© Reuters.
By Laura Sanchez
Investing.com – The is trading these days with high volatility. If the United States entered a recession before the rest of the world, the greenback would face a period of weakness, according to the dollar smile theory. Schroders (LON:) debates whether the theory is still valid.
“The ‘good news’ about the economy can be taken as ‘bad news’ for financial markets in an environment like that of 2022, in which inflation led the markets and the normalization of monetary policy was set in motion,” he explains. Caroline Houdril, Portfolio Manager and Joven Lee, Schroders multi-asset strategist.
According to Houdril and Lee, in such an environment, both equities and fixed income can lose money at the same time, meaning there are fewer places for investors to take refuge. The US dollar may then play a unique role, as it did last year, benefiting from rising interest rates and growth concerns.
“Looking into 2023, it may be growth, not inflation, that is keeping investors up at night. Given this shift, we thought it was worth putting last year’s standout winner in the spotlight and review the role of the US dollar in portfolios,” these experts point out.
What is “the dollar smile”?
Schroders points out that what happened to the US dollar last year reflects a phenomenon known as the “dollar smile.”
The dollar smile was identified 20 years ago by Stephen Li Jen and refers to when the US dollar outperforms other currencies in two extremely different scenarios:
- When the US economy is strong and there is optimism in the markets.
- When the global economy is doing poorly and risk appetite is low (a “risk aversion” environment).
The theory holds that when the US economy is strong and enjoying robust GDP growth, investors will invest heavily in US assets, thus further boosting the value of the dollar. Conversely, in risk-off environments, investors will flock to perceived safe-haven assets such as the dollar, and huge demand will drive their value up again.
In between the two extremes, the dollar will plunge if US equity markets struggle to outperform relative to other global stocks, as dollar flows will shift to riskier assets but with better results. This is how things are now.
How much is a dollar?
“Looking ahead, we are potentially in a rare situation where the US can enter a recession before other countries. Historically, a recession in this country is always followed by a recession in the rest of the world. In In global recessions, how does the US dollar typically behave? Next, we calculate the US dollar’s return (DXY index) during periods of global recessions, as determined by our Global Wave model,” the Schroders experts explain.
The Global Wave model is made up of seven equally weighted components, normalized with a z score. The seven components are: Industrial Confidence, Consumer Confidence, Capacity Utilization, Unemployment, Producer Prices, Credit Spreads, and Earnings Revision Ratio. The Global Wave model covers more than 30 countries weighted by GDP, and the final Global Wave indicator is converted to an index that oscillates around a threshold of 50.
What about periods when the United States is in a recession, but other economies have yet to catch up? Here we look at the average return of the dollar index when the US is in recession but the rest of the world is not, and when both the US and the rest of the world are in recession.
Here Schroders identifies two things:
- When the US enters recession earlier than its global counterparts, investors choose to invest in assets with higher prospects for returns and the dollar suffers.
- When both the US and the rest of the world are in recession, the dollar experiences a turnaround. One explanation is that, in a risk-reducing environment, investors flock to the dollar as a safe haven asset and demand drives its value up.
What role did the US dollar play in the portfolios and how can we consider it going forward?
In 2022, both the equity and fixed income markets fell. In a 60/40 portfolio, there were little or no benefits from diversifying into fixed income, due to the normalization of monetary policy through central bank rate hikes.
Across the investment universe, only a small handful of asset classes delivered positive returns over the year, and the US dollar was one of them. Investors used the dollar as a safe haven. In baskets of currencies, the dollar outperformed virtually all other currencies, and investors were hard-pressed to find alternatives.
“Our hedge monitor, which allows investors to gauge the effectiveness of a hedge against the cost of holding it, corroborates this picture. US dollar currency pairs (where an investor is long USD and short another currency ) currently perform better on the hedge monitor than assets that were traditionally considered hedges, such as government bonds and the “, they point out in Schroders.
“We believe the dollar smile theory remains valid in this new environment. With our economists predicting that the US economy will enter recession before the rest of the world by the end of the year, the dollar may hold until the time comes. that global economies follow in the wake of the US In situations where a US recession precedes the rest of the world, we believe that other factors such as rate developments, safe-haven status and – what is more important- liquidity are better indicators to focus on”, they point out in the manager.
“When the rest of the world finally follows the US into a recession, what return could we expect from the US dollar? We looked at the average returns of the US dollar index in a global recession and found that the most consistent strengthening of the dollar occurred during scenarios where the US economy outperformed others: the US outperformed the rest of the world more often,” they add.
Conclusion
“It’s all relative. The US growth outlook relative to the rest of the world is critical to US dollar outperformance. Right now, our economic models point to a global slowdown and the US market is expected to get worse results than their peers. Consequently, we believe that we should focus on factors such as monetary policy and liquidity conditions when analyzing the potential benefits of investing in the US dollar,” they conclude in Schroders.
