Austin Pickle, CFA Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS Dead Dollar Bull? March 3, 208 Key takeaways» The U.S. dollar has experienced three secular cycles of appreciation (bull-market cycles) which interrupted its long-term depreciation trend. While it may be too early to tell, the evidence suggests that the most recent secular dollar bull market of the past few years is dead.» U.S.-dollar-denominated allocations to international developed- and emergingmarket equities are two of the simplest (and most effective) ways to insulate a portfolio from a declining dollar. Commodities (gold, in particular), have had success as well. What it may mean for investors» We strongly encourage U.S. investors to consider bringing their international developed- and emerging-market equity allocations up to recommended target weights.» Commodities, like gold, have had some success in providing a hedge against dollar weakness, but we currently have an unfavorable near-term outlook on commodities and gold prices. The U.S. dollar is the most widely used currency in the world. Roughly 63% of all national foreign-exchange reserves are in dollars (the euro is next, with only 20%). The vast majority of commodities and international transactions and trades are contracted in dollars. Many economies peg their own currency to the dollar, and some countries have even adopted the U.S. dollar as their official currency. When the world s most widely used currency fluctuates in value, it receives heightened attention. And this is what we have experienced this past year as the dollar s broad exchange value (how many dollars it takes to buy one euro, one Japanese yen, or one British pound, for example) has depreciated considerably. When the dollar s exchange value is rising, it is said to appreciate; when it is falling, it depreciates. But dollar depreciation is nothing new. The dollar s value has been trending steadily lower for the past 50 years. The significant U.S. dollar appreciation that occurred from the financial crisis to 206 was actually the exception and not the norm. In fact, the dollar has experienced only three such periods of sustained appreciation (bull-market cycles shaded areas in Chart ) that have interrupted the historical depreciation trend International Monetary Fund, September 30, 207. 208 Wells Fargo Investment Institute. All rights reserved. Page of 7
(dashed line in Chart ). And now, the rising tide that had lifted the dollar since the financial crisis seems to be going out. In this report, we hypothesize that the recent dollar bull market is dead and review how U.S.-dollar-based portfolios might be insulated from the possibility of extended dollar weakness. Dollar cycles The U.S. Dollar Index (DXY) combines the greenback s exchange value against six of the world s principal currencies and allows us to easily examine whether the dollar s exchange value is broadly appreciating (DXY is increasing) or depreciating (DXY is decreasing). In the simplest of terms, the dollar s value is determined like that of so many assets as a result of the balance between supply and demand. Factors that increase demand relative to supply tend to produce dollar appreciation, and vice versa. Better economic growth prospects, higher U.S. interest rates, and a more attractive investment environment are just a few examples of what increases the demand for one currency versus another (and hence, raises its value). From the dollar-supply side, the fewer dollars in global circulation, the more the dollar tends to appreciate. And the reverse also is true. So, if U.S. borrowing (either from domestic or international creditors) decreases, the dollar tends to appreciate. In fact, these examples are largely what spurred the three secular dollar bull-market cycles shown in Chart. Chart. The U.S. dollar s bull and bear cycles 70 60 50 40 5 4.5 4 3.5 30 20 0 00 90 3 2.5 2.5 80 0.5 70 0 970 974 978 982 986 990 994 998 2002 2006 200 204 208 Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 3, 970 March 7, 208. The Dollar Index is represented by the DXY Index, which indicates the general international value of the U.S. dollar (USD). The index does this by averaging the exchange rates between the USD and major world currencies. 208 Wells Fargo Investment Institute. All rights reserved. Page 2 of 7
