Global Multi-Asset Viewpoint The Case for a U.S. Dollar Rally

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1 Global Multi-Asset Viewpoint The Case for a U.S. Dollar Rally SOLUTIONS & MULTI-ASSET GLOBAL MULTI-ASSET TEAM MACRO INSIGHT FEBRUARY 2018 Since peaking in late 2016, the U.S. dollar has declined over 10% on a trade weighted basis, and 17% versus the euro, unwinding close to half of this cycle s rally and in the process confounding many market participants and observers. The dollar has deviated from its traditional relationship with interest rate differentials between the U.S. and other countries, which have continued to improve in favor of the U.S. as the dollar sold off. At this point, a bearish dollar view is pervasive, with the most optimistic observers suggesting mere stabilization. The main arguments put forward by U.S. dollar bears have been: structural deterioration in U.S. external and budget balances, comparatively weaker growth in the U.S., a shift in foreign currency reserve allocations away from the U.S. dollar, repatriation of capital by foreign investors, and the prospect of hawkish policy surprises outside the U.S. In this note, we consider these bearish arguments, and review the case for a more positive view on the U.S. dollar, concluding the dollar is likely to rally 10% from current levels, rather than decline further. The current backdrop of bearish sentiment and valuation is beginning to look attractive as a starting point for considering what could go right for the dollar. After being over one standard deviation overvalued at its peak, today the dollar looks fairly valued on a real effective basis on a variety of measures (using CPI or PPI differentials) and across most commonly-used broad measures (tradeweighted, DXY index, Fed index (Display 1). AUTHORS CYRIL MOULLÉ-BERTEAUX Portfolio Manager Head of Global Multi-Asset Team Managing Director SERGEI PARMENOV Portfolio Manager Global Multi-Asset Team Managing Director Display 1: Dollar Looks Fairly Valued U.S. Dollar Real Effective Exchange Rate Z-Score STDV AVERAGE STDV Source: MSIM Global Multi-Asset Team Analysis; Haver Analytics; BIS. Data as of February 28, 2018.

2 MACRO INSIGHT And investor positioning is approaching extended levels of pessimism in contrast to registering predominantly optimistic readings in the run-up to the recent correction. (Display 2) Display 2: Investor Positioning is Oversold DXY vs. U.S. Dollar Sentiment Overbought Oversold GMA USD Composite Sentiment Indicator, LHS DXY, RHS Source: MSIM Global Multi-Asset Team Analysis; Haver Analytics. Data as of February 28, The U.S. dollar has fallen despite the fact that U.S. 10-, 5-, and 2-year Treasury yields are highest among G-10 in both nominal and real terms (except for New Zealand). At about 100 basis points premium to the aggregate developed market 10-year yield (or about 60 bps on a real basis), the rate differential in favor of the U.S. has rarely been higher. 1 (Display 3) Display 3: U.S. Real Rate Differentials vs. G10 Near Historic Highs U.S. vs. G10 Real 10Yr Rate Differential AVERAGE The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results DXY Constituents include: EUR, JPY, GBP, CAD, SEK, CHF. Source: MSIM Global Multi-Asset Team Analysis; Haver Analytics. Data as of February 28, But what s been particularly surprising to the market is that this rate differential has widened by about 35 basis points since early September while the dollar made a fresh low. While it is true that at times, factors other than rate differentials have mattered for the dollar (in fact, over the last ~15 years, oil prices and the U.S. federal budget deficit have been more important), real rate differentials, especially at the 10-year maturity, have been the most consistent predictor of U.S. dollar performance since the 1970 s. We believe that now that the market is likely close to having digested the negative effect of the wider budget deficit, it will focus on the positive growth effect of fiscal stimulus and on supportive rate differentials. Wider budget deficits have been recognized by the market as a potential rationale for continued dollar weakness. Indeed, the prospect of a widening budget deficit in the U.S. from 3.5% in 2017 to 5.3% in 2019, based on the recently-passed tax reform and federal budget, has most likely contributed to the dollar decline in recent weeks. 2 The majority of observers view U.S. fiscal stimulus this late in the expansion as a policy error; as a result this appears to have amplified anxiety about the competence of the current administration s policymaking. However, if such worries about U.S. policy were a primary driver, we would expect to find evidence in other market indicators. And yet U.S. sovereign CDS and the term premium on U.S. government bonds have remained in their recent ranges, and U.S. equities have outperformed global equities (even in U.S. dollar terms) since September of last year. We see the expected widening of the U.S. federal budget deficit as a modestly negative factor for the dollar, but one which is likely already priced in. Over the past four decades, we find that a one percent change in the U.S. Federal budget deficit has lowered the trade-weighted dollar by 0.6%. During historical episodes of higher budget deficit sensitivity (since the 1990 s), the impact on the dollar had been somewhat larger at 2.2%. Based on these sensitives, everything else being equal, the impact of the expected 2% deterioration in the budget deficit should have generated between 1.2% and 4.4% in dollar weakness, less than the 5-7% depreciation of the U.S. dollar since October. In addition to budget deficit concerns, dollar bears have expressed worries about how much fiscal stimulus would exacerbate external deficits and lead to expanding twin deficits. Historically, we find that the trade deficit or the current account deficit have not been a strong predictor of the dollar s performance. The main reason is that the dollar has caused shifts in the trade deficit with one to two year lag. So additional trade deficit widening may be expected based on past dollar strength. Looking at the past couple of instances of widening twin deficits, we are unable to discern a reliable pattern: the dollar s performance ranged from -23% in to +32% during Moreover, the expected twin deficits widening is mild in comparison with history. During the five historical precedents of twin deficit widening (since the 1970 s), the average deterioration has been just over 5 percentage points, 2 MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

