The U.S. dollar, like the U.S. economy, is suffering from the impact of the COVID-19 pandemic, and that has implications for advisors’ clients’ portfolios.
The dollar index, which measures the greenback against a basket of developed market currencies, including the euro and yen, fell 4% in July, its biggest monthly drop since September 2019, and it’s down about 9% from its mid-March high.
At that time, earlier in the pandemic, global investors rushed into dollar-based securities like Treasurys as safe havens because the U.S. was experiencing far fewer infections and deaths than many other countries, including those in Europe. Now the U.S. leads the world in infections (over 4.6 million) and deaths (near 155,000), though a few other countries have higher rates of both per million people.
The dollar’s decline also reflects narrower differentials in economic growth rates and real bond yields between the U.S. and other countries, largely due to their differences in pandemic trajectories.
“The dollar benefited from the uncertainty around the global COVID Crisis, but the U.S. will now have to ‘win the peace’ to keep the dollar from losing more than a typical post-crisis decline in value,” writes Nicholas Colas, co-founder of at DataTrek Research.
He expects another 13%-14% decline in the dollar over the next 2 years; Goldman Sachs foreign exchange strategists are forecasting another 5% drop over the next 12 months.
Given these outlooks, which are shared by many other strategists, how should advisors reposition client portfolios?
“When the USD weakens, investors should favor firms with a larger share of revenues generated abroad,” according to Goldman Sachs strategists led by David Kostin.
On a sector basis, that would favor U.S. technology and materials stocks, which derive over half of their revenues from overseas, according to FactSet’s 2020 first quarter Earning Insight report. The energy sector also tends to perform well “during months when the trade-weighted USD fell by at least 1.25%,” according to the Goldman strategists.
International stocks, too, are generally touted as a good investment when the dollar weakens, but not all international stocks or global indexes will benefit from a weaker dollar.
The EAFE index, which tracks major non-U.S. and non-Canadian equity markets in Europe, Australia, New Zealand and the Middle East, for example, has underperformed the S&P 500 by more than two percentage points over the past three months and as much as five times that amount year to date.
Tracie McMillion, head of global asset allocation strategy at the Wells Fargo Investment Institute, explains these performance differences are due to the different composition of the two indexes.
Technology and communication services constitute a much larger share of the S&P 500 index than the EAFE index — 25% and 11%, respectively, vs. 8% and 5.4%. The EAFE index is also more heavily weighted toward financials — 16% vs. 10% in the S&P 500.
Wells Fargo Investment Institute believes U.S. investors should allocate their assets globally, including exposure to developed and developing markets, but favors U.S. stocks over foreign equities because investors need to match assets with the currency of their liabilities. Still, the institute has been recommending tactical changes to investor portfolios to take advantage of the dollar’s weakness over the next 16-18 months, among them, a greater allocation to commodities, which are priced in dollars.
“We continue to like gold in a diversified portfolio,” said McMillion noting the institute’s target price for gold for 2021 is between $2,200 and $2,300 an ounce, up from about $1,990 currently. In addition to commodities and large-cap multinationals, McMillion likes U.S. mid-caps but not small-caps, which are more dependent on U.S. revenues and tend to underperform when the dollar rises.
Investors need “to consider how a weaker dollar impacts different investments,” says Katy Kaminski, chief research strategist at AlphaSimplex Group, an affiliate of Natixis Investment Manager.
She views the dollar’s weakness after years of unrelenting strength as “an indicator of a bigger issue,” namely rising inflation down the road, due to the almost doubling of the Fed’s balance sheets and trillions of dollars worth of fiscal relief during the pandemic.
“At some point something has to give,” said Kaminski, adding that there could be a temporary ‘correction’ to the dollar’s current decline though the long-term outlook calls for more weakness.
Kaminski also favors real assets, such as commodities, due to the dollar’s drop. “We’ve seen commodity prices go to record lows,” says Kaminiski. “That means there is only way to go, and that’s up.”
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