Stocks and bonds catch a ride on the surging dollar

As economic strength and Fed policy push the greenback to a 7-year high, market strategists see knock-on gains for other assets

Dec 2, 2014 @ 12:20 pm

By Jeff Benjamin

The surging strength of the U.S. dollar is laying the foundation for an investment strategy that is likely to play out over the next several years. In addition to the trickle-down consumer-related benefits of cheaper commodity prices and more bang for your buck outside the United States, a strong dollar also bodes well for domestic stocks and bonds.

“Our outlook is concentrated in large-cap U.S. stocks, because a strong dollar makes it more attractive to invest in the U.S.,” said John Canally, an economist at LPL Financial. “Over long periods of time these kinds of [currency moves] tend to be self-correcting, because as our stuff becomes more expensive overseas we start to export less, and so on. But we think over the next year, the U.S. stock market will outperform any other global asset class.”

The dollar, which has been climbing in earnest since June, is now at a seven-year high relative to global currencies.

The move represents a welcome change for global currency traders and was, in many respects, telegraphed over the past several months as the U.S. economy strengthened relative to the rest of the world. In addition, the Federal Reserve's monetary policy is moving against the grain of most of the world's central bankers.

“There is a fundamental growth story in the U.S. that makes it an attractive place for foreign investment,” said Douglas Cote, chief investment strategist at Voya Financial Inc.

“We're seeing record corporate profits, and (economic growth) has seen back-to-back quarters of 4% growth,” he added. “We're having an energy revolution and we're part of the cause of oil prices going down.”

The economic strength story is coupled with the turning point for Fed policy that is expected to see interest rates adjusted higher starting next year. That move is counter to the direction seen by bankers in Japan, China and Europe, which are adopting policies geared toward depreciating their currencies.

“The way to play the strong U.S. dollar is to own more cyclical companies like mid-cap and small-caps, as well as industrial and tech companies,” Mr. Cote added. “We're still in a bull market for equities.”

For the average consumer, the strength of the dollar has been translated at the gas pump, where the average price of gasoline has fallen to below $2.60 a gallon, and some are forecasting it could fall below $2.

Most global commodities are priced in dollars, which means the price of those commodities goes down when the value of the dollar goes up.

“I would never say 'get out completely,' but we think we've reached a peak in commodity prices,” said Kathy Jones, fixed-income strategist at Charles Schwab & Co. “We think investors should be reducing their exposure to foreign bonds and commodities.”

For some context, it's important to understand that while the dollar has been gaining strength over the past several months — and steadily climbing since 2009 — it is still far below the peaks of 2002 and 1985.

As detailed in a report by Ms. Jones, the U.S. Dollar Index, a gauge of the dollar against a basket of six currencies, at the end of November was at 87.9, compared with 120.21 in January 2002, and an all-time peak of 160.41 in February 1985. (The index dates back to 1971 when the dollar's ties to gold were severed.)

As Ms. Jones explained, currency appreciation and decline is a major contributor to the total return of foreign bonds, which is why she believes U.S. debt will outperform foreign debt as long as the dollar maintains its relative strength.

“This is especially true in the developed-country bonds, where yields tend to be lower than in the U.S.,” she said. “Even among the countries with higher bond yields, such as Australia, the yield spread versus U.S. bonds is relatively low compared to a year ago and may not compensate for the risk of a further decline in the currency.”

Stephen Mason, portfolio manager at Collins Capital, takes comfort in the “diverging central bank policies,” comparing the U.S. to the rest of the world. The fact that the Federal Reserve has already wound down its quantitative easing program and is now inching toward raising interest rates suggests a wide gap between other economies that are just ramping up large quantitative easing programs.

“That creates dispersion across markets and the dollar has benefited from that,” Mr. Mason said. “It's not just the fact that it's a stronger dollar, but it's about the fact that the dollar is moving independent from all other currencies.”

The divergence, he added, represents a boost for global macro managers who tend to do their best work in the presence of trends and volatility.

Of course, as Ms. Jones pointed out, market forces could keep the dollar's run from getting too extreme.

“One general benefit of a stronger dollar is that it holds down inflation,” she said. “And that may mean that interest rates stay low for longer than people are expecting.”

But if the Fed holds off on raising rates, that could limit the dollar's strength.

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