A weakened dollar might emerge going forward

A weaker dollar might lead to more investment diversification by hedging with other currencies

During the month of November, the dollar index fell toward its lowest levels since mid-August after the latest Federal Reserve meeting minutes showed a unanimous inclination towards a slower interest rate hike going forward. Earlier this month, the Fed delivered its fourth straight 75 basis point rate increase to 3.75%-4% in an effort to fight consistently high inflation, elevating borrowing costs to the highest levels since 2008.

Shares recovered over the past two months, repairing some of the damage done in 2022. Wall Street’s benchmark S&P 500 index was up 13 per cent from its recent low point and Europe’s Stoxx 600 has risen more on positive data from Germany, with producer prices even falling for the first time in two years despite further rate-hike threats coming from the Federal Reserve’s battle with inflation. 

A jump in equities ensued in November when the S&P 500 leapt 5.5 per cent in one particular trading session that could have been caused by the US reporting a more gradual increase in the inflation rate than economists expected. This could be a one-off event. However, as the data at hand presents the possibility of slower inflation occurring, this leads investors to speculate that the Fed would not raise rates as much as previously anticipated, in turn boosting the relative value of companies’ future earning potential. 

Bearish investors conversely believe that markets are not reflecting corporate profit deterioration adequately, which would be due to higher borrowing costs and a weakened economy on the whole. In Europe, the Stoxx 600 was up nearly 3 per cent last week, reflecting strengthening French and German markets as US investors worry over inflation and the risk of a recession. 

Although the latest US inflation data reassures US investors that there will be no surprises going forward, they might still wish to hold on to their investments for the time being so as to benefit from higher pricing leading to higher corporate profits. To add to this, the cash buffers built by companies as well as the corporate reorganisations that took place during the pandemic might all mean that earnings could hold up for longer than expected. 

To recap, the dollar slipped across the board recently, with the most pronounced selling occurring against the euro and the yen. Consequentially, weaker currencies have a negative effect on consumers as they will have less power to participate in the economy. 

Although many countries trade in the US dollar due to its reliability as a historically strong currency, a weaker dollar would give rise to a scenario where a stronger euro could emerge, this in turn leading to more upside potential for countries like China, which trade heavily with the eurozone area, thus benefiting from more buying power for the euro-based consumer should this scenario emerge. This is all the more likely given the possibility of further lockdown reversals, which will have a multiplier effect should China, the world’s second largest economy, open up completely in an effort to live with the virus. 

All things considered, this predicament makes economists less optimistic about a recovery as further rate hiking due to stubborn inflation has the potential to cause the dollar to weaken further with high borrowing costs simultaneously cutting into corporate profits. For this reason, investors might wish to diversify their portfolios by hedging with alternative currencies or equities—namely, European-based equities—that provide such exposure. 

Disclaimer: This article is brought to you by Shaun Frendo, Research Analyst at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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