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US dollar and rates have limited upside

Steven Wieting

By Steven Wieting

Chief Investment Strategist and Chief Economist

September 21, 2017Posted InForeign Exchange, Equities, Investment Strategy, Investments and Fixed Income

The Citi Private Bank Global Investment Committee left its asset allocation unchanged at its meeting on 21 September 2017. Global Equities remain 2.0% overweight. Global Fixed Income remains 3.0% underweight, with cash and gold small overweight positions.


Our overweight position in equities remains entirely concentrated in emerging markets (EM) and select developed markets (DM) such as the Eurozone. We remain neutral (fully allocated) to US equities. This reflects the near record valuation discount of non-US markets to the US. It also reflects accelerating global growth, while the US expansion has remained at a solid, but similar pace to that of the last six years.

In fixed income, emerging markets and US credit remain far more competitively valued globally than European and Japanese bonds. We continue to overweight both US investment grade debt and U.S. high yield debt. However, the two market segments play a different role in portfolios as both their volatility and correlation to equities differ sharply.

While our across-the-board overweight in EM equities and EM credit has delivered tactical outperformance this year, we suspect there could be near-term performance wobbles. Markets underestimated the US Fed’s resolve to continue gradual monetary policy tightening this month. Markets may also under estimate the probability of US tax cuts. The impact of tax cuts on the US current account deficit is complex, but international savings flows would still finance the US Treasury at higher interest rates under various plausible scenarios.


Importantly, speculative long positions in the US dollar and short positions in US Treasuries have reversed. The market consensus has come to our view the dollar is at or near a cycle peak. These factors make a counter-trend rebound in the dollar and interest rates more likely near-term. History suggests this would hurt EM assets while boosting local-currency DM markets.

We expect upward movement in US interest rates and the dollar to be contained even if the US Congress passes a variety of tax cuts. However, following the recent strength in EM assets, a modest correction would be unsurprising. Priced in dollars, EM equity benchmark total returns have already exceeded 30% this year. At the same time, the asset class still trades at a near record 40% cycle-adjusted valuation discount to the US. We would take advantage of a correction in the right circumstances to add further to our overweight in the expectation of outperformance over the long-term. Key EMs such as China have shown far more structural reform progress than many expected this year, while Brazil seems poised for cyclical recovery from quite depressed economic conditions.


We remain fully invested in US equities despite above-average valuations late in an economic cycle. Earnings growth in the US should exceed 10% in 2017 and continue at a slower but positive pace in 2018. Low inflation and even wage growth suggests a very gradual approach to monetary tightening ahead. This could allow for a record long US economic recovery if there are no big policy mistakes or external shocks.


With many local political risks, investors appear to under appreciate the value of international diversification at a time of wide valuation divergences that present opportunities. It is less common than feared for national economic problems or unpredictable geopolitical shocks to sink multiple regions. Globally diversified multi-asset class portfolios are a first defense against many risks to our optimistic base-case view.