Mike Pyle, Global Chief Investment Strategist, together with Scott Thiel, Chief Fixed Income Strategist, Kurt Reiman, Senior Strategist for North America, and Tara Sharma, Member of the Macro Research team, all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
A prolonged period of U.S. dollar gains has reversed abruptly. The policy revolution to cushion the pandemic’s blow is a key driver, as it has eroded the dollar’s interest rate advantage and helped lift risk appetite off its March trough, in our view. The different restart dynamics in the U.S. and Europe have also pressured the dollar, underscoring our preference for European equities and caution on U.S. stocks.
We upgraded European stocks to overweight, on the back of the region’s robust public health infrastructure and a galvanized policy response. These two factors have moved the currency market more than the equity market so far. Unhedged, dollar-based investors in European equities have benefitted as a result, even as returns in euro terms have lagged. The price return in dollar terms (yellow) had largely trailed that in local-currency terms (orange) until late June when the trend reversed. See the chart above. We see the fundamental dynamics ultimately flowing through and helping local-currency equity returns. We are much less sanguine about emerging market (EM) equities as many EM countries outside northern Asia struggle to contain the virus spread and have limited policy space to cushion the virus shock, even with the help of a weaker dollar.
The dollar had enjoyed a decade of nearly uninterrupted gains – and had a strong start in 2020 in part helped by pandemic-triggered global risk aversion and a seizing-up of the dollar funding market. We see the unprecedented policy revolution as helping reverse that trend since March. The Federal Reserve and other central banks have cut rates and initiated other easing measures, leading to the compression of interest rate differentials between the U.S. and most developed economies, just as governments have unleashed fiscal stimulus to help households and businesses bridge the virus shock. The forceful policy response has revived risk appetite, driving investors away from perceived safe-haven assets. The Fed’s measures to alleviate the dollar funding shortage also helped take the wind out of the greenback’s rally.
The euro as well as a handful of other European currencies have led the outperformance against the dollar in recent months, cheered on by the region’s improving virus dynamics and galvanizing policy response. The creation of the European recovery fund, and its upcoming issuance of pan-European bonds, has been a boon for the euro. The situation in the U.S. appears less encouraging. Negotiations over the next round of fiscal relief measures have dragged on even as key benefits expire, while COVID cases are rising in most of the country. We expect dollar weakness to persist in the near term as the drivers for its recent decline remain in place. The longer-term outlook is harder to gauge. A key question is the currency implications of the policy revolution – especially if and how central bankers build guardrails to manage growing balance sheets in the face of greater fiscal deficits and debt issuance. The prospect of the dollar retaining its perceived safe-haven status is another concern. We are weighing these as a contentious U.S. presidential election looms.
The bottom line: The shifting pandemic and restart dynamics in the U.S. and Europe have helped weaken the dollar and strengthen the euro, underpinning our overweight on European stocks and caution on their U.S. peers. A weaker dollar generally is positive for EM assets, yet we see the relatively weak public health infrastructure and limited policy space more than offsetting such benefit across much of the EM complex. We are underweight EM equities overall and EM dollar debt, as many of developing countries have limited capacity to control the virus spread and cushion the blow to the economy. We are neutral and more constructive on EM Asia equities and local-currency EM debt.
Activity has started to normalize in both Europe and North Asia, albeit with localized lockdowns to contain virus clusters. The pandemic is still spreading in the U.S. and many emerging markets. The unprecedented policy response has boosted risk assets. Europe has agreed on a historic recovery fund, but U.S. stimulus is now at risk of fading. Talks over the size and makeup of a new U.S. fiscal package have dragged on as some key benefits expired and states face huge budget shortfalls. We could see a $1-1.5 trillion fiscal package that extends some (but not all) federal stimulus measures through late-2020.
Markets will focus on the sentiment data from Germany and the U.S., after some levelling-off of some sentiment indicators amid ongoing concerns of renewed spread of the virus around the world. A flurry of data from China, including inflation, industrial output, retail sales and lending, could shed light on the progress of the activity restart in the world’s second-largest economy.
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