What are the key drivers behind the strength of the U.S. dollar?

On the latest edition of Market Week in Review, Investment Strategy Analyst BeiChen Lin and Sophie Antal-Gilbert, Head of AIS Portfolio & Business Consulting, discussed the surge in the U.S. dollar and the outlook for markets through the lens of cycle, valuation and sentiment.

U.S. dollar surges on Fed hawkishness and safe-haven appeal

Antal-Gilbert opened the conversation by noting that the U.S. dollar has strengthened considerably in 2022, with the U.S. Dollar Index up approximately 15% to 20% on the year. Lin said this has made the dollar significantly stronger in value when compared to other major currencies, including the British pound, the Chinese yuan and the Canadian dollar.

There are two key drivers fuelling the strength in the dollar, he said - the first of which is the U.S. Federal Reserve (Fed)’s aggressive rate-hiking campaign. "From a currency perspective, this has made investing in the U.S. a little bit more attractive, because investors can earn a higher rate of return on their investments. This, in turn, encourages capital flows into the U.S.," Lin remarked.

The second reason why there’s been such an uptick in the dollar is due to its safe-haven appeal during times of economic uncertainty, such as today, he said. Lin explained that as the Fed continues to raise rates into restrictive territory, investors have become more concerned about the potential for an economic slowdown or a recession. "This has led investors to look for safe-haven assets - and the U.S. dollar is a crucial safe-haven asset," he stated.

So, what are the implications of a strong U.S. dollar for other currencies? Lin said that because the dollar is always priced relative to other currencies, a strong dollar means weaker currencies elsewhere. This is certainly the case today, he remarked, noting that in Japan, a weakening Japanese yen led the Bank of Japan to intervene in the currency market by buying yen for the time since 1998.

Meanwhile, in China, the yuan recently reached its lowest level against the dollar since 2008, Lin noted. "This prompted the People’s Bank of China to tell state-owned financial institutions to get ready to start selling the U.S. dollar and buying Chinese yen in order to halt the slowdown in their currency," he said. Lin added that the British pound has also been impacted by a strong U.S. dollar, with significant volatility rippling through UK currency markets as the pound traded at a record low against the dollar on 26 September.

"Ultimately, when it comes to markets, the events of the past few weeks show the importance of also focusing on currencies, in addition to equities and bonds," he remarked.

What do cycle, valuation and sentiment suggest about the market outlook?

Turning to recent equity-market performance, Lin reiterated what the team of Russell Investments strategists noted in their recently released Q4 Global Market Outlook - that 2022 has been a very, very difficult year for equities. The selloff in markets has accelerated in recent weeks, he noted, with the benchmark S&P 500® Index reaching its low for the year the week of 26 September.

"Investors are becoming increasingly concerned about what will happen to the economy as global central banks continue tightening monetary policy to try to rein in inflation," Lin explained. Assessing the outlook through Russell Investments’ framework of cycle, valuation and sentiment, he said that the business cycle outlook has deteriorated. "While there’s still a lot of uncertainty in this regard, I think what’s most likely in the U.S. is that a recession will either be avoided or there will be a fairly mild one," Lin stated.

Looking at things from a valuations perspective, he noted that the selloff in equities has made valuations a little less expensive compared to earlier in the year. However, Lin cautioned that this doesn’t mean that equities are necessarily cheap per se.

Lastly, he said that sentiment is very pessimistic, which means that there could be a potential contrarian buying opportunity. Lin noted that Russell Investments’ composite contrarian indicator, which the strategist team closely watches, is now roughly three standard deviations above neutral.

Ultimately, when weighing each of these three factors together, Lin said he believes investors should stay disciplined by sticking to their strategic beliefs and strategic asset allocations. "Every investor has a plan that they put together, and it’s important during these times of uncertainty to stick to that plan," he concluded.

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