Lazard Insights. What Can Change the Strong Dollar Narrative? Summary. Why Has the US Dollar Strengthened?

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1 Lazard Insights What Can Change the Strong Dollar Narrative? Ardra Belitz, Managing Director, Portfolio Manager/Analyst Jared Daniels, CFA, Managing Director, Portfolio Manager/Analyst Summary The current heightened risk aversion in global markets has resulted in significant global currency weakness and lackluster US dollar-based returns. The dollar has strengthened thanks to a confluence of fundamental and policy factors, including US economic outperformance relative to the rest of the developed markets, the pro-cyclical US tax reform act, and ongoing tightening by the Fed versus continuing accommodation by most developed markets central banks. Currency market positioning has served to accentuate dollar strength. The global synchronized growth narrative that prevailed in 17 occurred alongside a weak US dollar. If heightened global tensions dissipate, US dollar weakness could reassert itself. A host of emerging markets central banks have hiked rates, resulting in wider interest rate differentials that favor emerging markets. We believe the greatest long-term investment opportunities, particularly from a valuation perspective, may ultimately lie in the international markets. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via The surging dollar in recent months has weighed heavily on international asset returns, as measured in US dollar terms. The dollar has rallied against most currencies globally this year, with some exceptions, notably Japan's and Norway's, and some emerging markets currencies, including those in Colombia, Malaysia, and China (Exhibit 1). This dollar strength has resulted from a confluence of relative fundamental and technical factors, including pro-cyclical tax reform coming on top of an already strong US economy, and the Federal Reserve s ongoing policy tightening against the accommodative stance maintained by most other developed markets central banks. Notably, a host of emerging markets central banks have also hiked rates. This paper looks at this changing narrative through the lens of the global currency market, the world s largest and most liquid financial market and the one that most rapidly reflects the changing currents of the global economy. Why Has the US Dollar Strengthened? The desynchronization of global growth, with cyclical outperformance in the United States, and disappointing euro zone economic results relative to expectations over the past several months, has contributed to broad dollar gains since the end of January.

2 Exhibit 1 The US Dollar Has Appreciated against Most Global Currencies 18 Spot Performance Japanese Yen Norwegian Krone Chinese Renminbi Swiss Franc British Pound New Zealand Dollar Euro Danish Krone Australian Dollar Canadian Dollar Swedish Krona Russian Ruble Turkish Lira Argentine Peso As of June 18 Source: Bloomberg We highlight three factors behind recent dollar strength: Fed policy and tax reform Fundamentals Technical conditions Fed Policy and Tax Reform For the first time since the global financial crisis, developed markets, like the United States, euro zone, and Japan, and emerging markets started growing in tandem in 17. Risk assets performed well in this environment, but increasing global uncertainty (including rising trade war tensions between the United States and China) disrupted this narrative even as the US economy gathered steam in 18. The Fed, which started its monetary tightening process at the end of 15, continues to normalize. It has hiked the bellwether fed funds rate seven times and progressively reduced its balance sheet in a well-telegraphed manner. Meanwhile, although a host of emerging markets central banks have raised rates as their domestic conditions warranted, some developed markets' central banks, in particular the European Central Bank (ECB), have been slower to embark on the path to normalization. Despite the fact that the ECB will end its bond buying program, or quantitative easing scheme, at the end of this year, it does not plan to implement its first rate hike until at least September 19. By extension, investors are questioning the timing and sequencing of other central bank policy normalization. The Fed, on the other hand, has reduced its balance sheet at an increasing rate by allowing Treasuries and mortgage-backed securities purchased during the quantitative easing phase to roll off its balance sheet at up to $5 billion per month by October 18. Coming alongside this quantitative tightening and the Fed rate hikes, provisions of the recently passed tax reform act have drained liquidity from the large offshore dollar market. Tax reform enabled US corporations to repatriate profits earned from their overseas operations unburdened by heavy income taxes. The resulting flows back to the United States have exerted upward pressure on the dollar LIBOR market (a crucial offshore financial mechanism) reduced liquidity, and tightened economic conditions globally. Fundamentals One of the most important fundamental drivers of US dollar strength is the relationship (and incremental change) between global interest rates and exchange rates. Today, the spread between the yield on a -year US Treasury, boosted by the Fed s rate hikes, versus the yield on a -year German bund, anchored to the ECB s accommodative policy, is the widest it has been in over 3 years (Exhibit ). Compounding this divergence, the current state of affairs related to trade agreements and tariffs and the fluid political landscape in Europe have created additional market uncertainty. This dynamic has supported the dollar, which has been benefiting from its status as the safe-haven currency. Exhibit The -Year US Treasury/Germany Bund Spread Has Reached At Least a 3-Year High US/Germany -Year Spread 4-8 As of June 18 1 Source: Lazard, Bloomberg Despite recent emerging markets currency weakness, relative real interest rates in the asset class point to rising compensation for investors. Emerging markets real rates have risen into positive territory in the past five years since the taper tantrum (Exhibit 3), in contrast to the developed markets, where even in the United States real rates languish near zero.

