The US dollar in portfolios

The US dollar has been remarkably strong this year. Since the end of 2021, the dollar has strengthened from $1.35 to $1.15 against sterling¹ and now sits at 20-year highs against both the Euro and the Japanese Yen.

There are three factors behind the trend. Firstly, the more aggressive response from the Federal Reserve to rising inflation in comparison to other central banks. This has meant rates in the US have risen faster and further than in other developed markets, making the dollar look relatively more attractive. Secondly, increasing concerns over global economic growth have seen greater demand for the dollar as a perceived safe haven asset. And finally, the UK and Europe have seen worsening current account deficits given their greater reliance on imported energy. The US, by contrast, remains more self-sufficient.

For sterling- and euro-based investors with exposure to dollar-denominated assets these currency moves have been supportive, positively contributing to returns in a challenging period for asset prices. On the other hand, for dollar-based investors with exposure to global currencies through bond and equity holdings, dollar strength has compounded negative returns.

For sterling investors, we have consciously maintained an overweight dollar and underweight sterling position relative to our strategic asset allocation benchmark over the course of this year. This has been beneficial to headline returns, but the key question now is whether to lock in profits arising from our currency positioning and hedge dollar exposure back to sterling. For context, “cable” (the GBP/USD exchange rate) has just experienced the largest monthly move since 2016 and the dollar has only been stronger twice before in history (briefly in 2020 and in 1984).

At this stage, we are happy with our current positioning and we are not minded to either reduce our exposure to the US dollar or increase exposure to sterling. The reasons for this are as follows:

- A “long” US dollar position continues to act as a risk diversifier within portfolios. From a portfolio construction and risk management perspective, maintaining an overweight dollar exposure is beneficial, particularly when considering the limited options in other defensive assets in the near term.

- It is difficult at this stage to be overly optimistic on the outlook for sterling. The economy faces significant challenges from rising inflation driven by higher energy costs and the increasing probability of a recession. Furthermore, with one of the largest twin deficits (both a current account deficit and a budget deficit) in the world at 11.1% of GDP there is a significant dependence on foreign capital. Sterling remains a “risk on” currency which could face further headwinds as global growth slows.

We are conscious that over time currencies tend to return to long-term average levels and that there may be an opportunity to tactically switch exposure away from the US dollar. We continue to actively monitor our currency exposure across models and will be focusing on a number of factors to guide our thinking on sterling and the dollar in particular. These include:

- The relative hawkishness of central banks. If we see the Bank of England become more aggressive in its response to inflation, or the Federal Reserve slow the pace of rate hikes and the interest rate differential narrow, we could see some support for sterling.

- Improving energy supply. An end to the Russia-Ukraine conflict and disruption to European energy markets both sadly looks unlikely. However, if we were to see an improvement in energy supply dynamics, sterling would likely benefit.

- Investor positioning. While investors generally have overweight exposure to the US dollar, they are not yet betting on further falls in sterling. More significant “short” positioning in the UK currency could be a signal that all the bad news is in the price and prompt us to reduce our underweight sterling exposure.

¹ Source: Bloomberg. Data as at 5th September.