The biggest threat to investors right now is the strong US dollar

The year so far has been epic for investors. But with the US dollar hitting a two-year high, things could be about to change. John Stepek explains why.

190426-dollar
The dollar is at a two-year high

This week, US markets hit a fresh all-time closing high. On Wednesday, the S&P 500 closed at 2,933, beating the record set in October.

Central banks have turned dovish. Growth has held up a little better than expected. Jobs data remains solid.

What's not to like? No wonder markets are heading skywards again.

Unfortunately, there's a financial serpent in this bullish paradise.

It takes the form of the US dollar.

This has been an epic year for investors so far

Markets have been in "risk-on" mode all this year. 2019 has seen just about every asset class enjoy monster rallies, even if it hasn't always felt terribly cheerful on this side of the Atlantic, what with shrieking Brexit headlines everywhere.

According to Bank of America Merrill Lynch, by mid-April, commodities were up nearly 20%, global stocks by 14%, and junk bonds by about 7%. That has made it one of the strongest starts to a year on record.

Fair enough, the year started on a low, following the panic in the last quarter of 2018. Even so, that's an impressive start to the year (though notably 1987 started off in the same way, so let's not count our chickens yet).

Anyway, one thing about a "risk-on" market is this you'd normally expect it to be accompanied by a weaker US dollar.

Why? Firstly, the US dollar is generally viewed as a "safe haven" asset. When people are feeling exuberant, they sell dollars and dollar assets to buy riskier assets overseas. So that's one reason why the continued strength of the dollar is a little surprising.

Second, a stronger US dollar typically goes hand in hand with tighter monetary policy. The Federal Reserve has U-turned quite dramatically this year on interest rates. And yet the dollar has hung on and in fact stubbornly continued to head higher.

Indeed, this week the US dollar index (a measure of the strength of the American currency against a basket of the currencies of its main trading partners) hit its highest point for the year, and it's now near a two-year high.

That's a bit of a worry for the bulls for a third reason that is, a strong US dollar effectively means tighter monetary policy for the entire world. Put simply, everyone needs dollars, so the more expensive they are, the less money there is for everything else.

We're already seeing the resulting squeeze having an impact on the world's more perennially fragile markets, such as Argentina and Turkey. And if the dollar stays up here for much longer, the jitters could spread to emerging economies normally viewed as more resilient.

As Macro Intelligence 2 Partners points out in a recent commentary, the dollar at this level is "stuck firmly in the middle of the crisis zone'. A band where historically, dollar strength was sufficient to trigger the Latam Debt Crisis in the 80s, the Asian crisis in the 90s and China's 2015 devaluation."

That's a bit of a worry.

Are we facing a melt-up or a meltdown?

So why has the US dollar been so strong? A lot of it is simply down to weakness in other currencies. It's true that the Fed U-turned at the start of this year. But so has pretty much every other central bank in the world.

Europe is slowing down. China is warming up to do more "stimulus". Japan is well, Japan. The UK has Brexit to suppress sterling. Australia's economy is slowing due to its house price bubble popping. Sweden has just decided to do more quantitative easing.

In effect, the Fed is losing the war of the "doves". The US is hardly enjoying epic economic growth and yet it is still one of the healthiest-looking economies out there.

With central banks around the world showing no signs of raising rates, that should be good for asset prices. But the risk is that a strong dollar not only exerts a pinch on vulnerable countries with dollar-denominated debt, but also that it starts to squeeze earnings for big US companies a big chunk of profits in the S&P 500 derive from overseas sales.

Some are already feeling the pinch US conglomerate 3M, maker of Post-It notes, issued a profit warning yesterday, and saw its share price tumble by more than 10%. Combine a strong dollar with a weakening global economy and that's a recipe for a profit squeeze, which is in turn, bad news for highly-valued share prices.

Now, if I'm writing about this, it's hardly a big secret. So it's quite possible that a nervy Fed will act to curb dollar strength, or that Donald Trump will get on Twitter and try to talk it down.

To be clear, if Janet Yellen was running the show right now, I reckon the Fed would already have stopped quantitative tightening (QT) and raised hints about another bout of QE. But Yellen is not in charge any more, and the market has yet to fully believe that Jerome Powell has its back.

My base case at the moment is that we get the "melt-up followed by meltdown" scenario, driven mainly by overly loose monetary policy allowing inflationary pressure to get out of hand. But if the US dollar doesn't turn lower soon, we might have to see another big plunge in the S&P 500 to convince the Fed that it needs to address this.

(By the way, to be clear, I am not calling for Fed intervention. I like the idea of free markets being able to roam as they see fit, ideally being informed by economic reality rather than the volume of printed money available. But this is the way the world currently works for the bull case to win out from here, we probably need to see the Fed pull another surprise out of its hat.)

For more on melt-ups and meltdowns, check out my colleague Merryn Somerset Webb's letter in the latest issue of MoneyWeek magazine (and get your first six issues free here if you haven't already).

Recommended

The currencies to bet on this year
Currencies

The currencies to bet on this year

The US dollar could be set to weaken this year, while the euro, Canadian dollar and the Swiss franc could be good bets for optimistic traders.
17 Jan 2020
The British equity market is shrinking
Stockmarkets

The British equity market is shrinking

British startups are abandoning public stockmarkets and turning to deep-pocketed Silicon Valley venture capitalists for their investment needs.
8 Nov 2019
Why China appeals to good investors
China stockmarkets

Why China appeals to good investors

China is one of the few places left to good investors hoping to make a decent return, says Merryn Somerset Webb.
14 Sep 2020
Mega-cap tech stocks: a very crowded trade
Tech stocks

Mega-cap tech stocks: a very crowded trade

It’s a dangerous time for markets when investors can no longer afford to go against the consensus
14 Sep 2020

Most Popular

Here’s why you really should own at least some bitcoin
Bitcoin

Here’s why you really should own at least some bitcoin

While bitcoin is having a quiet year – at least in relative terms – its potential to become the default cash system for the internet is undiminished, …
16 Sep 2020
Central banks want politicians to take charge – but what will they do?
US Economy

Central banks want politicians to take charge – but what will they do?

The US Federal Reserve has come to the end of the road in terms of what it can do to accelerate any recovery, says John Stepek. It's over to the polit…
17 Sep 2020
IAG's share price is ready for take-off - here's how to play it
Trading

IAG's share price is ready for take-off - here's how to play it

The owner of British Airways has had a turbulent year, but is now worth a punt. Matthew Partridge explains the best way to play it.
8 Sep 2020