By John Bilton
At the start of January we said the path of the US dollar would be the defining influence on asset allocation in 2016.
We thought stretched valuation, after a blistering three year dollar rally, and a gradual closing of the growth differential between the US and the rest of the world would leave the US dollar with only modest upside, effectively mitigating what has been a headwind for sentiment and providing relief to companies that have borrowed in USD.
Although we see scope for a more virtuous end to the US dollar strength cycle playing out later in 2016, the recent reversal in the US dollar – one of the sharpest drops in 20 years – is more concerning. It is worrying because the weakness is not a symptom of growth broadening out from America to the rest of the world, but instead of pockets of economic stress around the world starting to affect the US.
Exactly how worried should we be? US stocks and credit markets are trading as if the US economy is holed below the water line. While we echo the near term caution, it is too soon to conclude that the US economy is heading for a contraction. Nevertheless, the path of the US dollar will again be critical as the level of US growth is likely insufficient to reassure asset markets in the near term.
Three central considerations tend to drive asset markets – growth, liquidity and tail risk. Other factors such as valuation, positioning, momentum and sentiment matter, but these can be swung, even dominated, by the three primary factors.
Taking the first of our primary considerations – growth – it’s fair to say that recent US data are underwhelming. Nevertheless, the all-important labour market remains resilient. Economists often cite “small open economies” as vulnerable to external shocks, but the US is the diametric opposite. The domestic consumer and housing account for 70% of the US economy and while manufacturing and external sectors are weak, these alone are unlikely to shunt the US economy into recession.
To be clear, we aren’t suggesting the US economy is booming. When a ship sails in shallower water the risk of running aground is clearly higher; likewise a shallower trajectory of growth increases the vulnerability of an economy to exogenous shocks. So a negative shock is possible, but outright recession is unlikely.
There has been much fixation on whether the Fed will take action, given the market’s nasty start to the year. The notion that they may have made a policy error in raising rates in December is wide of the mark. We think US rates will slowly normalise but only as US economic data and financial conditions allow, so realistically an increase at their March meeting is off the table. Reinforcement of the very gradual and data dependent path of U.S. policy would in turn reduce upside risk to the US dollar in the near term.
This brings us to the second consideration – liquidity. The Fed is acutely aware that despite their domestic US mandate, they are de facto the world’s central bank. As such it is little surprise that the lift off from zero interest rate policy has led to a tightening of global financial conditions. This tightening has been coincidentally compounded by the slump in commodity prices and shift in Chinese policy.
Collapsing energy prices had a direct impact on financial conditions via wider credit spreads and weaker earnings. It also has an arguably more persistent secondary effect in pushing petro-economies from surplus into deficit. As those economies slow or halt their foreign exchange reserve accumulation in response, this effectively removes an important source of global liquidity. China too has deployed reserves to manage the currency, exacerbating the net draw on global liquidity.
Despite the Fed’s faith in the US economy, the tightening of global financial conditions has scope to force them into a more accommodative stance than some board members would prefer. Whilst tighter financial conditions may imply a scramble for US dollars and other “safe” assets, the consequent delay to Fed policy has an offsetting impact.
Finally, and inevitably, a sluggish path of growth and poor liquidity places greater emphasis on tail risks. Markets are struggling to calibrate tail risks; policy divergence, uneven global growth, and excess capacity and debt in some countries and sectors all complicate this process. The net result is an upward marking of risk premia, and a downwards marking of growth expectations – in particular where the economic cycle is seen as either fragile (e.g. China) or long-in-the-tooth (e.g. US). Diluting of growth expectations weighs on risk assets and, eventually, the currency.
Put another way, consider the noisy, negative gyrations of asset markets as being reflective of a world where the level of growth is insufficient to offset the tightening of financial conditions. As such, we see limited scope for a sharp rebound in stocks.
However, there are two more encouraging conclusions: first, the US economy is relatively isolated from global risks – growth may be low, but so too is recession risk. Secondly, the US Fed remains data dependent and as such rate hikes are likely to be delayed, in turn taking some of the steam out of the US dollar.
Look for the US currency to act as a sort of balancing mechanism in the meantime. Both the US and the global economy would struggle to absorb another year of significant dollar strength, but stabilisation will ultimately take some of the pressure off.
With sentiment damaged, valuations fair, and growth lacklustre we would not bet on stocks quickly reversing their current malaise. But without the headwind of excessive dollar strength, there may well be a more positive backdrop for the world economy as the year progresses.
John Bilton is global head of multi asset strategy at JP Morgan Asset Management