Notice how significantly the dollar has depreciated since the 206 peak. It may be too early to call the most recent dollar bull market dead, but the evidence seems to suggest that it is. Our forecast is for continued dollar depreciation at least for the remainder of 208. Heavier U.S. government borrowing, a broad-based international economic recovery, and the forthcoming end to the European Central Bank s accommodative policy all should conspire to put downward pressure on the dollar this year. And if history of past cycles repeats itself, or even rhymes, we may be faced with a weak dollar for years beyond 208. How may U.S. investors potentially insulate their portfolios from dollar weakness? The answer can be summed up in two words: diversify globally. To illustrate how global exposure can benefit a portfolio when the dollar depreciates, we created Chart 2 and Chart 3. Chart 2 shows the DXY in orange and the ratio of U.S. stocks divided by international stocks in blue (both indices are in U.S. dollars to illustrate an investor buying stocks with U.S. dollars). When the blue line is going up, U.S. stocks are outperforming international stocks. When the blue line is going down, international stocks are outperforming U.S. stocks. Notice how this relative outperformance and underperformance closely matches dollar movements. In dollar terms, international stocks have consistently outperformed domestic stocks when the dollar depreciates (and vice versa). Chart 2. Dollar cycles and performance of U.S. stocks versus international developed-market stocks 70 60 50 40 30 20 0 00 90 U.S. stocks/international stocks 80 0.2 70 0 970 974 978 982 986 990 994 998 2002 2006 200 204 208 Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 3, 970 March 7, 208. U.S. stocks are represented by the MSCI U.S. Index and International stocks are represented by the MSCI World (ex-u.s). Index (in U.S. dollars). Ratio is U.S. stocks divided by international stocks..8.6.4.2 0.8 0.6 0.4 Ratio 208 Wells Fargo Investment Institute. All rights reserved. Page 3 of 7
Chart 3 uses the same format as Chart 2, but it shows the relative performance of U.S. stocks versus emerging-market stocks (green line both indices are in U.S. dollars). While there is less history to examine, the story remains the same emerging-market stocks (in U.S. dollar terms) have consistently outperformed domestic stocks during periods of dollar weakness. Chart 3. Dollar cycles and performance of U.S. stocks versus emerging-market stocks 25 4.5 4 5 U.S. stocks/emerging market 3.5 stocks 05 3 95 85 75 65 0.5 988 993 998 2003 2008 203 208 Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 3, 988 March 7, 208. U.S. stocks are represented by the MSCI U.S. Index and emergingmarket stocks are represented by the MSCI Emerging Markets Index (in U.S. dollars). Ratio is U.S. stocks divided by emerging-market stocks. Gold as a dollar hedge At this point, some investors may say, why don t I invest in a commodity like gold instead? Wouldn t that provide me with a better dollar hedge? Since most commodities, including gold, are priced in dollars, they often have provided an effective hedge in the past. However, during the 980s dollar bear-market cycle, gold did not provide a performance benefit over U.S. stocks (Chart 4, gold line). Although gold often has provided an effective dollar hedge (as noted), it has been less consistent than emerging-market and international developed-market stocks in outperforming domestic stocks during dollar bear-market cycles. In addition, commodities are struggling with their own bear super-cycle, and we have an unfavorable near-term outlook on gold, and on commodities in general. Chart 4. Dollar cycles and performance of U.S. stocks versus gold 70 60 50 40 30 20 0 00 90 80 U.S. stocks/gold 70 0 973 978 983 988 993 998 2003 2008 203 208 Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: January 3, 973 March 7, 208. U.S. stocks are represented by the MSCI U.S. Index and gold is represented by the spot price of gold. Ratio is U.S. stocks divided by the price of gold. 208 Wells Fargo Investment Institute. All rights reserved. Page 4 of 7 2.5 2.5 Ratio 6 5 4 3 2 Ratio
