How worried should investors be? Look to the dollar
At the start of January we said the path of the dollar would be the defining influence on asset allocation in 2016.
We thought stretched valuation, after a blistering three year dollar rally, and a gradual closing of the growth differential between the US and the rest of the world would leave the US currency with only modest upside, effectively mitigating what has been a headwind for sentiment and providing relief to companies that have borrowed in USD.
Although we see scope for a more virtuous end to the dollar strength cycle playing out later in 2016, the recent reversal in the dollar – one of the sharpest drops in 20 years – is more concerning. It is worrying because the weakness is not a symptom of growth broadening out from America to the rest of the world, but instead of pockets of economic stress around the world starting to affect the US.
Exactly how worried should we be? US stocks and credit markets are trading as if the US economy is holed below the water line. While we echo the near term caution, it is too soon to conclude that the economy is heading for a contraction. Nevertheless, the path of the dollar will again be critical as the level of US growth is likely insufficient to reassure asset markets in the near term.
Three central considerations tend to drive asset markets – growth, liquidity and tail risk. Other factors such as valuation, positioning, momentum and sentiment matter, but these can be swung, even dominated, by the three primary factors.
Taking the first of our primary considerations – growth – it’s fair to say that recent US data are underwhelming. Nevertheless, the all-important labour market remains resilient. Economists often cite “small open economies” as vulnerable to external shocks, but the US is the diametric opposite. The domestic consumer and housing account for 70% of the US economy and while manufacturing and external sectors are weak, these alone are unlikely to shunt the US economy into recession.
To be clear, we aren’t suggesting the US economy is booming. When a ship sails in shallower water the risk of running aground is clearly higher; likewise a shallower trajectory of growth increases the vulnerability of an economy to exogenous shocks. So a negative shock is possible, but outright recession is unlikely.