One of the biggest stories of the second half of 2014 was the strength of the U.S. dollar relative to major foreign currencies. While the trade-weighted Broad U.S. Dollar index (which measures its value versus 26 foreign currencies) gained more than 9% in the second half of 2014, it rallied even more versus the majors — up 18%, 16% and 13% versus the yen, euro and pound, respectively. And so far this year we’ve seen more of the same, with the Broad U.S. Dollar index gaining nearly 3% due partly to a 7% appreciation versus the euro.
During our weekly investment strategy meetings we have been spending significant time discussing and debating the stronger dollar’s impact on asset prices. As a rule, history is a good starting point for this type of analysis but it is never the ending point; there have only been two periods of multi-year dollar strength since the currency was taken off the gold standard.
The first period of strength was in the late 1970s and early 1980s when the Federal Reserve Board (the Fed) hiked rates to combat rising inflation. U.S. equities did just fine then, returning high single digits per annum. The second period coincided with the U.S. tech boom in the late 1990s. Stocks did even better on both absolute and relative bases, with annualized returns well in excess of 10%*. So while a stronger dollar may be a temporary headwind for earnings of U.S. multinationals (as we’ve seen this quarter), there is no evidence to support tactically reducing U.S. equity exposure solely on the basis of a stronger dollar.
It’s too early to call this the third secular dollar rally, but the evidence is mounting. The strengthening U.S. economy continues to outperform the rest of the world, and the related divergence between the Fed and other central banks could widen. Even though the Fed has been threatening to tighten monetary policy, the European Central Bank just delivered a larger than expected easing package (as we discussed in our last Spotlight) while a handful of other central banks have cut interest rates in recent weeks. In this environment, U.S. assets will look increasingly attractive to foreign investors and this can continue for some time. Even the 10-year Treasury’s 1.7% yield looks relatively attractive when compared to same maturity rates of 0.4% and 0.3% in Germany and Japan, respectively.
Given the easing measures abroad, we have recently upgraded our view of international securities, though we continue to express a slight preference for U.S. assets given the attractive U.S. backdrop. And while we are underweight core bonds due to the risk of an eventual rise in yields, we are hesitant to go further underweight in light of their attractiveness relative to overseas fixed income and the conditions discussed above.
*Measured by the annualized S&P 500 index return from 12/31/78 to 12/31/84 and 6/30/95 to 6/29/01 respectively.