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The U.S. Dollar Continues To Dominate, Drive Markets Higher

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From BlackRock: As Russ discusses, we remain in a strong dollar environment, which continues to have consequences for the market.

2018 started with investors asking the same question as every other post-crisis year: Is this the year rates finally rise? In fact, the answer has been yes, although the backup in rates has been modest. U.S. 10-year yields surged in January but have been range bound ever since. Instead, as I wrote back in early July, the dominant return driver has been the dollar. Whether or not the dollar remainsstrong is likely to be as, if not more, important than the direction of rates.

One currency to bind them

Two months ago, I suggested that you could explain much of the first half’s performance by referencing the dollar. The first two months of the third quarter is proving to be more of the same.

While the dollar has been flat since June, it did hit a one-year high in August and remains 7% above the spring low (see Chart 1). In other words, we remain in a strong dollar environment, particularly against emerging market currencies.

dollar index

As the dollar has remained strong, dollar sensitive assets are still under pressure. In most cases things have only gotten more challenging. Since the end of June, gold is down another 3.5%. Industrial metals, notably copper, have fared even worse.

Read more stories from Russ.

Outside of metals, the main casualty of the dollar has been emerging markets (EM). EM stocks managed a brief, but fleeting, rally in July, but the MSCI Emerging Market Index is now trading at its lowest level in over a year. At the same time, locally denominated emerging market debt is also getting hit, as EM currencies continue to lose ground against the dollar. The J.P. Morgan GBI-EM Global Diversified Index is now down 6% since the end of the second quarter and nearly 14% year-to-date.

The dollar is still tied to trade

Back in July I suggested that relative growth and trade will prove the keys to the dollar’s direction. I still hold to that view. On the latter, trade tensions continue to simmer, particularly in regards to China. The potential for another $200 billion of tariffs on Chinese imports remains a genuine risk and a short-term resolution seems elusive.

On growth, the outlook is more nuanced. The U.S. economy remains strong on the back of fiscal stimulus and a strong consumer. That said, stellar U.S. growth is now well discounted by investors. For the first time in a year U.S. economic reports are no longer topping estimates. The Citi U.S. Economic Surprise Index recently turned negative.

In contrast, while European growth remains soft and vulnerable to China, the bad news appears discounted. Unlike in the U.S., Europe’s economic surprise indexes are now back in positive territory.

Narrowing relative growth suggests the dollar may be more contained relative to the spring surge. Should this prove the case, a more range bound dollar should provide some relief to beleaguered emerging markets. The wild card remains trade. Any further escalation in trade frictions will likely see traders scurrying back to the dollar.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

The iShares S&P 500 Index ETF (IVV) was unchanged in premarket trading Friday. Year-to-date, IVV has gained 9.44%.

IVV currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #2 of 150 ETFs in the Large Cap Blend ETFs category.

This article is brought to you courtesy of BlackRock.

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