Where to invest if the US dollar weakens?

I remember a time when there were two dollars to the pound. It was back in the 1990s and it used to be a ‘thing’ to go on holiday to America and come back with loads of cheap shopping. Last summer, when I went to San Francisco on holiday the two currencies were almost on a par.

In fact, the US dollar has been strong for a while now and, in late 2022, it hit a 20 year high compared with other major currencies including the euro, pound and the yen.

How the strong dollar has helped UK investors

While this hasn’t been great for holiday spending money, the strong dollar was helpful to UK investors last year in a couple of ways. Firstly, many large UK firms are multinational and get their revenues in dollars. This means some companies in the FTSE 100 in particular have found their profits have remained healthy even while the economy has been slowing.

Secondly, if UK investors have holdings in US or global equity funds, the strong dollar has protected them from some of the market falls. For example, XYZ American fund has shares worth $5 each. The exchange rate is $1.50 /£1, so each share is worth £3.33. You buy 100 at a cost of $500, or £333 in sterling terms. Sometime later, assuming the share price is still $5, but the exchange rate is now $1.34/£1, $500 is now worth £373, so you have gained £40 as a result of the pound weakening against the dollar.

Where to invest if the dollar weakens?

We asked a number of Elite Rated managers and their colleagues which asset classes could do better if the dollar weakens. Here is what they had to say:

Mike Riddell, manager of the Allianz Strategic Bond fund

“It’s important to first understand in what scenario the US dollar would likely weaken,” said Mike. “If the Federal Reserve (Fed) hikes interest rates by more than markets expect because growth and/or inflation are too high, the US dollar would probably strengthen.  If we have a deep recession, and particularly if we get some sort of crisis, then the US dollar would also probably strengthen due to its safe haven properties.

“The environment in which the US dollar weakens is likely the ‘middle ground’, where we get a benign economic outcome, or only a brief and mild recession, where nothing blows up.  If we do get that ‘muddle through’ scenario where the US dollar continues to weaken, which is essentially a repeat of what we saw from end October 2022 to end January 2023, then risk assets would probably do well, and emerging markets would do particularly well.”

Goldman Sachs Asset Management believes the tide is turning in favour of equities outside the US, driven by an improving economic outlook, especially in the Euro area, and US dollar weakness. “Historically, periods of US dollar weakness have coincided with strong performance for equities outside the US. In a world of heightened market volatility, we also believe that their elevated dividend yields may support total returns,” it said.

The chart below shows the returns of the MSCI EAFE – a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. and  Canada – when the dollar is appreciating and depreciating.

James Mee, co-head of multi-asset strategies at Waverton

“Consensus (and to be fair, precedent) would suggest that dollar weakness should lead investors to trade commodities (energy, industrial metals, precious metals), emerging and Asian equity and debt markets, and US-listed companies with dollar costs and foreign currency earnings,” said James.

“Of course, long term, the drivers of returns are more complex, and rarely so one dimensional as a single currency’s strength or weakness. So ‘what to own if the US Dollar weakens’ is more of a trade, which is a question of time horizon.

“It is important to consider why the dollar is depreciating. Today, the dollar seems to be weakening not because other economies look stronger than the US, but rather because the US looks further down the road on taming inflation, and the Fed appears closer to terminal rates than perhaps other central banks do.

“So if the Fed pauses sooner, it does so from a position of strength. The European Central Bank, Bank of England and Bank of Japan may have to continue to hike, which could mean stronger currencies in the short term, but their economies (which are more vulnerable to higher rates) will begin to slow – and faster than the US’.

Paradoxically, the very same reason for US dollar weakness could, in time, lead to USD= dollar strength…

“Short term, there is no reason to believe historical relationships mentioned above won’t hold: commodities and emerging markets could do well. But we wouldn’t be all- in on risk simply because the dollar is down.”

Sharon Bentley-Hamlyn, Investment Director, Aubrey Capital Management

“Japan should be a beneficiary of a weaker US dollar,” said Sharon. “Any signs of further Yen strengthening and a repatriation of funds back to Japan would be hugely positive as the Japanese are big investors in foreign assets.  Japan is coming late out of covid, just as China is re-opening.  Japanese companies do major business in China, which accounts for over 20% of its exports and Japan is one of the most favoured destinations for Chinese tourists, with visits estimated at 9.5m in 2019, numbers which collapsed during covid.

