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Dilantha De Silva
Dilantha De Silva
Articles (118)  | Author's Website |

The Dollar's Plunge Calls for Tactical Asset Allocation Decisions

The greenback is likely to shed some of its recent gains

The U.S. dollar has enjoyed a nice run since late 2013 thanks to the strengthening economy. The U.S. Dollar Index (DXY), which is often used to gauge a measure of the greenback’s strength against a basket of currencies representing developed nations, gained more than 23% through April this year, only to shed over 7% since then along with the macroeconomic challenges faced by the global economy. A few fund managers and analysts have already made their case for a weaker dollar in the coming years. Not paying attention to this ongoing development could cost investors money in the long run. The prudent decision, therefore, is to identify the business sectors that are likely to benefit from a weak dollar and allocate assets in favor of companies representing such industries.

The case for a depreciating dollar

The U.S. dollar is the world’s primary reserve currency, so to project it shedding value is a hefty claim. Things get more complicated as the dollar is perceived as a safe-haven asset that performs well during economic recessions, which is exactly what the global economy is going through at the moment. There are several factors that suggest things could take a different turn this time around.

First, the persistently low interest rates in the country could eventually take its toll on the U.S. dollar, leading to a significant depreciation of the currency in comparison to other developed market currencies. Federal Reserve Chair Jerome Powell has confirmed his stance on maintaining record-low policy rates to boost consumer spending and credit growth, and the dot plot released in early July suggests the next rate hike would only occur by 2022. This is an ominous sign for the dollar.

Second, the widening current account deficit is not good news for the greenback. Generally, an increase in the deficit leads to a weaker currency for any country. The U.S. dollar has been the only exception in the last four decades. Even on the back of unfavorable current account numbers, the dollar continued to gain momentum thanks to its status as the world’s reserve currency. This time around, things could take a drastic turn if investors flock to alternative currencies such as the euro or the Chinese yuan, which is predicted by a few well-known analysts. The expected decline in the savings rate is also another concern as it is negatively correlated with the strength of a currency. Stephen Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, wrote in a Bloomberg Opinion piece:

“The coming collapse in savings points to a sharp widening of the current account deficit, likely taking it well beyond the prior record of -6.3% of GDP that it reached in late 2005. Reserve currency or not, the dollar will not be spared under these circumstances. As the economic crisis starts to stabilize, hopefully later this year or in early 2021, that realization should hit home just as domestic saving plunges. The dollar could easily test its July 2011 lows, weakening by as much as 35% in broad trade-weighted, inflation-adjusted terms.”

Third, the United States might lag its peers during the recovery phase, which would be a headwind for the dollar in the short term. China, India and many European countries are already showing signs of recovery as all these nations are believed to have seen the worst economic impact of the pandemic. In the U.S., however, the risk of a second lockdown remains significant as many states are finding the situation too difficult to cope with. If economic growth in the country falls behind that of its developed peers, the greenback is likely to shed some of its recent gains to make way for the euro, Chinese yuan and the Japanese yen to shine in the coming months. In an article published on July 1, Barron’s revealed that strategists representing BlackRock and Morgan Stanley agree that European stocks could outperform their American peers in the next couple of years as well.

Where to look for bargains?

Companies that generate the bulk of their revenue from international markets are likely to perform better as the dollar weakens. Goldman Sachs’ chief U.S. strategist David Kostin notes that in months where the trade-weighted dollar fell by at least 1.25%, international tech companies and energy companies outperformed the broad market by a handsome margin. Going a step further, he listed down a few companies that fit this description.

  1. Lam Research Corp. (NASDAQ:LRCX)
  2. NVIDIA Corp. (NASDAQ:NVDA)
  3. Baker Hughes Co. (NYSE:BKR)
  4. Phillip Morris International Inc. (NYSE:PM)
  5. Booking Holdings Inc. (NASDAQ:BKNG)
  6. Las Vegas Sands Corp. (NYSE:LVS)

Investing in international markets is another tried-and-tested strategy of generating alpha returns during periods where the dollar weakens. American Depositary Receipts of Chinese and Indian companies and dual-class shares of European companies could be used to gain exposure to foreign markets. A better way to achieve the same objective is to invest in an exchange-traded fund that focuses on either one of these regions. In a note to clients, Gavkeal Research’s Louis Gave wrote:

“The dam is now starting to break for the dollar. And as it breaks, this has the potential to unleash a dramatically different investment environment than the one that prevailed in the past decade.”

The outperformance of U.S. equities might finally be coming to an end along with a weak dollar, which makes now the right time to be exploring investment opportunities beyond borders to secure attractive returns in the long run.

Gold is poised to head higher

The precious metal has already surged past its previous highs and more gains are on the cards considering the ultra-low interest rate environment and the projection for a weaker dollar. In an article published on July 13, I discussed the fundamentals behind gold’s price movements and concluded that investing in gold could turn out to be a rewarding decision. During periods of weak economic growth, fund managers tend to prefer gold over many other asset classes due to its negative correlation with the dollar and interest rates.

Takeaway

The U.S. dollar is likely to come under pressure as a result of various macro-level developments that were discussed in this analysis. At this point, however, there is no clarity regarding the directional movement of the greenback. To account for the risk of a substantial collapse of the dollar’s value, investors might want to rebalance their portfolios in a bid to be prepared for the worst possible outcome. Failing to do so, on the other hand, could lead to irrevocable losses as the playing ground will change permanently for companies that depend on a strong dollar.

Disclosure: I do not own any stocks mentioned in this article.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I'm a CFA level 2 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). During my free time, I enjoy reading.

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