The resilience of U.S. stocks since the 2008 financial crisis has been supported by the strength of the U.S. dollar, a factor often underestimated.
However, this trend may shift as the greenback is expected to enter a period of prolonged weakness, according to a senior strategist at Morgan Stanley.
Historically, a stronger dollar has been associated with higher equity valuations, as illustrated in the chart below.
Despite some exceptions, such as in 2022 when the dollar surged due to international investors seeking safety amidst significant inflation, the worst in 40 years, which negatively impacted global stocks and bonds.
A sustained weaker dollar could leave the U.S. economy vulnerable to a scenario resembling stagflation, with sluggish growth and persistent inflation.
This contrasts with the "goldilocks" scenario that has supported U.S. equities recently, as noted by Morgan Stanley Wealth Management Chief Investment Officer Lisa Shalett.
Shalett has highlighted several signs suggesting a potential "regime shift," including the Bank of Japan's recent decision to raise interest rates and loosen its control over domestic markets.
While this initially weakened the Japanese yen against the dollar, the subsequent tightening of monetary policy by the BoJ, coupled with other global central banks' preparations to lower interest rates, is expected to strengthen the yen over time.
This change could prompt Japanese investors to repatriate funds from overseas investments, thereby removing a crucial source of support for U.S. stocks and bonds.
Another threat comes from China, where escalating geopolitical tensions could accelerate de-dollarization, weakening the dollar's role in international trade and finance.
Additionally, the rising prices of commodities like gold and bitcoin suggest the dollar may weaken further in the months ahead.
Despite a 3% decline in the ICE U.S. Dollar Index in 2023, the dollar started 2024 strongly but has since stalled.
This suggests that the traditional driver of dollar strength, favorable interest-rate differentials, may no longer be sufficient to support the currency, according to Shalett.
Gold's recent surge to record highs also indicates a potential diversification of reserves away from the dollar and into gold by China, a trend that could continue.
To hedge against these risks, Shalett recommends considering international stocks, particularly in Japan, Mexico, Brazil, and India, as alternatives to U.S. investments.
Investing in real assets like crude oil, copper, and safe assets like gold could also be beneficial in a weakening dollar environment.
Additionally, shifting more exposure to Real Estate Investment Trusts (REITs) within U.S. stock portfolios could be advantageous, as they have recently underperformed the broader stock market.
While a strong dollar has supported U.S. stocks since 2008, its role intensified during the COVID-19 pandemic, aiding stocks by mitigating inflationary pressures.
The dollar's status as the primary global currency has also sustained demand for Treasurys, helping counterbalance rising U.S. budget deficits.
Despite these factors, rising long-term Treasury yields, often seen as a threat to stock valuations, have coincided with recent stock market declines.
Shalett attributes 100% of the U.S.'s decline in inflation over the past two years to the strong dollar, which has appreciated by nearly 6% during this period.
Presently, the dollar remains robust, trading higher on Tuesday while U.S. stocks opened mostly lower. The dollar index was up 0.5% at 103.90, with the S&P 500 down 0.3% at 5,133.
The Nasdaq Composite was down 0.9% at 15,959, while the Dow Jones Industrial Average traded higher, up 63 points, or 0.2%, at 38,850.