Putting a value on dollar appetite for U.S. pension executives

Currency markets have been very volatile in the past year, with the U.S. dollar exhibiting its strongest rally on a trade-weighted basis in over 10 years. For U.S. pension executives with substantial international investment portfolio exposures, the key question is whether this rally is in its ninth inning or closer to the fifth, as a prolonged U.S. dollar rise for several more years would result in large losses on overseas investment holdings if these remain unhedged back to the dollar.

Hence, it is critical for U.S. pension plan chief investment officers to assess the outlook for the dollar as the impact on international investment returns is likely to be significant in an era of higher currency volatility. Furthermore, the proportion of total returns in international portfolios coming from the currency impact is likely to be high in an era of low expected future nominal returns from equity, sovereign fixed income and corporate credit markets given the lofty valuation levels that have now been reached. Indeed, given the above, these currency effects are likely to be more significant as a proportion of total returns from international asset returns than for many decades of financial market history.

The cyclical and monetary policy divergence argument, which pivots around the idea that the U.S. is far ahead in the cyclical recovery compared to most other advanced economies (as illustrated in Chart 1), has clearly been a key powerful driver for the dollar, leading to broad dollar appreciation of over 10% in the past year.

Talk of Fed tightening later this year in response to a growing U.S. economy in the face of weak growth in Europe, Japan and many emerging markets is causing capital to flow into the United States in public markets, real estate and foreign direct investment, raising the value of the dollar. A moderation in Fed tightening expectations in April and May has led to a setback to the dollar's ascent but leaves it nowhere near the extremes it reached in 1985 under Reagonomics or 2001 post the tech bubble.

The building blocks for potential for U.S. dollar gains to extend over the medium term, though, go beyond purely cyclical considerations. A number of structural factors underpin a constructive view on the dollar.

Among advance economies, the U.S. in fact has one of the highest potential growth rates, with growth potential between 2% and 2.5%, according to OECD estimates. This is backed by solid trend productivity growth, which, despite the lousy performance since the 2008 financial crisis, remains the strongest in the G-10 since the turn of the century (Chart 2).

After suffering from a period of private sector deleveraging in the years after the financial crisis, the balance sheets of U.S. households and corporations are now in much better shape and aggregate private sector debt stands out as the lowest among advanced economies (Chart 3). Fiscal accounts also have been improving rapidly (the fiscal deficit was only 2.4% of GDP in Q4 2014), driven by a steady rise in receipts at broadly steady expenditure levels. Longer term fiscal challenges remain, mostly linked to Social Security reform and the consequences of an aging population, with the IMF estimating the U.S. fiscal gap among the highest in the G-10.

While as Chart 4 illustrates the U.S. is not now in a particularly favorable position as far as external balances are concerned, given its current account deficit of 2.5% of GDP and negative international investment position, there are certainly reasons to believe the external position ought to improve going forward. From a current account perspective, the U.S. is set to benefit from the ongoing energy revolution: energy self-sufficiency seems in fact achievable over the medium-long term (Chart 5), with obvious positive impact on the current account deficit (estimated around 1% of GDP). Furthermore, after years of disappointing flows, the capital account should benefit from both Fed normalization and structural attractiveness of the U.S. in terms of foreign direct investment destination (e.g. U.S. tops the World Bank ease-of-doing-business ranking among major advanced economies).

Lastly the U.S. dollar could find sources of support from more technical drivers. One argument is that after years of easy Fed policy, with households and corporations abroad having borrowed heavily in dollars, non-resident debt overhang is now at record highs (U.S. dollar denominated bonds and loans outside the U.S. now stand at $9 trillion, up about 50% from pre-crisis levels according to the Bank for International Settlements). Furthermore, following years of diversification, central bank reserves may start to re-pivot around the dollar, fueled by negative yields across eurozone fixed-income markets and emerging market central banks reserve reallocation toward dollars to rebuild FX intervention ammunition. Unwinding of dollar short positions and renewed central bank reserve reallocation would therefore add to dollar positive flows.

In summary, the prospects for an overshoot in the value of the dollar for structural as well as cyclical reasons is high and we could be in the midst of only the third great structural bull market in the U.S. dollar since the Bretton Woods system of fixed exchange rates collapsed in August 1971. In response to this risk, U.S. pension plan CIOs are encouraged to analyze the currency risks inherent in their portfolios and consider both applying an appropriate strategic passive hedge ratio and an active currency overlay to both mitigate left tail risk and exploit the potential investment opportunities in currency markets.

Mark Astley is CEO of London-based Millennium Global Investments.