History suggests that US dollar rallies often last longer than fundamentals justify. We are carefully watching, however, for signs of an overshoot that could reverse in 2023.
Investor positioning, including very large net short positions in non-US currency futures, US stocks and bonds, is indicative of bearish expectations across much of the world. The US appears to be a “safer haven.” For now, our asset allocation is effectively overweight US dollar assets, and dollar strength has benefited these positions.
While that may be true, unwinding positions held by a very widespread consensus of investors can lead to sharp contrarian movements across asset classes. We see overbought and oversold markets in wartime as reasons to maintain the highest quality, income-oriented investments for the present time.
Surging energy costs in Europe and Japan have compounded the effects of the Fed’s rapid tightening pace, sinking the euro, pound and yen in a way that might remind some observers of EM currency crises of the 1980s.
Our most recent forecast update (August Quadrant) estimates the forthcoming economic impact of rapid central bank tightening steps. We are slightly underweight global equities and overweight global bonds and have far higher weightings in US assets than non-US assets. This has benefited our portfolios as the US dollar returns of equity markets such as Japan (where we are underweight), have been dramatically worse measured in dollars than yen.
For many non-US investors, unhedged US dollar bond holdings have added value simply through currency appreciation. All of this creates the likelihood we will make major changes to portfolio composition this coming year.
At present, our allocations continue to earn US dollar income from the investment grade company bonds and quality equity dividends. As conditions evolve in 2023, foreign exchange considerations – which have helped our current allocations – will be continuously revaluated as events unfold and as the US dollar achieves unsustainable value relative to other currencies.
While we are quite confident the US and other world economies will slow, we need to be mindful of the volatility inherent at this uncertain time. We must, therefore, proceed with caution and discipline in how we manage portfolios that seek to protect and build wealth.