3 THE CASE FOR A U.S. DOLLAR RALLY measurably larger than the point deterioration that may be expected over the next two years (roughly 2% from the budget and roughly 1-1.5% from the current account). The diminishing relevance of the U.S. dollar as a reserve currency has also been offered as another rationale for the dollar to remain in a structural bear market. Arguments have been put forth in favor of alternatives to the dollar as reserve currency, such as the euro or the Chinese renminbi. We do not see this supposed change in the perception of the dollar s reserve currency status as justified. First, the renminbi remains controlled and not market-determined, and China s capital account is tightly regulated. Until this changes, major reallocations are unlikely, recent steps to attract flows via the bond-connect program notwithstanding. Second, although French elections last summer lowered anxiety about the eurozone s long-term integration plans, we do not believe enough meaningful change has occurred. Although the breakup risks were probably overestimated at the time of the election, they have only moderated slightly. Structural reforms (such as common deposit insurance and some form of fiscal policy or Eurobond issuance) are yet to be implemented. And mainstream parties have continued to lose ground to populist fringe parties, many of whom are substantially less supportive of, if not outright opposed to, further European integration. Although it is unlikely that euroskeptics will affect policy in the near term, we believe it is premature to talk about the elimination of breakup risk in the eurozone. We do not see evidence of foreign currency reserve managers being over-allocated to U.S. assets at present, or evidence of major recent shifts in allocations that may explain the decline in the dollar. U.S. Treasury data suggests that foreign official holdings of U.S. securities are close to 55%, about in line with the average over the past years. And monthly TIC data indicates that foreign outflows moderated in 2017, as compared to preceding two years. 3 According to the IMF, the share of U.S. dollar reserves stands at about 64% (as of Q3 2017), which is the higher end of the last 10-year range. In our view, the 30% rally in oil prices since last September is one factor that has had a bigger negative impact on the U.S. dollar than is currently acknowledged. Our analysis shows that over the past 15 years, oil prices have been the most significant factor explaining U.S. dollar performance (Display 4). And while causality in some cases has been ambiguous, in the majority of cases we find that it is the change in the oil price that affects the dollar. This causality makes intuitive sense: a higher oil price as a result of stronger global demand would be dollar bearish (in the same way that higher global growth relative to U.S. growth is dollar bearish). If changes in oil prices are supply-side driven, they will affect U.S. terms of trade and therefore should also affect the dollar. Given that the U.S. remains the world s largest oil importer, a supply-driven increase in oil prices would worsen the U.S. s terms of trade and thus weaken the U.S. dollar. Interestingly, substantial moves in the dollar during this business cycle have been associated with large oil supply shocks. The Arab Spring in , the 2014 loosening of supply by Saudi Arabia, and the recent production cuts by OPEC+, have all caused large moves in oil prices and consequently the dollar. 4 At the current level of oil prices ($65 Brent), we expect continued supply growth by U.S. shale to balance the market by 2019, capping further oil price appreciation. Stable oil prices would provide support for the U.S. dollar. Display 4: Higher Oil Prices Have Depressed the USD U.S. Dollar Real Effective Exchange Rate vs. Oil U.S. Dollars per Barrel Oil, LHS USD REER (Inverted, RHS) Past performance is no guarantee of future results Source: MSIM Global Multi-Asset Team Analysis; Haver Analytics. Data as of February 28, Another recent bearish argument for the U.S. dollar has been stronger global growth outside the U.S. In the U.S. Dollar smile paradigm, stronger growth tends to be bearish for the dollar (while periods of comparatively stronger U.S. growth and global recessions have tended to be bullish). While the negative effects of a wider budget deficit may be more than adequately discounted, the positive effect of fiscal stimulus on U.S. growth and a more hawkish outlook for monetary policy may be underappreciated. We expect global growth to moderate somewhat in the coming months led by policy tightening in China, where credit conditions are being tightened, fiscal stimulus is contracting, and housing activity has moderated substantially. In addition, we believe growth in the eurozone may moderate somewhat following a period of substantially above-trend growth. We expect the 7% appreciation of the trade-weighted euro over the past 12 months to subtract basis points from eurozone GDP growth over the next two years. In the U.S., we expect fiscal stimulus to add basis points to GDP per year this year and in After nearly two years of downward revisions of U.S. GDP growth relative to global growth, upward revisions to consensus forecasts for U.S SOLUTIONS & MULTI-ASSET MORGAN STANLEY INVESTMENT MANAGEMENT 3

