During our last webinar focusing on the much-discussed idea that more and more countries are abandoning the US dollar as a reserve currency, UBP’s senior strategists shared their thoughts on the combination of cyclical and structural factors that should indeed lead to a weaker dollar, and the impact this will have on asset classes.
Get some insights about the webinar by listening to this podcast discussion between Norman Villamin, Group Chief Strategist, and Peter Kinsella, Global Head of Forex Strategy at UBP.
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The population of the United States accounts for 3% of the world’s total population and its economy represents 15% of world GDP. Yet, for decades, the USD has been the dominant reserve currency and a major reference for global trade; it is used in about 90% of all foreign exchange transactions.
We are beginning to see state-driven moves to reduce dependence on the dollar in trade, invoicing and financing. Recent bilateral trade agreements between China and Saudi Arabia, and Russia and Brazil have brought the theme of dedollarisation back into the limelight. However, these bilateral agreements do not amount to much in the short term, and there are doubts about their long-term effects. In this area, the leadership of the USD is still far from being challenged.
The decline of USD’s reserve currency status
That said, central banks’ use of the dollar as a reserve currency has been gradually diminishing since 2000, with its overall share of allocated foreign exchange reserves falling from 70% to 58%. In real, valuation-adjusted terms, the decline has been even more impressive: in 2022 alone, its use as a reserve currency declined from 55% to 47%, with the euro increasing its share to 25%.
This significant move can partly be explained by the sanctioning of Russia’s central bank’s foreign exchange reserves. This unprecedented decision led several central banks to conclude that they could face confiscation risks in the event of political disagreements with the United States. As a result, some institutions, particularly in emerging markets, have heavily divested from the dollar. In total, central banks bought a record of more than 1,000 tonnes of gold in 2022.
“It is a watershed moment for the USD in terms of reserve composition, of which the euro should be one of the prime beneficiaries.”
Peter Kinsella, Global Head of Forex Strategy
A number of other factors are weighing on the dollar. Some are cyclical in nature, such as the steepening of the US 2–10-year yield curve. Structurally, the fact that the US twin deficits (fiscal and current account) are now approaching USD 2 trillion, or 10% of GDP, is another big driver for further weakness. This combination of cyclical and structural factors, along with the decline of dollar’s reserve currency status can be expected to have a lasting impact on the currency in the coming years.
The investment implications of a weaker dollar
Since the 1960s, there has been three long-cycle USD bear markets, each lasting 10–15 years; a fourth cycle is probably already under way.
Previous cycles show that USD weakness is unevenly distributed across national currencies, making active currency selection very important. History also shows that gold outperforms equities in inflationary/reflationary environments, whereas equities outperform gold in disinflationary environments. Within equities, non-US equities tend to outperform US equities in a long cycle of dollar weakness. The inflation backdrop is also important from a sector perspective.
“Whether the weak USD is cyclical or marks the beginning of the end of its reserve currency status, the implications for investors are the same: they need to look beyond US equities to find investment opportunities, and selection is key to adding value.”
Norman Villamin, Group Chief Strategist.
Emerging currencies are benefiting from worldwide deglobalisation
Another point made during the webinar was the diversification benefits that could come from investing in emerging markets in an era of dedollarisation. “Emerging markets are benefiting from the global deglobalisation that is moving production closer to the US, with Mexico and Brazil as the main beneficiaries, and the same trend is occurring with Europe and Eastern Europe. In addition, with nominal rates between 8% and 16% in emerging markets, exposure to emerging currencies offers a real carry advantage,” notes Sergio Trigo Paz, CIO & Head of Emerging Markets Fixed Income.
