A Powerful Dollar Could Spell Trouble for Investors

The U.S. dollar has been on a tear, growing an impressive 14% in 2022 compared to a basket of currencies. There are several key reasons for its rise:

• Investors find the dollar to be a safe haven during times of market volatility.
• The U.S. economy has held up better than those of other countries.
• Inflation-adjusted U.S. interest rates are rising, thanks to one of the swiftest Federal Reserve rate-hike cycles in modern history.

What is concerning, however, is that relative dollar strength is now rather extreme: The greenback is at its highest level in 20 years versus other major currencies. The pound has fallen to its lowest level against the dollar since 1985, while the yen recently hit its lowest since 1998, and the euro has traded below parity, something that hasn’t happened since 2002. 

This extreme relative dollar strength could lead to bouts of instability, similar to the market-based 1997 Asian debt crisis or the mounting trade imbalances that led to the 1985 Plaza Accord, in which the U.S. agreed to weaken the dollar to reduce those imbalances. Yet investors don’t seem to appreciate the risk. To wit, market-positioning data shows investors around the world still favor the dollar and expect its strength to persist. 

This merits a note of caution, as markets may find themselves in a disorderly unwind when the dollar ultimately tops out. There are three particular risks to consider.

• Currency extremes threaten corporate earnings. For U.S. companies with business in other countries, including many in the S&P 500 Index, a stronger dollar dents the value of their foreign profits when translated back into dollars. At the same time, American companies’ global competitiveness is at risk, as products become pricier in local-currency terms. These factors may be felt more sharply in coming months as global demand is likely to slow, but they do not seem priced into 2022 or 2023 earnings estimates.

• U.S. financial assets may become less attractive to foreign investors. For one, a stronger dollar drives up the local-currency costs of U.S. financial assets, which could weaken new flows into U.S. stocks and bonds. What’s more, foreign investors may face growing pressure to repatriate their U.S.-based holdings to reap currency-related gains, especially as local opportunities become available, potentially further pressuring demand for U.S. financial assets.

• Finally, a strong dollar contributes to trade deficits. The U.S. trade balance—calculated by looking at imports minus exports—is averaging a deficit of nearly $1 trillion per year. That is almost 5% of the country’s gross domestic product (GDP), at a time when total U.S. debt is already well over 100% of GDP. Persistent dollar strength could sustain U.S. consumer purchasing power of foreign assets, which is apt to widen these deficits and lead to tightening domestic financial conditions.

Even if investors are not paying attention to these risks yet, policymakers might be. A G20 summit in November could consider programs to cap dollar strength and, in turn, provide a floor for other currencies. Granted, current geopolitical dynamics may present an obstacle to coordinated currency-market intervention. But any material shift in policy could quickly slow, or even reverse, the greenback’s trajectory. 

U.S. dollar investors should manage these risks by adding more-affordable international assets. Maintain global diversification, as valuations for non-U.S. stocks look much more compelling than for U.S. equities in the near term.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from September 12, 2022, “Beware the Destabilizing Dollar.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.