Keeping a Close Eye on the Dollar

Rising yields and recession risk are likely to abate in 2023, sending the US dollar lower and opening the door for a broad rally in risk assets, particularly non-US equities.

2022 has been an extremely difficult year. Fixed income and equity markets have been hit hard by high yields and rising growth risks, which have largely been attributed to persistently high inflation, a near record-setting pace of monetary tightening, geopolitical uncertainty, and lingering impacts from Covid (particularly in China). Following a decade of strong outperformance, US equity markets have continued to outperform developed markets (DM) and emerging markets (EM) in 2022: The MSCI USA Index has outperformed the MSCI ACWI ex USA Index by 1.5% year-to-date.¹

However, despite these challenges, we do see signs of opportunity. A historically strong US dollar (USD) has contributed to this outperformance year-to-date, and since the end of 2020. However, stripping out the impact of the surging USD, the MSCI ACWI ex USA Index actually has outperformed the MSCI USA Index year-to-date in local terms. This is particularly relevant for investors because we see a strong case that the USD should reach its peak and begin to decline in 2023.

A Supercharged US Dollar

The USD has been supercharged by a combination of rising relative yields and its appeal as a safe haven during a tumultuous time. Near term, high yields and rising recession risk are likely to continue to support the dollar and keep us in a defensive stance, i.e., underweight equities. Looking forward to next year, however, we expect a gradual change in this economic regime. A key driver of this change is a transition from inflation to disinflation and a policy shift by central banks to focus on growth. This shift should result in lower yields, helping to build confidence that global growth will stabilize and eventually recover. In other words, rising yields and recession risk, the two key supports for the USD, should abate and send the dollar lower, opening the door for a broad rally in risk assets, particularly non-US equities.

A defining feature of USD strength is its safe-haven appeal during periods of heightened geopolitical risk. Such risks have depressed 2022 economic performance outside of the US, most notably in Europe and China. The “probability of outcomes” favors the creation of an improved environment in which ex-US growth narrows the gap with US growth. In Europe, the Russia-Ukraine War has delivered a full stagflationary energy shock, which we believe will continue to ripple through 2023. However, markets have largely priced-in the war. Going forward, marginal negative shocks are less likely to impact markets than the continuing geopolitical status quo, or even de-escalation. It would be naïve to ignore tail risks — the use of nuclear weapons, new humanitarian disasters, or sabotage of European energy infrastructure — but the probability of additional significant macroeconomic shocks is diminishing. While the perception of increasing tail risks may rise with Ukrainian success on the battlefield, the recapturing of Russian-held territories by Ukraine also serves to bring the conflict closer to an endgame or stabilization scenario.

China’s Zero-Covid Policy has constrained growth throughout 2022. China will almost certainly loosen restrictions over the course of 2023, with the magnitude and speed of economic effects still to be determined. This loosening is certain to lift Chinese growth relative to 2022, and thus will also help narrow the gap versus ex-US growth. We think that increased geopolitical fallout from US-China tensions is only likely once China has fully normalized its economic conditions — so the near-term outlook is encouraging on that front, too.

Equities

We view the outlook for equities through the following primary lenses: fundamentals, valuations/discount rates, and positioning.

Fundamentals have been strained globally in 2022, and we expect this to continue into 2023. The global outlook, ex-China, shows deceleration almost everywhere, suggesting that after a rather weak 2022 we will see only a mild rebound for earnings in 2023. Earnings in the US have improved slightly so far in 2022, but are likely to see some significant headwinds with the sharply rising dollar. We do not expect any major equity region to generate better than mid-single-digit earnings-per-share (EPS) growth next year. The clear advantage that the US has had in EPS growth may now be in question.

Valuations of non-US equities are at average levels, while valuations of US assets remain relatively overpriced. It is difficult to say that non-US assets are attractively priced, either in DM ex-US or in EM, which have declined 30% this year. Both EM and DM ex-US are trading fairly close to their long-term averages, but remain relatively inexpensive relative to US stocks. Historically, appealing price levels have not been enough (by themselves) to attract significant flows, given the high profitability differential and innovation advantage of US companies. If valuation levels were very cheap relative to history, some investors would look to pick up exposure and be happy to hold it, awaiting future improvements. However, we are yet not at that point. On the flip side, rising rates are likely to put valuation pressure on long-duration assets, of which the US has multitudes.

Positioning is a critical area where we see an upside to non-US assets. Other global economies are significant long-term investors in USD-denominated assets. Institutional owners have the highest overweight to the US in approximately 25 years (see Figure 1). In contrast, institutional owners have strong underweights to emerging markets across a similar time frame (see Figure 2). Will this trend persist long-term? We think the likely answer is no, and conditions may suggest a reversal. This evolution will require a catalyst of some sort to encourage investors to take positions outside of the US safe-haven currency. Historically, positioning at these levels has not stayed this one-sided for long — something will move. While the timing of a catalyst may be uncertain, we think some level of repositioning makes a great deal of sense over the medium term. The time is now to prepare one’s trades.

Key Takeaways for Investors

• The strong US dollar is a headwind to international equities; emerging markets are most negatively affected by a strong dollar.
• The US dollar is at historic heights, which might suggest a reversal is on the way.
• With increased value exposure outside the US, value outperformance could be a tailwind for non-US equities.