By Witold Bahrke
Although political risks should be on investor minds ahead of the US election and beyond, they also tend to distract from the underlying fundamental problems. Looking through some election-induced volatility in markets more lately, this begs the question what could derail markets from a more fundamental perspective.
In our view, the renewed US dollar strength bears watching. It could turn out to be one of the key risk factor for markets as we approach year end, especially since some of the better performing parts of the markets seem out of sync relative to the dollar strength. A Clinton victory will not reduce these risks in a meaningful way.
When the US dollar began to weaken last year, it laid the groundwork for a strong performance in equity markets in the first half of 2016, as a weaker dollar means looser financial conditions to support risk assets. Since May however, we have seen renewed US dollar strength, fuelled by a rising probability of a Fed rate hike in December. Before lection nervousness crept into markets last week, the broad dollar was up 7% since the lows in May. On top of medium term problems this might cause (lowering US GDP growth over the coming year), we see two key risks that have the potential to roil markets: weaker commodity prices and the resurfacing of China currency risks. Both factors are side effects of a stronger dollar.
Firstly, a strong dollar normally means weaker commodities, as most commodities are denominated in dollar. As a consequence, a strong dollar makes them more expensive, weakening overall demand. But so far, commodity prices have done quite well since the summer – with oil prices weakening only recently. The strength in commodities over the recent months has contributed to what some people call a ‘regime shift’ in equities, with cyclical sectors starting to outperform. However, we think the combination of a strong dollar and strong commodities is unsustainable – something has to give in a meaningful way: either commodities weaken or the US dollar must weaken.
The US dollar tends to lead the commodity market, indicating that there are considerable downside risks to commodities caused by the dollar strength we already have seen. Going forward, these downside risks are unlikely to fade in any meaningful way, rather the opposite. Either, because the Fed will hike or because a renewed weakening of the economy will create growth scares, ultimately supporting the US dollar through its safe-haven merits.
On balance, there is a high probability commodities will weaken further from here. This would reverse the so called regime shift tendencies we have seen since summer in the equity markets, where investors have been allocating away from defensive sectors towards more cyclical sectors. It would also put renewed pressure on the commodity producing part of the EM universe. In other words, a strong dollar is a latent threat to some of the most popular trades in the market.
Secondly, the flip-side of the strong dollar has been a weaker Chinese currency, currently trading at the lowest level since 2010. This makes Chinese products cheaper. Still being the global manufacturing hub, this helps Chinese exports, but it also means higher deflationary pressures globally, which would put a lid on the current reflation debate and clearly pose a downside risk for risk assets and EM in particular. Also, it increases the risk of capital outflows in China, contributing to rising financial risks as such.
The bottom line is that if the dollar continues to strengthen, we might see a lot of the risks that spooked markets in 2015 re-emerge, albeit in smaller scale, as the pace of the dollar strengthening is more muted so far. If dollar strengthening does not take a pause, a 2015 deja-vu has the potential to spoil any year-end party in financial markets.
The US election deserves to be mentioned in this context: both candidates advocate higher fiscal spending, leading to higher interest rates, contributing to a stronger dollar as well. To say the least, a strong dollar would make some incredibly popular trades much less popular. It might even keep the Fed from hiking in December, as a stronger US dollar means tighter financial conditions, basically doing the tightening job for the Fed. Keep an eye on the dollar elephant in the room.
Witold Bahrke is a senior strategist at Nordea Asset Management
