A weaker U.S. dollar is often described as a positive for U.S. stocks, particularly shares of large-cap companies that derive a big chunk of revenue from overseas. But high dollar-hedging costs could drive overseas investors away from U.S. assets this time around, warn analysts at Morgan Stanley.
Also read: Why the stock market’s fate could hinge on the U.S. dollar
What’s more, that dynamic means that dollar weakness could be “self-reinforcing,” wrote strategists led by Andrew Sheets, in a note.
The ICE U.S. Dollar Index DXY, +0.28% which rose 4.4% in 2018, helped by the Federal Reserve’s monetary policy tightening, government stimulus and strong economic data, is expected to have a less rosy 2019.
Why does it matter?
“Sustained dollar weakness has major implications for global allocations,” wrote the analysts in a note. “For the better part of the last nine years, the best trade global investors could make was to own U.S. assets — both stocks and bonds — on an unhedged basis.”
Since then, the Fed raised interest rates while its peers mostly didn’t, sending dollar hedging costs soaring. This didn’t matter when the dollar was appreciating, because global investors wanted that positive foreign exchange exposure. But with a weaker dollar, the dynamic reverses.
Suddenly, foreign investors investing in the U.S. could have unfavorable currency exposure. But hedging costs for U.S. assets, such as stocks in the Dow Jones Industrial Average DJIA, +0.35% or S&P 500 SPX, +0.45% have seldom been higher than they are now, making FX-hedged yields rather unattractive, the Morgan Stanley strategists said. This could lead to a temptation to sell.
“Selling unhedged U.S. assets, and reinvesting locally, would only put more downward pressure on the dollar,” the analysts wrote.
“We think that this case is strongest in equities, where the differences in relative valuation, relative FX-hedged yield and Morgan Stanley price targets are least favorable for the U.S. market,” they said. “For U.S. bonds TMUBMUSD10Y, +1.37% the impact could potentially be more muted.”
In addition, the analysts argued that the “conventional wisdom that ‘a weaker dollar means better relative U.S. equity performance’ is wrong.”
“Comparing the Broad Dollar Index with relative U.S. versus RoW [rest of the world] equity performance, they peaked in the same month [in 1999], and then reversed together for the next six years. This is our expectation for 2019 — a weaker broad dollar and RoW stocks outperforming the US, and both running on a sustained basis.”
The implications, they said, are to stay dollar-bearish across the board, as well as to prefer stocks outside the U.S.
Morgan Stanley’s view on the dollar also remains bearish “driven by our FX strategists’ concerns about rich valuation and a shift in the U.S. growth and policy narrative. [Last week’s] FOMC meeting further supports the idea that major dollar peak is now in,” the strategists said.
Dollar bears believe the drivers that boosted the buck last year will peter out in 2019, leaving the greenback with little left to give. Last year, for example, the Fed raised interest rates four times, which was immensely dollar-positive. And while interest rate differentials still favor the U.S., the central bankers sounded markedly more dovish over the past months, and last week’s Federal Open Market Committee meeting was so apprehensive regarding further monetary tightening that it caught many market participants off guard.
Similarly, the corporate tax cuts and as other government stimulus look to be 2018-only events that won’t be much help this year. Many expect U.S. economic data to grow more sluggish this year. Plus, the unresolved U.S.-China trade spat, which didn’t weight on the buck last year due to the assumption that the likes of China would be comparatively worse off, is also beginning to weigh now.
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