Investment implications The U.S. dollar is the most widely used and most easily obtained currency in the world. It is not in imminent danger of losing that status. Yet, the dollar s importance does not equate to strength. The past few years of dollar strength actually have been the exception to the weaker long-term trend and not the norm. In an effort to combat potential future dollar depreciation, we strongly urge U.S. investors to consider bringing their international developed- and emerging-market equity allocations up to their recommended target weights. At times, commodities, like gold, have proved to be a successful dollar hedge; however, we have an unfavorable near-term outlook on commodities, and we expect lower gold prices in 208. 208 Wells Fargo Investment Institute. All rights reserved. Page 5 of 7
Economic Calendar Date Report Estimate Previous 3/3/208 NFIB Small Business Optimism 07. 06.9 3/3/208 CPI MoM 0.20% 0.50% 3/3/208 CPI Ex Food and Energy MoM 0.20% 0.30% 3/3/208 CPI YoY 2.20% 2.0% 3/3/208 CPI Ex Food and Energy YoY.80%.80% 3/3/208 CPI Index NSA 248.982 247.867 3/3/208 CPI Core Index SA 255.807 255.287 3/3/208 Real Avg Weekly Earnings YoY -- 0.40% 3/3/208 Real Avg Hourly Earning YoY -- 0.80% 3/4/208 MBA Mortgage Applications -- 0.30% 3/4/208 Retail Sales Advance MoM 0.30% -0.30% 3/4/208 Retail Sales Ex Auto MoM 0.40% 0.00% 3/4/208 Retail Sales Ex Auto and Gas 0.30% -0.20% 3/4/208 Retail Sales Control Group 0.40% 0.00% 3/4/208 PPI Final Demand MoM 0.0% 0.40% 3/4/208 PPI Ex Food and Energy MoM 0.20% 0.40% 3/4/208 PPI Ex Food, Energy, Trade MoM 0.20% 0.40% 3/4/208 PPI Final Demand YoY 2.80% 2.70% 3/4/208 PPI Ex Food and Energy YoY 2.60% 2.20% 3/4/208 PPI Ex Food, Energy, Trade YoY -- 2.50% 3/4/208 Business Inventories 0.60% 0.40% 3/5/208 Empire Manufacturing 5.5 3. 3/5/208 Import Price Index MoM 0.30%.00% 3/5/208 Import Price Index ex Petroleum MoM 0.20% 0.50% 3/5/208 Import Price Index YoY 3.50% 3.60% 3/5/208 Export Price Index MoM 0.30% 0.80% 3/5/208 Export Price Index YoY -- 3.40% 3/5/208 Initial Jobless Claims 228k 23k 3/5/208 Continuing Claims -- 870k 3/5/208 Philadelphia Fed Business Outlook 23 25.8 3/5/208 Bloomberg Consumer Comfort -- 56.8 3/5/208 Bloomberg Feb. United States Economic Survey 3/5/208 NAHB Housing Market Index 72 72 3/5/208 Total Net TIC Flows -- -$9.3b 3/5/208 Net Long-term TIC Flows -- $27.3b 3/6/208 Housing Starts 290k 326k 3/6/208 Housing Starts MoM -2.70% 9.70% 3/6/208 Building Permits 328k 396k 3/6/208 Building Permits MoM -3.60% 7.40% 3/6/208 Industrial Production MoM 0.30% -0.0% 3/6/208 Manufacturing (SIC) Production 0.40% 0.00% 3/6/208 Capacity Utilization 77.70% 77.50% 3/6/208 JOLTS Job Openings -- 58 3/6/208 Revisions: JOLTS 3/6/208 U. of Mich. Sentiment 99.5 99.7 3/6/208 U. of Mich. Current Conditions -- 4.9 3/6/208 U. of Mich. Expectations -- 90 3/6/208 U. of Mich. Yr Inflation -- 2.70% 3/6/208 U. of Mich. 5-0 Yr Inflation -- 2.50% Source: Bloomberg as of 3/9/8 208 Wells Fargo Investment Institute. All rights reserved. Page 6 of 7
Risk Considerations Forecasts and targets are not guaranteed and are subject to change. Diversification cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification does not guarantee profit or protect against loss in declining markets. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Currency risk is the risk that foreign currencies will decline in value relative to that of the U.S. dollar. Exchange rate risk between the U.S. dollar and foreign currencies may cause the value of the portfolio's investments to decline. Definitions MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. MSCI U.S. Index is designed to measure the performance of the large and mid-cap segments of the U.S. market. With 624 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the U.S. The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries*--excluding the United States. With,06 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country U.S. Dollar Index (DXY) measures the value of the U.S. dollar relative to majority of its most significant trading partners. This index is similar to other trade-weighted indexes, which also use the exchange rates from the same major currencies. An index is unmanaged and not available for direct investment. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 038-027 208 Wells Fargo Investment Institute. All rights reserved. Page 7 of 7