Last year Steve Forbes co-authored a book called Money: How the destruction of the Dollar Threatens the Global Economy – and What We Can Do About It. Prominent on the cover is the image of a battered one dollar bill with a savage tear that threatens to consume the portrait of George Washington at its centre.
And yet, as 2015 unfolds, the prospect of a US dollar in terminal decline is far from our thoughts. The dollar has strengthened against most major currencies this year. Within six months we expect the dollar to trade at its strongest levels against the euro since Europe’s sovereign debt crisis. Against the yen, we forecast the US currency to be the strongest since December 2007.
Behind this call is an expectation the US will recover faster than other major economies which will allow the central bank to raise interest rates in 2015. This would be the first time the US central bank has raised rates since 2006 and represents the so-called ‘normalisation’ of US monetary policy following the end of quantitative easing – the controversial financial stimulus programme designed to support shaky markets after the global financial crisis.
What also makes the dollar (and assets denominated in the currency) more attractive is the divergence of US central bank policy from that of the European Central Bank (which is contemplating further stimulus that will weaken the euro) and the Bank of Japan (where a weak yen forms a central component of Prime Minister Shinzo Abe’s economic policies).
With US assets in favour once again, the argument goes, international investors will pull money from so-called ‘riskier’ investments in emerging markets. We saw a dress rehearsal in 2013 after former Fed chairman Ben Bernanke raised the prospect of an end to stimulus policies.
As long time fund managers in Asia, we are carefully watching the anticipated shift in US central bank policy. Uncertainty over the exact timing and questions surrounding the strength of the global recovery has already triggered the return of market volatility after a prolonged period in which volatility had been notably absent.
However, we’re quietly confident Asian markets will prove to be resilient. One of the most important consequences of the 'taper tantrum’ was that emerging markets underwent an adjustment process: current account deficits – largely driven by the degree to which imports exceed exports – are now smaller (or at least not bigger); real interest rates are turning positive; and real exchange rates have depreciated (helping to curb imports and manage deficits).
For example, India’s stocks and currency have recovered from sharp falls in2014. Granted, much of this has been due to election euphoria on hopes Narendra Modi, the new pro-business prime minister, will champion much-needed reforms. However, the country has also made significant strides in addressing those signs of economic weakness that had been behind investor concerns.
Indonesia, another of the so-called ‘fragile five’ emerging economies most affected by the ‘taper tantrum’, has also managed to restore monetary policy credibility but still faces headwinds. While sentiment has improved Joko Widodo, the country’s new president, must tackle political resistance to his reform agenda.
Higher interest rates and a stronger dollar may mark the end of the benign investment environment that has been a hallmark of much of the post-financial crisis era. However, it would be wrong to conclude that a stronger dollar is automatically bad for emerging market stocks.
A look at the relationship between emerging market equity performance (relative to developed markets) and the strength of the US dollar over the past quarter century shows long periods – in 1993, 1999, 2005, 2010 – when emerging markets outperformed despite dollar strength. Therefore the correlation is, at best, casual.
The normalisation of monetary policy is based on the assumption of a sustainable US economic recovery which bodes well for Asian exports growth.
a sustainable US economic recovery which bodes well for Asian exports growth.
This is set to benefit almost every economy in the region. Despite a couple of high-profile exceptions, most run a current account surplus – one of the reasons we continue to like Asia as an investment destination.
We believe the long-term benefits outweigh the inevitable short-term pain. Due to the central bank policies of Hong Kong and Singapore, low US interest rates have been mirrored in both markets, encouraging speculation that helped create two of the most expensive property markets in the world. Interest rates at ‘normal’ levels should lead to more productive investments.
The end of financial stimulus policies isn’t a bad thing. They have made a mockery of traditional methods of gauging value and risk. Their demise will drain markets of speculative capital and signal a return to investment fundamentals and the search for quality.
Markets will be better off in the long run.