Implications of a weaker dollar

Euro area equity return in local currency vs. in US dollar, 2020

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, as of August 5, 2020. Notes: The chart compares the price returns of the MSCI EMU Index in local currency terms and in US dollar terms. The returns are rebased to 100 at the start of 2020.

We upgraded European stocks to overweight, on the back of the region’s robust public health infrastructure and a galvanised policy response. These two factors have moved the currency market more than the equity market so far. Unhedged, dollar-based investors in European equities have benefitted as a result, even as returns in euro terms have lagged. The price return in dollar terms (yellow) had largely trailed that in local-currency terms (orange) until late June when the trend reversed. See the chart above. We see the fundamental dynamics ultimately flowing through and helping local-currency equity returns. We are much less sanguine about emerging market (EM) equities as many EM countries outside northern Asia struggle to contain the virus spread and have limited policy space to cushion the virus shock, even with the help of a weaker dollar.

The dollar had enjoyed a decade of nearly uninterrupted gains – and had a strong start in 2020 in part helped by pandemic-triggered global risk aversion and a seizing-up of the dollar funding market. We see the unprecedented policy revolution as helping reverse that trend since March. The Federal Reserve and other central banks have cut rates and initiated other easing measures, leading to the compression of interest rate differentials between the US and most developed economies, just as governments have unleashed fiscal stimulus to help households and businesses bridge the virus shock. The forceful policy response has revived risk appetite, driving investors away from perceived safe-haven assets. The Fed’s measures to alleviate the dollar funding shortage also helped take the wind out of the greenback’s rally.

The euro as well as a handful of other European currencies have led the outperformance against the dollar in recent months, cheered on by the region’s improving virus dynamics and galvanising policy response. The creation of the European recovery fund, and its upcoming issuance of pan-European bonds, has been a boon for the euro. The situation in the US appears less encouraging. Negotiations over the next round of fiscal relief measures have dragged on even as key benefits expire, while COVID cases are rising in most of the country. We expect dollar weakness to persist in the near term as the drivers for its recent decline remain in place. The longer-term outlook is harder to gauge. A key question is the currency implications of the policy revolution – especially if and how central bankers build guardrails to manage growing balance sheets in the face of greater fiscal deficits and debt issuance. The prospect of the dollar retaining its perceived safe-haven status is another concern. We are weighing these as a contentious US presidential election looms.

The bottom line: The shifting pandemic and restart dynamics in the US and Europe have helped weaken the dollar and strengthen the euro, underpinning our overweight on European stocks and caution on their US peers. A weaker dollar generally is positive for EM assets, yet we see the relatively weak public health infrastructure and limited policy space more than offsetting such benefit across much of the EM complex. We are underweight EM equities overall and EM dollar debt, as many of developing countries have limited capacity to control the virus spread and cushion the blow to the economy. We are neutral and more constructive on EM Asia equities and local-currency EM debt.