In a recent newsletter, I highlighted a trend that's starting to gain the attention of investment markets and that is the strengthening dollar. I wrote that there could be a new headwind forming for US stocks, in the form of US dollar strength. A weak dollar was a tailwind for US stocks for much of 2017 and 2018. However, it has recently started to strengthen. The US Dollar Index (a measure of the dollar against a basket of other currencies) surged to a two year high last week. Crucially it also crossed above the 98 level. From a technical analysis perspective if the Dollar Index is above 98 then it suggests more upside (dollar strength). Much like a strong pound is bad for the FTSE 100, a strong dollar is bad news for US stocks (and emerging markets assets for that matter).
Since I wrote that a lot of column inches and investment headlines have also started discussing the prospect of a stronger dollar and why it is even occurring given the US Federal Reserve's dovish u-turn. Usually, if interest rates are cut, or the market thinks that they might be, then the strength of the dollar falls. The problem for the dollar is that at the same time that the Fed has turned dovish other global central banks have surpassed them in their dovishness. Given that currency strength is only determined against other currencies the dollar's apparent strength is being driven as much by the weakening of other currencies as it is by what the US Federal Reserve (the Fed) is or isn't doing.
If the dollar is to strengthen significantly it could have a big impact on investment markets, not just US equities. But what funds would benefit from a US dollar rally?
Funds to buy to benefit from the dollar rally
Generally speaking a strong dollar is not good for emerging market (EM) equities or debt denominated in their domestic currencies. Firstly a strong dollar will attract money back into the US away from riskier EM assets. That's because a strong dollar increases the chance of interest rates being raised by the Fed. If interest rates go back up in the US it means that holding the dollar or other dollar-denominated assets becomes comparatively more attractive to everything else. So money tends to flow back from risky emerging markets (where investors were chasing better returns) back home to the US (where the returns on cash and low risk investments now look better). It's akin to suddenly deflating a balloon and so emerging market equities suffer as demand for them starts to evaporate. On top of that emerging market economies tend to borrow in dollars but have assets/income in their local currencies. That means that when the dollar strengthens their debts increase relative to their assets and income. This can hinder their economic growth and ultimately EM stocks. Commodities, such as oil also tend to underperform when the dollar rallies. That's because most commodities are priced and traded in dollars. So as the dollar strengthens it hits demand for the assets. Aside from avoiding these types of assets how could you benefit from a rising dollar?
The simplest (and riskiest) way is to buy an ETF which will directly benefit from a strengthening dollar relative to another currency. One of the most crowded currency trades at the moment is the long dollar / short euro (i.e a bet that the dollar will strengthen versus the euro). So for the brave, buying an ETF such as ETFS Short EUR Long USD would give you direct exposure to the currency trade. As an aside, it is possible to use the BFBS table for ETFs to look at potential currency ETFs. In both the 'Hedge/Stru Prod - Currency' section and the 'Currency - Other' section you can find long USD ideas. Watch out because some of the funds shown in the Hedge/Stru section are often leveraged (which means that they borrow money to invest and so amplify losses and gains). Those that are leveraged are usually called something like ETFS 3x Short EUR Long USD. While I wouldn't personally invest in currencies (as it is high risk) I certainly wouldn't invest in leveraged currency ETFs. However, they give you a starting point to find non-leveraged versions of the ETF from the same investment provider, in this case the ETFS Short EUR Long USD mentioned earlier
In the 'Currency -Other section' there are some ideas that pitch the dollar against a basket of currencies rather than just one, such as ETFs Bullish USD vs G10 Currency Basket Securities.
Rather than directly play the currency markets investors could gain exposure via a global bond fund. A good actively managed bond fund would be M&G Global Macro Bond as it is positioned to benefit from a rising dollar. But not only that the manager can actively alter the fund’s duration and credit exposure to boost your bond returns. Alternatively, look at something like Threadneedle Dollar Bond. Investors looking for a cheaper passive alternative might want to look at iShare $ Treasury Bond 7-10yr ETF which has an ongoing charge of just 0.2%.
The best way to find funds that perform well when the dollar rallies is to look at correlation. Correlation is a statistical measure that shows whether two things follow each other or not. You can work out whether two things are correlated by working out what is known as the correlation coefficient. It is complicated to work out but it is very easy to use. The correlation figure can range between -1 and 1. A figure of 1 would suggest that the two objects follow each other while a score of -1 suggests that as one rises the other falls and vice versa. A score of 0 means that the two assets are not correlated.
So I set about looking at the correlation between the US Dollar and a range of EM and global bonds which include the two mentioned above (from M&G and Threadneedle). You will also notice that those EM bond funds listed tend to favour dollar-denominated debt.
| Fund | Correlation |
| Threadneedle - Dollar Bond | 0.94 |
| Courtiers - Investment Grade Bond | 0.93 |
| M&G - Global Macro Bond | 0.92 |
| iShares - Overseas Corporate Bond Index (UK) | 0.9 |
| iShares - Overseas Government Bond Index (UK) | 0.86 |
| Janus Henderson Inst - Overseas Bond | 0.85 |
| Newton - International Bond | 0.85 |
| Scottish Widows - International Bond | 0.85 |
| Threadneedle - Global Bond | 0.84 |
| M&G - Global Government Bond | 0.82 |
| Man GLG - Corporate Bond | 0.82 |
| L&G - Emerging Markets Government Bond (US$) Index | 0.81 |
| Standard Life Investments - Emerging Market Debt | 0.81 |
| LF Canlife - Global Macro Bond | 0.8 |
| M&G - Emerging Markets Bond | 0.8 |
| Invesco - Global Bond (UK) | 0.78 |
| Threadneedle - Emerging Market Bond | 0.78 |
Beware of a consensus
As I've mentioned, at the moment the most crowded investment trade is long dollar versus / short euro. Whenever there is a consensus you need to be wary, as crowds have a habit of being wrong. The best example of this was back in December 2016 when the dollar was at multi-year highs and above 100 on the dollar index and the Economist put the following image on its front cover.
From that moment the dollar collapsed, as you can see in the chart below:
Right now, the dollar is trying to break higher, but it is struggling. The chart below highlights the resistance levels and previous failed breakouts on the Dollar Index. So don't always bank on the consensus being right. But if we do get a rally in the dollar then don't be surprised if the above funds do too.
(charts produced via bloomberg)
