Despite its recent slide, the US dollar is still overvalued. In time, the greenback could go much lower. This has positive implications for European, Japanese and EM equities, but is a bad prospect for Wall Street, according to Michael Devereux, multi-asset fund manager at Schroders.
Devereux is not surprised by the recent weakening of the dollar. ‘Usually the dollar performs poorly in an early stage of economic recovery,’ says Devereux. He believes the dollar weakness will continue for the time being, although the slide will level off this year. ‘By 2020, the US dollar has fallen 7% compared to other major currencies. This is extraordinary. However, a further fall of around 5% during the next phase of global economic recovery is likely,’ he says.
According to Devereux, a weak dollar will make European and Japanese equity markets thrive. For European exporters, a stronger euro would mean more headwinds, but the fund manager is not concerned. ‘A stable to slightly stronger euro is actually good for the European equity market, as it increases confidence in the currency and can trigger capital inflows.’
US small caps
For Wall Street, the outlook is less positive. The strong returns of US equity markets in recent years went hand in hand with the appreciation of the dollar, Devereux notes. ‘US stock markets have relatively little exposure outside the US and are dominated by the technology and healthcare sectors,’ he says. ‘The strong dollar kept a lid on inflation, allowing the Fed to keep interest rates low. This has driven up the valuations of IT and healthcare stocks. With the expected weakening of the dollar, this tailwind for Wall Street will be gone. This is a major reason for us to be negative on US equities.’
Devereux still sees opportunities in US small caps though. ‘For smaller US companies, the domestic market is much more important than exports. They are especially sensitive to interest rates and inflation. A cheaper dollar leads to higher inflation expectations and rising interest rates in the US. This is therefore to the advantage of small caps.’
Euro as an alternative
In the medium to long term, Devereux anticipates a more meaningful downward trend in the US dollar. ‘The dollar is simply too expensive in a world of abundant liquidity, low interest rates and rising US budget and trade deficits. Now that the Democrats have also won the majority in the Senate, the way is open for large-scale fiscal stimulus. This will only serve to strengthen the dollar’s downward trend.’
Moreover, Devereux thinks that in the long term the dollar will lose ground as a global reserve currency. ‘In 10 to 20 years’ time, the dollar could easily lose another 10 to 15%. If you look at the weight of China in the world economy, the dollar currently plays too big a role as a reserve currency. But the Chinese do not want to take over that role because they do not want to give up control over their capital account and their national currency. This makes the euro the most obvious alternative reserve currency. The eurozone has a large population and economy, and there is potential for growth to accelerate.’
If the euro, Japanese yen and Chinese yuan gain importance on the world stage, the volatility of the dollar would increase. ‘This is not good for the global economy,’ Devereux warns. But the biggest losers are, once more, US equities. ‘Because of its status as a reserve currency, the world has an interest in keeping US interest rates low. This has made stocks extremely expensive, especially in the US. Not only the dollar is overvalued, but also the US stock market. A structural weakening of the dollar can hit home hard.’
That is why, according to Devereux, the time has come to diversify outside the US. ‘The US has had an exceptionally good pre-corona period, with growth much higher than in Europe and Japan. We think that the benefits of the huge US stimulus packages will also be felt elsewhere in the world and that the strongest economic growth will take place outside the US. Since the US stock market is much more expensive than the rest of the world, it makes sense to invest less in US equities.’