The greenback is likely at or near peak levels as the economic distance between the US economy and China stabilises, a recent Brandywine Global Investment Management (BGI) client note argues.
According to the Brandywine Global note, the US dollar has risen 7 per cent this year as the US economy, boosted by tax cuts, experienced a “mini boom” just as China fell into a “mini-bust”.
The divergence between the two “anchor countries in the global economy” explains much of the dollar strength, the paper says, with Chinese and US fiscal and monetary policies both heading in different directions.
“Markets act to adjust to equilibriums. Dollar strength is both a manifestation of the divergences in the global economy and a corrective mechanism,” the Brandywine Global note says.
However, there were signs the US economic acceleration relative to China and the rest of the world may have slowed – although the trend has not yet reversed to the level witnessed during a similar divergence between the world’s two largest economies over 2014-2015.
The broad US dollar index rose 27 per cent over 2014-2015 in line with strong domestic growth and a Chinese slowdown. By early 2017 the US dollar index had slumped 11 per cent from the 2016 high as growth in China rebounded while profits stalled in the US.
But this time around the Chinese government is only cautiously loosening fiscal and monetary constraints while US “profit outlook remains strong”, emboldening the Federal Reserve to lift interest rates.
“In theory, there is an inflection point where the dollar gets so strong, emerging markets so weak, and commodity prices so depressed that U.S. profits begin to weaken and the domestic cycle turns lower,” the Brandywine Global paper says. “Our sense is that the divergence is already rather stretched and U.S. growth is probably near a peak.”
The report, authored by the manager’s head of global macro research, Francis Scotland, says US corporate profits might peter out once the effects of recent tax cuts filter through the system.
“Furthermore, the tax cuts could be concealing a weaker trend brought on by the combination of a strong dollar, higher interest rates and energy prices, and the added operating costs related to tariffs,” the note says.
“… If this divergence has peaked, as we think it has, then there could be some—but not much more—upside in the greenback.”
However, a significant weakening in the dollar is not likely before there is a more defined convergence between the U.S. and China.
Until then, though, the stronger US dollar continues to exert its traditional influence on global affairs, putting pressure in particular on emerging markets. For example, the Brandywine Global note says both emerging markets currency and equity indices had slumped over the year – down 15 per cent and 20 per cent, respectively. Commodity and global share benchmarks were also down, the paper says, while currency crises flared in Turkey and Argentina.
“Bad things tend to happen when the U.S. dollar rises too much,” the report says. “Unfortunately, there has been a lot of that lately, with most of it playing out in the emerging world, at least so far.”
The Philadelphia-headquartered Brandywine Global manages over US$73 billion, mostly in fixed income strategies. Part of the Legg Mason multi-affiliate group, Brandywine Global manages about $800 million for NZ investors in an unconstrained fixed income fund – now also structured as a portfolio investment entity (PIE) under the Implemented Investment Solutions legal wrapper.
The Brandywine Global Opportunistic Fixed Income Fund recently listed on the Aegis investment platform.