Coming into the year, expecting the dollar to continue to appreciate relative to other currencies was very much a “consensus” trade. The dollar had strengthened by about 17% (broad trade-weighted basis) in the previous 18 months and the trend seemed likely to continue. We ourselves expected modest dollar appreciation this year due to monetary policy divergence — the Federal Reserve (Fed) looking to raise rates while other major central banks were expected to ease further — and the relative strength of the U.S. economy. However, after strengthening by almost 3% in the first three weeks of the year, the dollar (on a broad trade-weighted basis) has since weakened by 5%.
The easy explanation for recent dollar weakness appears to be the more dovish than expected tone of late from the Fed. Fed Chair Yellen laid out the case for a “go slow” mentality at a recent speech in New York. The argument relates to the asymmetry of monetary policy in the current environment. Essentially, the Fed has a lot of room to raise rates if growth and inflation surprise to the upside, but little room to ease if growth and inflation soften. Additionally, anecdotal data suggest that many speculative investors (i.e., hedge funds) have “thrown in the towel” recently on long positions in the U.S. dollar.
Two often-cited reasons for recent earnings weakness by CFOs of U.S. multinationals were a strong dollar and declining and volatile energy prices. In recent months, we have seen these headwinds begin to dissipate as the dollar has softened and energy prices have shown some signs of stabilization. While the first quarter of 2016 is expected to result in the fourth consecutive quarter of declining earnings for the S&P 500, to the extent that the dollar and energy prices continue their recent moves, the medium-term outlook for U.S. corporate earnings could be favorable.
We currently have a neutral exposure to U.S. equities across our portfolios. Despite recent earnings weakness, we feel that the U.S. economy and consumer support further upside. Additionally, any further dollar weakness (which would likely coincide with rising energy prices) would be positive for our overweight position in U.S. high-yield bonds. It would also help our overweight to international equities (when converted to USD) if foreign currencies rallied against the dollar.