Mapping a trajectory
Where does this leave asset allocation?
For John Bilton, global head of multi-asset strategy at JP Morgan Asset Management, the trajectory of the dollar will be the pivotal determinant for asset allocators this year. He holds the view that two possible scenarios could play out, which would lead to opposing outlooks.
Should excessive dollar strength choke the US economy, it would see the gap in growth differentials between the US and the rest of the world close as the US slowed down. Such an unwelcome scenario would see risk assets struggle, according to Bilton.
Alternatively, if dollar strength does not become excessive and the US expansion is reinforced, this would lead to growth outside the US stabilising, and possibly even accelerating. Under this second, “more virtuous end to the dollar cycle”, Bilton says the gap between the US and rest of the world would close, not through US weakness, but through a global pick-up. As such, it would see risk assets accelerate and eventually a rotation from developed to emerging market assets.
“We think the second scenario will prevail,” Bilton says, optimistically, but adds: “The interplay of interest rate differentials and dollar valuation early in 2016 will be critical in setting the market tone across all major asset classes over the course of the year.”
Growing concern
Bilton believes the movement of the dollar in 2016 rests with the decisions to be made by the Fed. Should growth disappoint, it might be forced to renege on its rate hike plan. However, should growth exceed market expectations, which is currently pricing in only two hikes in 2016, this will move closer to the Fed’s outlined four hikes.
“In the early stages of the Fed’s policy normalisation, we expect a repricing of the path of Fed hikes to provide support for the dollar. The market currently prices just two hikes each in 2016 and 2017; we believe the strength of the US domestic economy warrants four per year.”
Ultimately, a terminal rate around 3.5% rather than around 2%, as is currently priced, will again lend support to the dollar. Bilton expects to see further upside in the dollar, but says it will be modest and limited.
“Since the global financial crisis, the world economy has been underpinned by the steady, if unexciting, expansion in the US. As a result, we weathered the eurozone crisis, the slump in commodity exporters and, later, the slowdown in trade and manufacturing that centres on China’s economic rebalancing.
“In some ways the US currency is now doing what it should – acting as a natural governor on growth and policy until growth differentials relax.
“Simply put, the longer dollar strength persists, the more 2016 will look like 2015. The sooner the dollar stabilises, the quicker we will see sentiment recover and emerging economies repair.”
According to King, a counterpoint to this is that “the US authorities are well aware that the strong dollar would cause further problems for the emerging markets, including China, and I don’t think they want to see that. Unless the Fed sees compelling domestic reasons for tightening monetary policy in the US, it is likely they will hold off.”
The most likely scenario, he believes, is that the dollar trades roughly sideways. As a result, he has increased his exposure to the yen and the euro, while turning neutral on the dollar from an overweight position.
