By Xing Kui, investment consultant, GF Securities
When people mourned as China A-share index fell below the 2000-point benchmark in 2013, the Dow Jones index has been hiking constantly to breaking new highs. Many people started to lay their sight on overseas markets and hoped to grab a slice of the dollar assets feast.
The concept of dollar assets is not new to us. This type of assets include the US property related QDII products, which have been hotly pursued recently, passive index-based products tracking Nasdaq index that covers high-tech companies as well as a variety of complex financial derivatives. There are quite a few investors who have already exchanged part of their assets directly into US dollar savings with the hope the currency will appreciate over time.
Asset allocation is an important consideration to forecast the performance of dollar. Dollar has a major impact in the global financial markets. The dollar itself is also an important target in terms of asset allocation (the dollar exchange rate, dollar assets). Under such a scenario, it important and urgent for us to look at the historical trend of dollar and conduct reasonable analysis of its future trends. I believe that the pattern of a medium-term dollar bull run has already been formed. It is not only a direct result of strong recovery of the US economy and lack of recovering momentum in other economies, but also directly linked to the opposite direction between the US monetary policies and those in Europe and Japan.
Analysis of the historical trend of the US dollar
Historically, the dollar index has experienced five periods with appreciation or depreciation: 1971-1980 (depreciation), 1980-1985 (appreciation), 1985-1995 (depreciation), 1995-2002 (appreciation) and 2002 -2008 (depreciation). In the past two decades alone, the dollar index has gone through a complete ull and Bearpattern since 1995. From mid-1990s until 2001 and 2002, dollar was in a big bull run and it began to decline all the way until the financial crisis broke out since 2002.
The outbreak of the financial crisis has led to the realignment of currency exchange rates. Especially when European debt crisis emerged, people started to re-examine the inherent weakness of euro system and the structural contradictions in European economy. Euro position began to show gradual decline compared with dollar,.
Overall, the global economy has been constantly adjusting itself to a new balance. The currency exchange rates are the important tools in the process to reach an economic equilibrium for the whole world. Currently, dollar market is still lingering around the bottom of the slump since 2001. Here comes the key question: will dollar bottom out after consolidation and reverse the Bear market starting 2001? There are many factors affecting the exchange rate, such as US economic structure, global economy, political changes and etc. But fundamentally, the core factor affecting medium-to-long-term exchange rate is a country's economic strength. Specifically, the US economic growth rate largely determines the trend of the dollar index. But what we should be aware of is that there were several periods of time in history when the dollar index and the economic fundamentals diverged. We observed that when the US economic situation improved in 2003 and 2004, the dollar index continued its downward trend. One of the reasons was that the Bush administration expansionary fiscal policy led to a substantial increase of US deficit. Investor weakened appetite for risk aversion after the economic recovery also influenced the dollar performance. Therefore, there are a variety of factors that can affect the dollar exchange rate while their influence varies during different periods of time. When gauging the trend of US dollar, we should not only focus on US monetary policy, but also US foreign trade structure and external liability structure.
The fundamental supporting factor behind foreign trade and currency exchange rates is the competitiveness of goods. In the past, due to the decline of its competitiveness, US had a trade deficit for a long time. Meanwhile, it had to export US dollars due to the trade deficit, leading to the long-term depreciation of the dollar. However, after the financial crisis, US foreign trade situation has changed with its trade deficit narrowing. The US automobile industry has experienced major restructuring with export competitiveness rising significantly. In addition, agricultural products, especially soybeans, have made a greater contribution to US exports. In terms of imports, growth in 2011 and 2012 were both lower than export growth, resulting in a narrowed deficit with absolute amount of US foreign trade balance. The deficit of goods and services dropped from a peak of US$753.2 billion in 2006 to US$539.5 billion in 2012. The current account deficit declined from US$800 billion in 2006 to US$ 474.9 billion in 2012. In addition, the US will soon start exporting crude oil. BP, Royal Dutch Shell and other oil giants have submitted applications to the US government, seeking to export US-produced oil. With the gradual establishment of the advantages in the US energy sector and recovery of manufacturing industry, they will play a positive role in improving the current account. Trade conditions may continue to improve, and thus support the dollar.
As for external liabilities, during the financial crisis in 2008, in order to save the US financial system, there has been substantial growth in US debt, which grew to US$16.4 trillion by the end of last year from US$5.6 trillion by the end of 2000. The proportion of the US debt against its GDP grew from less than 60% to last year's 104%. Treasuries continued to grow, especially its percentage against GDP, which weakened the credit of dollar and drove its value lower in the past. Now the situation has changed. The US started to control the size of its debt, cut spending and increase revenue. According to a report unveiled by the US Congressional Budget Office (CBO) on May 14, the US budget deficit in fiscal year of 2013 is expected to be far lower than previously estimated. The budget deficit for fiscal year of 2013 will be US$642 billion, US$203 billion lower than the estimate of US$845 billion in February. It significantly lower than the budget deficit of around US$1 trillion in previous years.
The Congressional Budget Office also predicted that if the current austerity fiscal measures continue, US is expected to cut the budget deficit to US$560 billion in the fiscal year 2014, lower than the previous estimate of US$616 billion. If the trend continues, the US economy will constantly grow and the US budget deficit may continue to drop. The absolute amount of the Treasuries is likely to drop with the credit of the dollar to be strengthened and the value of the dollar to rise. The improved fiscal situation, the lower ratio of external liabilities and the enhanced dollar credit will undoubtedly benefit the dollar performance. Since the onset of the financial crisis, the US Federal Reserve has launched four rounds of quantitative easing, by lowering interest rates and conducting large-amount assets purchase simultaneously. The loosened policy has led to an exogenous increase in dollar supply, causing the dollar to increase in number, and then lowering the dollar exchange rate. But now the situation has changed. The US economic fundamentals are gradually improving. The Fed is set to tighten its monetary policy faces and gradually withdraw from the asset purchase. Fed Chairman has already given the exit paths of QE4.
In contrast with the US, other countries still feature poor economic fundamentals and they have started to loosen their monetary and fiscal policy. Europe economic situation has deteriorated to an unacceptable extent and the economic policy shift is inevitable. Japan has already launched a massive monetary easing program while Australia also began to cut interest rates. In short, compared with the loose monetary policy in other countries, the US monetary policy is set to push up the dollar. The different directions of monetary policies will boos the dollar strength.
In summary, I believe that the long-term strength of the dollar has been gradually formed. I suggest that investors properly increase the weight of US dollar-denominated assets in their asset allocation.