Equity investors’ eyes are fixed on the currency markets this week as, for the first time in four years, it has taken more than 100 yen to buy a US dollar. Everyone knows that a weak yen is good for Japan’s big exporters like Toyota – plot a chart of the exchange rate and the car-maker’s share price and the lines are barely distinguishable.
What’s more interesting to me is whether the flip side of this trade, dollar strength, is more than a short-term blip. The dollar has been falling against a basket of other currencies for 10 years now. If that process has run its course and the dollar is stabilising or even set to appreciate again, that could have big implications for investors’ asset allocation decisions.
The last 10 years was a period in which the US government spent heavily on costly military adventures abroad and cut taxes at home. The resultant deterioration in America’s fiscal position unsurprisingly weighed on the value of the dollar, helped commodity prices surge and drove investors into alternative homes for their savings such as emerging markets.
So what does this mean for clients?
First, it looks like the commodity super-cycle has finally hit the buffers. The usual lag between higher prices and new supply coming on stream was already bad news for commodities. A slowing in growth in China and a strengthening dollar will complete the bear case for resources.
Second, the relationship between the dollar and share valuations in the US is quite different from that in Japan. Less dependent on exports than Japan, the US actually benefits from a stronger currency. The price-earnings ratio of the US market rose in line with the dollar in the 1990s and fell as the dollar weakened in following decade. A stabilising dollar could therefore add impetus to the recent re-rating of the US market.
Third, a strengthening dollar could also have implications for the relative performance of US and emerging market stocks. Emerging markets are less dependent on dollar-denominated loans than they were 20 years ago, so a rising dollar will provide less of a headwind than it did in the 1990s. But at the margin, a strong dollar reduces the need for US investors to seek returns elsewhere and will most likely lead to American leadership of global stock markets in the next few years.
The other dog that hasn’t barked yet is the wall of Japanese money which could seek higher returns abroad if the decline in the value of the yen continues to 110 yen to the dollar and beyond. If the famously savvy Mrs Watanabe, who holds the purse strings in Japanese households, senses a resurgence in the value of the dollar, then US assets could find another very powerful support.