End of an era for the US dollar

The fundamentals underpinning a strong United States dollar are steadily being eroded, with investors looking elsewhere for returns and safety amid increased volatility and uncertainty. 

This means the greenback is likely to weaken further in the coming years, with this potentially being the beginning of a longer-term shift out of US assets. 

Historically, shifts from investors out of the US dollar have been short-term cyclical rotations as commodity prices soared and emerging markets generated strong returns. 

What makes this time different, according to Old Mutual portfolio manager Zain Wilson, is that the dollar’s weakness has been driven by changes in US fundamentals. 

The key factors driving US exceptionalism over the past 15 years are slowly fading, bringing down the dollar with them. 

Wilson explained that the US financial markets have sucked up global liquidity over the past 15 years, driven by four key factors that created the perfect mix for a strong economy, a soaring stock market, and a strengthening dollar –

• Security of capital: Policy certainty, strong private property rights, and a tight lid on inflation assured investors that their capital was safe in the United States. 
• Growth and interest rates: The United States economy outperformed global peers and relatively elevated interest rates attracted capital to American assets.  
• Valuations: The soaring United States stock market was driven largely by earnings growth from American companies and not valuation expansion. 
• Returns: US assets, particularly equities, produced exceptionally high returns for investors, creating a feedback loop which attracted investors. 

One of the side effects of these factors was a much stronger dollar as money flowed into US assets. This was boosted by the lack of alternatives, as the American economy and financial markets dominated. 

In many cases, these factors are still apparent, Wilson said. However, they are slowly being eroded by factors well within the United States’ control. 

Wilson explained that security of capital and strong economic growth are the most important factors and that these are being eroded at the fastest pace. 

In particular, unconventional policy and increased uncertainty are making investors increasingly question the security of their capital in the United States. 

This has been exacerbated by attacks on key institutions, particularly the Federal Reserve, from United States President Donald Trump. 

Investors are also increasingly concerned about America’s financial health, with the Federal government running record deficits outside of wartime. 

The US government is now sitting on a debt pile worth more than $38 trillion, increasing fears of a financial cliff and concerns that it will look to inflate away this debt, thereby making capital less secure. 

Wilson added that increased pressure on the Federal Reserve, coupled with slowing growth and rising inflation, have increased the chances of a major monetary policy mistake that could result in stagflation and severely impact US economic growth. 

The key factors underpinning US exceptionalism can be seen in the graphic below, with some of the issues eroding these factors listed alongside. 

Expensive dollar has room to fall 

What makes the situation more severe for the US dollar is that it is historically overvalued at current levels, meaning that even without the end of American exceptionalism, the currency is likely to weaken. 

This is coupled with stretched valuations for American equities, which have pushed investors to look elsewhere for returns, weakening the dollar. 

Wilson explained that a combination of an expensive currency, expensive valuations, slowing growth, and higher inflation is potentially disastrous for the greenback. 

This does not mean the US currency will no longer be the world’s reserve currency or the primary currency used in global financial transactions. 

In fact, the use of the US dollar in global financial flows is at its highest levels in years, with its share of global reserves relatively flat. 

Thus, the erosion of the fundamentals underpinning US exceptionalism has been the catalyst for the dollar to fall back towards its historical mean.

If it were any other currency, it probably would have fallen further, but the world cannot simply turn away from the greenback.

One of the major reasons why the US dollar has not weakened more than it has is that there is a distinct lack of alternatives.

The euro is underpinned by a slow-growing economy that is hobbled by overregulation, an ageing population, and looming fiscal crises in major economies.

Thus, while European capital markets are relatively deep and transparent, they cannot attract the capital needed to be an alternative. Crucially, European capital markets are also fragmented across various countries.

China, on the other hand, has its own problems with a lack of transparency and depth in its capital markets. 

Wilson made it clear that the dollar will not weaken in a straight line, with the currency likely to have periods of strength. 

Furthermore, this does not indicate the death of the dollar or an exit from US investments, but reduced inflows and the end of a 15-year run of strength. 

Emerging markets, such as South Africa, are set to benefit from a weaker dollar as it eases financial conditions and results in lower inflation. 

A weaker dollar lowers debt-servicing costs held in the currency and makes it relatively cheaper to import goods, reducing inflation. 

The graph below shows the dollar’s currently expensive valuation, followed by that of US equities, and a graphic showing America’s slowing growth and rising inflation.