KYLE WALES: Unstoppable dollar is not going to last forever

The dollar is running rampant this year, and while its appreciation appears unstoppable that is unlikely to be the case down the line. Currencies play a far smaller role in investment outcomes than end-investors often assume, and they should instead ensure their investments will compound in value no matter what the dollar is doing on the world stage.

The dollar’s rally is largely attributable to the huge upheaval we have seen in markets in the face of inflation rates that have risen to multidecade highs, and central banks’ consequent efforts to halt the unfolding cost-of-living crisis. Year to date the MSCI World index is down 27% and the FTSE World Government Bond index almost 23%.

Not every asset market has been a loser, though. The US dollar has gained good ground against a basket of other countries’ exchange rates — now up almost 9% on trade-weighted basis in 2022. Some of this strength can be attributed to the dollar’s status as the world’s reserve currency, meaning it benefits from a flight to safety when market conditions are poor. But there have been other factors at play as well. 

Chief among these is that the US Federal Reserve (Fed) has been more proactive in raising interest rates than central banks in other parts of the developed world. The Fed has raised interest rates 3% since their lows while the Bank of England has raised them 2.05% and the European Central Bank 1.25%. Japan has seen no base rate increases at all.

This means that holders of dollars are “having their cake and eating it as well”, as they are being richly rewarded for holding a safe-haven currency. This also accounts for some emerging market currencies doing better than developed world peers. Interest rates in Brazil, and to a lesser extent SA, are now sitting at far superior real (inflation-adjusted) yields to other emerging markets. As a result, the Brazilian real has actually appreciated by 3% against the dollar in 2022.

A number of idiosyncratic factors are also at play. The euro has been weak, mainly due to weak German industrial activity and the effects of the Russian invasion of Ukraine. The UK, already weakened by Brexit, is plagued by political uncertainty and the fallout from (now former) chancellor of the exchequer Kwasi Kwarteng’s proposed minibudget.

But what does this all mean from a practical standpoint? First, a strong dollar benefits countries and industries that export to the US, as consumers there can purchase more of the goods or services they sell. This list includes China, Japan, and Germany, the US’s biggest sources of imports.

Second, a strong dollar coincides with weak commodity prices. This deeply affects a commodity exporter such as SA, largely negating the bounce in commodity prices at the beginning of the year due to the Ukraine invasion.

Lastly, a strong dollar means opportunities for contrarians to position portfolios for a weak dollar. While dollar strength could be with us for a while as many of the factors contributing to it look set to persist, we know that this is certain to change. Ultimately, a strong dollar will lead to a decline in US competitiveness, which will tilt the macroeconomic balance in favour of the rest of the world again.

Rather than fretting about the level of the currency or speculating on its direction, most investors would be better served by hedging themselves against currency risk where they can. This means using dollar cost averaging to build positions in global businesses that are “natural hedges” because they generate earnings in multiple currencies.

Investors should not lose sight of the ultimate goal when investing, which is a portfolio that compounds its value through good times and bad — and currencies play a smaller part in this than is often supposed.

• Wales is a portfolio manager at Flagship Asset Management.