflation expectations. As a result, investors should invest in real assets such as US and UK homebuilding, mining, and cement firms that benefit from government policy and have formal CPI links
- A weaker dollar benefits commodity prices, 5-8%, and 20% of demand for mining commodities and oil are from the US and they’re dollar-denominated. As a result, commodities become cheaper in the local currencies for non-buyers increasing commodity demand
- Gold prices benefit from a weaker dollar since 95% of gold consumers originate from outside the US. There is a strong inverse relationship between the gold price and the dollar price
How will a dollar bear affect different regions?
Emerging markets benefit from dollar weakness, with there being a strong correlation. Sometimes emerging markets can outperform with a lag. This is because the emerging markets have $5.4 trillion of FX-denominated debt and with imports, they are often dollar-denominated thus an appreciation in emerging currencies reduces inflation and allows their central banks to reduce rates.
Finally, the dollar weakness will cause the FX reserves to increase as emerging markets trade rise. The central banks then try to cap the currency strength by increasing FX reserve, as a result, the money supply increases causing leading asset prices and emerging markets to outperform. In Europe, a stronger euro is detrimental to the euro area equities.
Data shows that the euro area equities underperformed by 70% when the euro appreciates, there is a strong negative correlation between a strong euro and European returns.
Which sectors stand to benefit due to the dollar depreciation?
- Sales exposure, whereby the larger the sector earning’s, the less it will be impacted by currency strengthening
- A statistical relationship where the USD depreciates, the investor should increase their exposure to sectors that have a strong positive correlation to the Indian rupee. However, sometimes the dollar strengthens into a recession, and the performance of sectors is not driven by USD but by PMIs
- Select few companies from the consumer durables sector who depend on the derivatives of crude oil stand to benefit from a weaker dollar against the rupee. Also, the aviation sector, engineering goods, and commodities emerge as the winners as the rupee appreciates against the dollar