Investors have been surprised as U.S. stocks have outperformed in 2018 relative to the rest of the world. The S&P 500 benchmark in the U.S. market is up 8% to date, while the global equity index that excludes the U.S. is down 5%. Speculators say there could be many reasons for this divergence.
The United Kingdom, Italy and Brazil have had domestic politics which hurt returns in countries involved. During this time, the U.S. dollar strengthened relative to the basket of currencies and trade tensions hit China and emerging markets. Investors have seen U.S. markets skyrocketing due to tax cuts, fiscal stimulus and investor perception that the U.S. dollar could be a better safe haven asset against market volatility in the rest of the world.
A 40% decline in Turkey’s currency against the dollar this year hasn’t been enough to shake U.S. investors from apparent complacency. Keep in mind that the Turkish crisis raised concerns about a replay of the 1997-1998 emerging-market debt crisis that started with the Thai baht. Analysts claim, “We don’t expect it to spread to other currencies. However, it does show how important a stable relationship to the U.S. dollar is to the health of many foreign markets.” Even though the Turkish currency declined and serves to be detrimental to its economy, it seems to be a contained problem.
Two reasons why a strong dollar could be challenging for other countries like Turkey is because they have issued a lot of dollar-denominated debt to fund growth. It is important for investors to keep in mind various implications on how this can potentially impact U.S. equities.
- Commodities are usually priced in U.S. dollar, so foreign buyers effectively have to pay more when the dollar strengthens. That can directly result in less demand, leading to lower prices. This is a problem because the sale of commodities is a key revenue source for many emerging market countries.
- A strong dollar makes U.S. exports relatively more expensive and less competitive overseas. This is because weak economies outside of the U.S. might not buy as much from the U.S. multinationals. Also, countries who have borrowed in dollars see their total cost of debt service go up as the dollar strengthens against other currencies. There will cause slower economic growth when liquidity and credit dry up.
On the other hand, investors should also be wary of an opposite situation, the dollar weakening. This would result in commodity prices rebounding, triggering higher inflation readings that reinforce the Federal Reserve’s intent to keep raising interest rates. A higher interest rate could hurt the U.S. government bond market and upend stocks. The bottom line to watch out for is the dollar volatility and potentially reducing exposure to passive investments like index funds or exchange-traded funds.