The US dollar's prolonged strength has been a critical factor supporting the country's stocks since the 2008 financial crisis, but this trend might be changing, Morgan Stanley's analysis indicates. Lisa Shalett, Morgan Stanley Wealth Management Chief Investment Officer, believes that a shift in the greenback's dominance could have significant implications for global markets and portfolios.
A robust US dollar has traditionally been linked to increased stock market valuations. However, this correlation may soon be tested. In 2023, despite signs of a global economic downturn and high inflation rates, the American dollar continued to strengthen due to safe-haven demand. Nevertheless, recent developments have indicated a potential "regime shift," as Shalett put it in a report for Morgan Stanley clients.
The implications of a changing dollar regime
The Bank of Japan announced it would increase interest rates and scale back on market interventions, signaling a substantial change. This move could prompt Japanese investors to repatriate funds, reducing foreign demand for US securities.
Geopolitical tensions between the US and China pose another threat, potentially accelerating de-dollarization and weakening the greenback's role in international trade and finance. Moreover, gold, bitcoin, and other commodities have seen rising prices, suggesting a further decline in the US currency's value.
The dollar's worth, as measured by the ICE US Dollar Index (DXY), which compares its strength to six significant currencies, decreased by 3%. In 2024, following an impressive initial phase, it stalled in March and eventually went down by 0.3%. Despite this, some analysts argue that favorable interest-rate differentials could continue supporting the American dollar.
However, Shalett believes that this may no longer be enough to counteract other factors. The trend of central banks reducing their foreign currency reserves in favor of gold suggests a growing preference for safe havens over traditional legal tenders.
Strategic adjustments for a weakening dollar
For those seeking to hedge against the greenback's potential weakness, Shalett recommends investing in international stocks and more real assets, such as commodities and gold. Among suitable alternatives to US stocks, she suggests considering Japan, Mexico, Brazil, and India. REITs within US stock portfolios could also be worthwhile considerations due to their recent underperformance.
The country's stock market's resurgence since 2008 can be linked to the dollar's dominance, and it should be recognized that this development coincides with the Federal Reserve's accommodative monetary strategies. The strong dollar has helped combat inflation by weighing on import and commodity prices and supported demand for Treasuries, softening the impact of rising US deficits. However, its influence on long-term Treasury yields might not be sustainable as global economic conditions change.
Shalett suggests that a weakening US legal tender could contribute to lower long-term Treasury yields, which could, in turn, help support stock valuations. The strong dollar has also played a crucial role in maintaining demand for Treasuries during the Fed's aggressive interest-rate hikes and quantitative tightening. Nevertheless, as other currencies gain strength against the dollar, this advantage may gradually erode, potentially leading to increased volatility in US markets.
The possibility of a profound change in the American dollar's dominance could have far-reaching implications for global markets and investment strategies. As investors grapple with these challenges, staying informed about emerging trends and market developments will be crucial. For those seeking to navigate this complex landscape, it may be prudent to consult with experienced financial advisors and maintain a diversified portfolio.
To put it briefly, the prolonged strength of the country's currency could soon be challenged, potentially leading to significant changes in global markets and investment strategies. Shalett suggests that market participants would be wise to consider alternative assets and geographic exposures to mitigate risks associated with a weakening US dollar.
In the coming months, it will be essential for investors to stay informed about developments in global markets, particularly those related to the US dollar and interest rates, to make informed decisions about their portfolios.
