As markets limp towards an uninspiring finish to 2018, it’s starting to look increasingly like nothing can save it from a disappointing year ahead.
Traditionally balanced portfolios are offering their lowest forward returns since the Great Depression. Once-dominant tech stocks look shaky at best. And market-leading growth shares are being shunned in favor of their safer value counterparts.
Even though the landscape looks dire, INTL FCStone macro strategist Vincent Deluard sees light at the end of the tunnel. But his optimistic scenario comes with one major caveat: the strenghtening US dollar must sell off versus its global peers.
It’s a shift that’s likely easier said that done. The US Dollar Index is in the midst of a roughly 10% rebound since hitting a multiyear low in early 2018, and it’s shown few signs of weakness during that period.
The recovery is an inevitable byproduct of the 14% plunge the gauge experienced from December 2016 through mid-February 2018. At this point, the greenback still has much further to go to reach its late-2016 peak.
Still, a sharp reversal in the dollar would hardly be unprecedented. And, to that end, Deluard can think of three ways a move lower could help the broader market landscape.
First, a weaker dollar would help emerging markets address their outstanding debt, which would bring relief to China. Deluard points out that countries with large amounts of dollar-dominated debt, low dollar revenues, large current deficits, and minimal currency reserves are the most at risk when the greenback rallies.
By that same token, a falling greenback would help them. The chart below shows which nations in particular would be most affected.
The second benefit of a weaker dollar would be stronger US growth, since a soft greenback is beneficial to exports. Deluard notes that this type of development could boost President Donald Trump’s chance of re-election in 2020.
Third, Deluard says that the strengthening dollar has thrown off the Federal Reserve’s normalization schedule. That’s resulted in central bank chair Jerome Powell trying to talk the dollar back down, which has derailed his plan for interest rates, at least temporarily. This dynamic is shown in the chart below.
“A US dollar selloff could be the deus ex machina that saves the year because it is in the interest of the Fed, China, D. Trump, and emerging markets,” Deluard wrote in a recent client note.
But the dollar isn’t just going to magically reverse course. It’s going to require a major catalyst — four of which Deluard has outlined.
1) A redux of the 1985 Plaza Accord
Deluard is referring to the instance in 1985 when President Ronald Reagan locked the German and Japanese finance ministers in the Plaza hotel and threatened them with tariffs until they agreed to help weaken the dollar. After that, the greenback fell by half versus the yen over a two-year period.
Deluard says Europe — specifically Germany — could come under similar pressure from Trump in 2019. But why? Allow him to explain:
“First, because the German surplus is objectively monstrous, exceeding the Chinese surplus of the 2000s and the Japanese surplus of the 80s. Second, because Trump will need another scapegoat after he is done blaming China. Third, because Europeans are weak and likely to cave in and give Trump the big win he craves.”
2) A Watergate redux
In this case, Deluard is comparing Trump to former president Richard Nixon.
“Commonalities with the 70s include a demographically-induced global savings squeeze, exploding budget deficits, social and cultural wars, hatred between the Presidency and the media, and an impeachment investigation.”
Deluard notes that, amid all the turmoil of the Nixon years, the dollar lost 80% of its gold value and dropped 30% against the Swiss franc. And once it was down, it didn’t recover for another 10 years.
3) A Euro taper tantrum
Since a stronger euro inevitably means a weaker dollar, Deluard builds this scenario around the conditions that could push the European currency higher.
He points out that a so-called temper tantrum in Europe could reverse what he describes as the “massive undervaluation of common currency.”
“Because the euro and closely-correlated European currencies such as the pound and Swiss franc account for close to 80% of the Dollar Index, a big 2019 euro rally would necessarily lead to a big 2019 dollar selloff,” Deluard said.
4) A big commodity rally
Deluard sees a major oil rally taking place in 2019. He notes that the valuation of oil compared to financial assets is still too low.
“Since commodities are priced in USD, a big 2019 commodity rally would imply a big 2019 dollar sell-off,” he said.
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