“Around half Topix index companies are trading below book value and valuations are low on a historic basis.  Japanese companies are generally well cashed up and good levels of growth can be found with judicious stock picking.  Japan has a sophisticated industrial complex and produces advanced systems and components in many fields, notably semiconductors, robotics, factory automation, and automotive related industries.”

Simon Edelsten, co-manager of the Mid Wynd International Investment Trust

Simon also likes the prospects for Japanese equities. “In the mid-1980s, when I began my career, Japan made up over 40% of the global index; today it is just 6%. US equities made up 33%; today it is 62%,” he said. “Tides shift. Suggesting they might turn a little in Japan’s favour may elicit snorts of derision from some quarters – the recovery of Japanese markets has been foretold too many times before.

“But interest rate moves are triggering huge shifts in the tectonic plates of the currency markets. The dollar looks overly strong. The yen may be rising. Inflation has finally washed up on the shores of Japan. It has needed it. The era of negative interest rates may be coming to an end. That will encourage banks and other institutions with large amounts of capital overseas to repatriate their money. All this would be good for the yen and for overseas investors holding shares in Japan.

“In the meantime, you get a lot more for your money in Japan. It is full of companies loaded with cash, many selling world-leading products, like robotics, and often kicking out a respectable dividend. I think Japanese banks look particularly interesting – it would take only slightly higher interest rates for their profit margins to improve sharply.”

Ritu Vohora, capital markets specialist at T. Rowe Price

“A strong dollar has been a significant headwind for non-US stocks in recent years,” said Ritu. “A weaker greenback will ease imported inflation around the world and help reduce the debt burden for governments borrowing in US dollars. In particular, this could benefit emerging markets and the more capital-sensitive markets within the asset class. Historically, there has been a very high inverse correlation between the dollar and emerging market equities.

“Commodity producers in the region could get a double benefit, given most commodities are priced in US dollars. Emerging market debt offers another way to benefit from a weakening dollar, as it is easier to service debt if bonds are denominated in the dollar. Attractive yields and valuations also support the asset class.

“The Japanese yen has suffered some of the greatest weakness against the US dollar, however, the Bank of Japan’s surprise decision to tweak policy to increase rates on 10-year bonds could bode well for Japanese assets. Furthermore, after several years of underperformance international equities look more attractively valued and poised to outperform.

“US companies that derive a significant portion of their revenues abroad benefit from a weaker dollar as they translate foreign earnings and sales back into dollars.

Exporters and energy companies have been traditional beneficiaries in this regard but large multinationals and technology companies with a significant global footprint could also benefit. Of course this is only one variable and a focus on fundamentals will remain key.

“Gold is typically denominated in US dollars, so tends to have an inverse correlation to the dollar and could see its lustre come back. Furthermore, it’s seen as an inflation hedge and store of value in times of recession.”

Omotunde Lawal, head of emerging markets corporate debt at Barings

“In the coming months, the global economy will likely continue to decelerate as the momentum of past monetary policy decisions weighs relentlessly on activity,” said Omotunde. “This should provide a strong tailwind for global interest rates, including those of emerging markets countries. Softer global growth and expectations for an end of the U.S. Federal Reserve’s monetary tightening cycle will also limit the upside of the U.S. dollar—and this should prove particularly favourable for emerging market local currency debt.

“In particular, when it comes to hiking interest rates to combat higher inflation, emerging market central banks have been ahead of the curve relative to developed market central banks—and in cases where inflation seems to be peaking, they are nearing the end of their hiking cycle. With real rates in many of these countries now positive, we believe certain exchange rates look attractive given the potential carry on offer.

“In addition, even if rates in developed markets increase in the near term, emerging market rates don’t have much room to go higher. This tends to be a supportive environment for currencies to appreciate. At the same time, emerging market central banks are welcoming currency appreciation in order to tackle inflation—unlike in previous periods where central banks intervened to prevent rising currencies.”

_{Photo by GeoJango Maps on Unsplash}