Stronger dollar poses challenges

Investors are increasingly concerned about the impact of the strengthening US dollar to the global economy. What are the implications? 

28th April 2015

The first quarter of 2015 ended on a slightly softer note compared with how it began.  While the world economy still appears to be on the recovery path, certain risk factors have weighed on market sentiment.  Most notably, investors are increasingly concerned about the impacts of the strengthening US dollar – up around 14% since last July – on US and global economic prospects (Chart).

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Data from the US have become notably softer.  March’s stronger retail sales reading suggests that the first quarter’s deceleration has been driven by transitory factors (adverse weather and longshoremen strikes on the West Coast) rather than fundamental factors (the strengthening dollar), although recent weak PMI data indicate that the stronger dollar is biting US companies.  Federal Reserve officials have commented that Q1 weakness appears to be an aberration from underlying trends, but the market consensus on the first rate hike has been pushed back to late 2015.

Trading on the UK markets has been volatile ahead of the May general election.  The pound sterling has weakened against most major currencies and sterling volatility – often a harbinger of UK fixed income and equity volatility – has spiked as the composition of the post-election government remains uncertain.  GDP growth estimates for 2014 were revised up to 2.8% from 2.6%, but labour productivity growth estimates were negative.  The stagnation in labour productivity growth since the crisis is unprecedented in the post-war era and is a key challenge for the sustainable UK growth rate going forward.

The Eurozone has been on the mend.  This has been driven by improving fundamentals as well as lower oil prices, a weaker euro, and ECB government bond purchases.  The latter kicked off in March with €52.5bn of sovereign bond purchases, bringing total monthly ECB asset purchases (including ABS and covered bonds) up to roughly €60bn a month.  With US and Eurozone monetary policies moving in different directions, it is likely the euro will remain weak versus the dollar for some time.  The main Eurozone risk remains a potential Grexit, as negotiations between Greece and its creditors continue to be slow and fractious.

The Japanese economy is also on an upward trend, albeit more modest.  Activity indicators suggest Q1 growth will be positive but moderate.  Lacklustre capital expenditure, a source of weakness in Q4 2014, seems likely to continue, although expectations of wage boosts should support domestic demand and keep growth positive.

The outlook for China and other Asian emerging markets has weakened slightly.  Inflationary pressures continue to weaken across the region, but a deflationary spiral is unlikely.  Emerging markets are struggling with the stronger dollar as investors rotate capital out of emerging markets and into the US.  The biggest near-term risk to emerging Asia is capital flight, although countries are in a stronger position compared with previous episodes.

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