USD Strength = Protected Foreign Assets & Potential Domino Effect
An interesting phenomenon is taking place for foreign asset managers this year. Global equity markets are steadily deteriorating after two years of tremendous returns fueled by low interest rates and quantitative easing. Many traditional investors parked in the famed “60/40” portfolio have seen abysmal returns in 2022 and are regretting adding to their investments late in 2021. However, this is not the case for foreign investors that were positioned in U.S. stocks this year.
Europe and Japan command a large share of the globe’s Gross Domestic Product (GDP) after the United States and China. European and Japanese investors also have more discretionary income than most of the globe as they are developed countries, so money flows into capital markets in size from these countries. The United States has been the deepest pool of liquidity and one of the best places globally to park money the last 10+ years in aggregate. This trend caused investors from all over the world to move money into U.S. Dollars and buy U.S. stocks, especially from Europe and Japan.
As of writing this post, the S&P 500 is down 23% Year-To-Date. This is not a great start to the year, and as I mentioned early, many investors are feeling this pinch on their wealth. However, foreign investors who own U.S. stocks are not down nearly as much due to foreign exchange fluctuations that occurred in 2022. As you can see in Chart 1 below, the Euro, Japanese Yen, and British Pound all lost 14-20% of their value versus the U.S. Dollar in 2022 so far. This means a U.S. Dollar can buy more of each of these currencies this year, and owners of U.S. stocks effectively are long U.S. Dollars.
Chart 1: Returns for the EURO vs USD, GBP vs USD, and JPY vs USD in 2022 (Source: Koyfin)
So how did this currency event allow foreign investors to cushion equity losses this year? Let’s look at an example: If a British investor bought the S&P 500 ETF on December 31, 2021 and did not touch the assets until September 29, 2022, their total return would be around -3% nominally in British Pounds [-23% U.S. stock return offset by roughly 20% long U.S. Dollar return]. Compare this to a U.S. investor owning the same S&P 500 ETF bought on the same day whose return during this period in U.S. Dollars is -23%, and you get an “out-performance” of roughly 20% for the British investor. This assumes that the British investor held the S&P 500 ETF without a currency hedge (which is a safe assumption as the best trade for global investors has been long U.S. Dollars and long U.S. stocks over the last 10 years so few people hedged their currency risk during this time unless they had a mandate to).
You are probably thinking "great for the foreign investor, but what do I do with this information?"
Another Negative Market Catalyst:
Here is why the phenomenon above matters and how it could cause another major leg down in stock prices here in the United States.
The U.S. Dollar has been so strong in 2022 that other countries are facing financial turmoil because of it. Europe’s energy crisis, Japan’s currency instability, and food shortages across the globe are starting to materialize due in part from U.S. Dollar strength. These events will cause money to flow out of risky assets and into safe haven assets at increasing speeds as they unfold. Along with this movement into safer assets, countries are starting to find ways to buy energy in their own currency instead of the U.S. Dollar. This trend is a major issue for the United States as the whole Dollar system depends on global demand for energy via U.S. Dollars. Once the party starts moving away from the U.S. Dollar, the party will not stop. And remember, the U.S. Dollar strength is the only thing protecting foreign investor portfolios right now.
The sell off in risk assets has been going on for several months now, but with financial conditions continuing to tighten globally, there is more room for capital markets to go down from here. On top of the macro factors above, European and Japanese investors may grow increasingly concerned about their U.S. Dollar exposure and start selling U.S. based stocks to bring money back into their home countries. This is a domino effect in the making. Investors are loaded up on U.S. stocks still with 60% of global portfolio allocations in U.S. based stocks and the majority of United States based investors solely exposed to U.S. stocks. Foreign investors selling U.S. stocks will cause the market to go down and then converting U.S. Dollars into Euros or Japanese Yen will improve their respective currency strength against the U.S. Dollar. This would negatively effect every other foreign investor who is long U.S. stocks and short their own currency. These investors will soon follow suit causing a potential mass exodus of U.S. stocks and the U.S. Dollar. No one wants to be the last one holding the bag, especially when the risk for portfolios is the highest it has been since the Great Financial Crisis. Inevitably though, the last one holding the bag of U.S. stocks will be the U.S. retail investor as the foreign money and institutional money moves across borders.
I am not predicting the above as an end to the U.S. as a superpower, but I am detailing this in order to show one of the several risks that are still unrealized right now in global markets. Even with one of the worst starts for financial markets in decades, there is more risk to the downside that could be seen sooner than later if foreign investors begin to sell out of U.S. stocks. With foreign investors taking inventory of their portfolio holdings into the close of 2022, the first domino may be already falling.
Don’t Fight Convexity
Note: This post consists of high level commentary on research conducted by Tetelestai Capital, LLC into the United States, currencies, and related investments. Though compelling, your own research should always be done before investing into any security. The risks mentioned in this post are not all encompassing either. This post should not be viewed as investment advice. Tetelestai Capital is not associated with any of the investment companies or products mentioned in this post. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.