3 3 Exhibit 3 Emerging Markets Real Rates Have Risen since the Taper Tantrum EM Real Rates As of 1 June 18 Taper Tantrum Technical Factors Source: Lazard, Deutsche Bank (Data includes Russia, Brazil, India, Turkey, South Africa, Indonesia, Mexico, Colombia), Bloomberg 18 Technical considerations, which represent a third factor behind the dollar rally, can provide additional market context related to momentum and speculative market positioning. Alongside changes in underlying economic fundamentals, which can sometimes serve as the trigger, extreme technical valuations can result in price reversals back to longer-term average levels. For example, the overbought positioning at the end of 17 into early 18 highlighted by the Relative Strength Index 1 (in this case the euro/ dollar RSI, using the euro as a general proxy for global currencies) and further confirmed by stretched futures positioning (relative to long-term comparisons) created the potential for the subsequent short-term correction for a weaker euro and stronger US dollar, which is precisely what happened (Exhibit 4). The Structural EM and Cyclical DM Tailwinds The current heightened risk aversion globally has resulted in significant local currency weakness and lackluster dollar-based returns, particularly in emerging markets with high external financing needs or those with relatively low interest rates. The apparent weakness should not obscure the fact that the emerging markets as a whole enjoy much better macro metrics, valuations, and higher levels of risk premia compared to the vulnerabilities they exhibited during the mid-13 Taper Tantrum. Their external account positions have steadily improved, and the majority of the emerging markets boast basic balance of payments surpluses today. In addition, their public debt burdens are one-third to one-half the size of the heavily indebted developed nations. Finally, our emerging markets equities team reports consistent earnings growth among emerging markets corporates that the recent dollar s strength has temporarily masked. Even so, the Fed was the first among the developed nations to enter a quantitative easing program and has been the first to begin normalizing monetary policy (Exhibit 5). The Fed s ongoing tightening has buoyed the dollar in recent months. However, the timing disparity and its impact on broad dollar strength may well be running its course. Ultimately, the Fed will near the end of its Exhibit 5 The Fed Had Led the Tapering Charge Aggregate Central Balance Sheet Exhibit 4 Technical Factors Accentuated Short-Term Cyclical Trends Relative Strength Index (RSI) EUR per USD ($M) 16, 1, 8, Fed ECB BoJ BoE (RSI) Overbought 4, As of June 18 Source: Credit Suisse, Thomson Reuters 16 18E E Oversold As of June 18 Source: Bloomberg

4 4 monetary normalization cycle just as other major central banks will begin theirs. These shifting monetary cycles could work to temper or reverse the dollar s recent ascent. Has the Dollar Trend Come to an End? Cyclically and structurally, then, the signs point to a winding down of dollar strength over the longer term. Looking past geopolitical uncertainty and the threat of trade wars, the synchronization narrative could reassert itself in the developed world. Forecasting the timing of a turn in the narrative is, of course, impossible. The chronic and ongoing widening of the US twin deficits (fiscal and current account) suggests that the dollar's recent strength is vulnerable to reversal. These deficits make the dollar vulnerable to any slowdown in foreign investment in US securities, any diversification away from the dollar as the reserve currency of choice among the world s central banks, and any hikes that would narrow the difference between US interest rates and those of the rest of the world. Importantly, if global trade tensions dissipate, the global economy should improve and, hence, the dollar could lose some of its luster. Global diversification at this point would, as always, seem the prudent course. In the near term and fundamentally, international markets (both emerging markets and developed markets outside of the United States) offer attractive opportunities in this regard. For instance, on the basis of real effective exchange rates, emerging markets currencies seem most undervalued against the dollar (Exhibit 6). Their external financing burdens have also eased as they have gotten their fiscal houses in order (Exhibit 7) and their real interest rates the compensation for investing in their markets have risen, making all in all for an attractive investment proposition. Exhibit 6 Emerging Markets Currencies Appear Undervalued Valuation: REER/ToT vs.1-year Average Overvalued Undervalued Turkey Mexico Brazil Philippines Hungary Colombia Poland Peru Chile Argentina Russia Romania Singapore Indonesia Malaysia S. Africa Czech Rep. Israel Korea Thailand India China Hong Kong As of 1 June 18 Data reflect the real effective exchange rate (REER)/Terms of Trade (ToT) Source: Lazard, Bloomberg Exhibit 7 External Financing Burdens Have Eased in Emerging Markets (ex-china) GDP As of 31 March 18 Source: Lazard, Haver Current Account Basic Balance 16 18

5 5 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 The Relative Strength Index is a measure which tracks the momentum of currency moves. Important Information Originally published on 8 June 18. Revised and republished on July 18. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. 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