4 MACRO INSIGHT growth have been outpacing global ones since the passage of the tax cut in November. As the impact of U.S. stimulus becomes more evident and more fully incorporated into expectations, we think U.S. growth forecasts will likely continue to improve relative to the rest of the world (Display 5). The dollar s positive reaction to the improving growth outlook in the U.S. as compared to much of the rest of the world will likely be compounded by the U.S. economy s more advanced position in the economic cycle. We expect the U.S. Fed funds rate to be hiked four times this year, suggesting scope for further improvement in real and nominal rate differentials in favor of the U.S. The recently-proposed U.S. tariff increases are too small to have a material impact on the dollar. However, if they were broadened to more industries, or prompted retaliation and escalation into a trade war, they would potentially be supportive of a stronger dollar in two ways. First, import tariffs tend to be dollar bullish, as they raise prices, leading the Fed to raise rates as a countermeasure to higher inflation. Second, if tariffs prompt retaliation which escalates into a global trade war, the resulting slower global growth would likely prompt a flight to quality assets like the U.S. dollar. A recent IMF working paper estimates that a 10% symmetrical increase in import tariffs between the U.S. and the rest of the world would result in a 1% fall in world trade and a 50 bps fall in global GDP. 5 Display 5: Stronger U.S. vs. Global Growth to Support USD U.S. Dollar vs. U.S. Growth Differentials Percent We expect the dollar to rise by about 10% over the next 6-12 months rather than continue to decline. With investors bearish and their concerns about widening deficits largely priced in, we believe there is scope for upside surprises to prompt dollar appreciation. We suspect more resilient growth in the U.S. relative to the rest of the world as well as stable oil prices could lead investors to put aside worries about the impending structural decline of the U.S. dollar s relevance. And a more hawkish Fed forging ahead with quantitative tightening as well as rate hikes will likely make investors focus on wide and further improving rate differentials as a bull case for the dollar DXY, LHS Global vs. U.S. Growth Differential (Inverted), RHS Source: MSIM Global Multi-Asset Team Analysis; Haver Analytics. Data as of February 28, MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

5 THE CASE FOR A U.S. DOLLAR RALLY There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. In general, equity securities values fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longerterm securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities (MBS and ABS) are sensitive t early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Portfolio, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the United States. It is possible that these issuers will not have the funds to meet their payment obligations in the future. The issuer or governmental authority that controls the repayment of sovereign debt may not be willing or able to repay the principal and/ or pay interest when due in accordance with the terms of such obligations. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Real estate investment trusts are subject to risks similar to those associated with the direct ownership of real estate and they are sensitive to such factors as management skills and changes in tax laws. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the Portfolio s performance. Trading in, and investment exposure to, the commodities markets may involve substantial risks and subject the Portfolio to greater volatility. Nondiversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company s portfolio securities. In addition to the Portfolio s fees and expenses, the Portfolio generally would bear its share of the investment company s fees and expenses. Subsidiary and Tax Risk The Portfolio may seek to gain exposure to the commodity markets through investments in the Subsidiary or commodity index-linked structured notes. The Subsidiary is not registered under the 1940 Act and is not subject to all the investor protections of the 1940 Act. Historically, the Internal Revenue Service ( IRS ) has issued private letter rulings in which the IRS specifically concluded that income and gains from investments in commodity index-linked structured notes or a wholly-owned foreign subsidiary that invests in commoditylinked instruments are qualifying income for purposes of compliance with Subchapter M of the Internal Revenue Code of 1986, as amended (the Code ). The Portfolio has not received such a private letter ruling, and is not able to rely on private letter rulings issued to other taxpayers. If the Portfolio failed to qualify as a regulated investment company, it would be subject to federal and state income tax on all of its taxable income at regular corporate tax rates with no deduction for any distributions paid to shareholders, which would significantly adversely affect the returns to, and could cause substantial losses for, Portfolio shareholders. SOLUTIONS & MULTI-ASSET MORGAN STANLEY INVESTMENT MANAGEMENT 5

6 MACRO INSIGHT FOOTNOTES 1 MSIM Global Multi-Asset Team estimates; GDP-weighted 2 MSIM Global Multi-Asset Team Analysis; Center for Responsible Federal Budget estimate 3 MSIM Global Multi-Asset Team Analysis; U.S. Department of the Treasury; TIC = Treasury International Capital 4 MSIM Global Multi-Asset Team Analysis; S&P Global; OPEC+ refers to the alliance of OPEC and non-opec countries, including Russia, formed in 2016 to negotiate supply cuts. 5 MSIM Global Multi-Asset Team Analysis; Linde, Jesper; Pescatori, Andrea; The Macroeconomic Effects of Trade Tariffs: Revisiting the Lerner Symmetry Result, Working Paper, retrieved from July DEFINITIONS The S&P GSCI Total Return is a composite index of commodity sector returns, representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. 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