By Matthew Haupt

 

The US dollar’s haven status is faltering, showing signs of overvaluation. Weak inflows and record foreign outflows highlight the risk of mean reversion that could see a cyclical decline in the greenback that will drive excess returns from commodities and emerging markets.

Three fundamental drivers move currencies: valuation; monetary and fiscal policies; and the balance of payments. Currency values rarely settle on “fair value” and this concept only matters at extremes, when deviations are so stretched that they snap back.

The real effective exchange rate (REER) is a tool to value a currency – it is weighted by the importance of its trading partners and is adjusted for inflation. The US dollar’s REER is replicating previous bull market heights, but that alone does not predict an imminent fall. Historically, mean reversion has required a catalyst – presently, that role looks to be played by monetary and fiscal policy.

Collective wisdom holds that strong economies lead to strong currencies. In reality, growth differentials affect currencies through interest rate spreads –stronger economies should provide higher real interest rates which drive capital inflows. Recent bull markets in the US dollar have benefited from these yield differentials and the latest bull run led to the US Federal Reserve normalising interest rates, in late 2019, while other central banks drove zero and negative rates.

The coronavirus recession has triggered a major reversal of the US dollar’s yield advantage. The US is not positioned for a V-shaped recovery given its questionable management of the pandemic: the Fed has proven the most interventionist central bank during the coronavirus crisis; and when the US economy does stabilise, the Fed is unlikely to rush to raise interest rates.

A range of future pressures sits on the horizon. A Democrat sweep at the November election may deter foreign inflows; any adoption of modern monetary policy would drive them away further; and a slated policy review may have the Fed letting inflation run ahead of policy intervention.

The balance of payments also presents trouble ahead. Investors pulled $US570 billion from US Treasuries over the past 12 months, a record rout, and corporate bonds are also suffering outflows. Foreign interest in US equities has somewhat offset this impact, but foreigners are net sellers of US securities. This leaves the US reliant on short-term capital flows to finance its trade and current account deficits that will weigh on the greenback.

 

Investing in the decline

This macroeconomic theme creates two clear winners: commodities and emerging markets. A cyclical decline in the world’s currency is a tailwind for commodities, as most trade in US dollars. In particular, gold stands to benefit as it may prove the safer of the two traditional havens.

A decline in the dollar will drive a rally in emerging markets as capital continues to flow out of the world’s largest economy seeking a greater yield differential. As intense consumers of commodities, strong trading in emerging markets assists the asset class.

In our view, macroeconomic trades are best deployed alongside solid fundamental analysis. We believe investors are best placed when focusing on the best companies within sectors that stand to benefit from a macroeconomic theme. We have invested in several gold companies to take advantage of this rally, with Newcrest Mining our preferred exposure. The company has recently delivered strong production performance, presents growth optionality across key projects and is led by a solid management team.

There is cause for short-term wariness in the gold run, but the longer-term dynamics remain supportive. Similarly, Oz Minerals, the South Australia-based copper-focused mining company, is meeting increased production targets while cutting costs, as supply constraints and improved prospects for the global economy add to the US dollar tailwind.

Several solid Australian companies provide investors with exposure to emerging markets. The world’s largest listed winemaker, Treasury Wines, derives about 40 per cent of its earnings from within Asia. Other companies, such as global packaging firm Amcor, boast growth engines throughout Asia.

An overvalued US dollar faces multiple catalysts to force it into a long downward trend. The decline of the dollar presents a clear opportunity for investors to combine macroeconomic insights with quality stock selection in a highly uncertain investing environment.

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