At the start of the year, we at J.P. Morgan Asset Management predicted that the path of the dollar would be the defining influence on asset allocation in 2016. We thought a stretched valuation, after a blistering three-year dollar rally and a gradual closing of the growth differential between the U.S. and the rest of the world, would leave the dollar with only modest upside, effectively mitigating what has been a headwind of sentiment and providing relief to companies that have borrowed in dollars.
Although we see scope for a more virtuous end to the dollar strength cycle playing out later in 2016, the recent reversal in the greenback — one of the sharpest drops in 20 years — is more concerning. It is worrying because the weakness is a symptom not of growth broadening out from the U.S. to the rest of the world but rather of pockets of economic stress around the world starting to affect the U.S.
Exactly how worried should we be? U.S. stocks and credit markets are trading as if the U.S. economy is holed below the waterline. Whereas we echo the near-term caution, it is too soon to conclude that the U.S. economy is heading for a contraction. Nevertheless, the path of the dollar will again be critical as the level of U.S. growth is likely insufficient to reassure asset markets in the near term.
Three central considerations tend to drive asset markets: growth, liquidity and tail risk. Other factors such as valuation, positioning, momentum and sentiment matter, but these can be swung — even dominated — by the three primary factors.
Taking the first of our primary considerations, growth, it’s fair to say that recent numbers out of the U.S. data have been underwhelming. Nevertheless, the all-important labor market remains resilient. Economists often cite small open economies as vulnerable to external shocks, but the U.S. is the diametrical opposite. The domestic consumer and housing markets account for 70 percent of the U.S. economy, and whereas manufacturing and external sectors are weak, these alone are unlikely to shunt the U.S. economy into recession.
To be clear, we aren’t suggesting the U.S. economy is booming. When a ship sails in shallow water, the risk of running aground is clearly higher; likewise, a low trajectory of growth increases the vulnerability of an economy to exogenous shocks. So a negative shock is possible, but outright recession is unlikely.
There has been much fixation on whether the Federal Reserve will take action, given the market’s nasty start to the year. The notion that the Fed may have made a policy error in raising rates in December is wide of the mark. We think U.S. rates will slowly normalize but only as U.S. economic data and financial conditions allow so realistically. An increase at the March meeting is off the table. Reinforcement of the very gradual and data-dependent path of U.S. policy would in turn reduce upside risk to the U.S. dollar in the near term.
This brings us to the second consideration: liquidity. The Fed is acutely aware that despite its domestic mandate, it is de facto the world’s central bank. As such, it is little surprise that the liftoff from its zero-interest rate policy has led to a tightening of global financial conditions, which has coincidentally been compounded by the slump in commodity prices and shift in Chinese policy.
Collapsing energy prices had a direct impact on financial conditions via wider credit spreads and weaker earnings. The price drop also has a more persistent secondary effect in pushing petroeconomies from surplus into deficit. As those economies slow or halt their foreign exchange reserve accumulation in response, an important source of global liquidity is effectively removed. China, too, has deployed reserves to manage its currency, exacerbating the net draw on global liquidity.
Despite the Fed’s faith in the U.S. economy, the tightening of global financial conditions has scope to force it into a more accommodative stance than some Federal Open Market Committee members would prefer. Although tighter financial conditions may imply a scramble for dollars and other “safe” assets, the consequent delay to Fed policy has an offsetting impact.
Finally, and inevitably, a sluggish path of growth and poor liquidity place greater emphasis on tail risks. Markets are struggling to calibrate tail risks; policy divergence, uneven global growth and excess capacity and debt in some countries and sectors all complicate this process. The net result is an upward marking of risk premiums and a downgrading of growth expectations, particularly where the economic cycle is seen as either fragile, as in China, or long-in-the-tooth, as the case may be in the U.S. A weakened outlook for growth weighs on risk assets and, eventually, the currency.
Put it another way: Consider the noisy, negative gyrations of asset markets as being reflective of a world in which the level of growth is insufficient to offset the tightening of financial conditions. As such, we see limited scope for a sharp rebound in stocks.
There are two encouraging conclusions, however. First, the U.S. economy is relatively isolated from global risks. Expansion may be sluggish, but so too is recession risk. Second, the Fed remains data-dependent, and as such, rate hikes are likely to be delayed, taking some of the steam out of the U.S. dollar.
In the meantime, look for the dollar to act as a sort of balancing mechanism. The economies of the U.S. and the world as a whole would struggle to absorb another year of significant dollar strength, though stabilization will ultimately reduce some of the pressure.
With sentiment damaged, valuations fair and growth lackluster, we would not bet on stocks quickly reversing their current malaise. But without the headwind of excessive dollar strength, there may well be a more positive backdrop for the world economy as the year progresses.
John Bilton is head of global multiasset strategy at J.P. Morgan Asset Management in London.
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