The US dollar remains strong

However, bond flows are much more likely to be hedged and often these hedging costs are quite expensive given the sharp rise in US policy rates. Equity flows, on the other hand, are less likely to be hedged and US equity outperformance is a clearer reason for dollar strength – even in an equity bear market.

There’s no doubting that US stocks have outperformed most, if not all other markets for some time. What’s more, this outperformance appears impervious to the state of equity markets in general; US stocks seem to outperform in bull markets and bear markets.

For instance, if we look at the performance of US stocks since the Covid low in early 2020, we see a rough 80% rally in the MSCI measure compared to a sub-5% rise in European stocks and a more than 10% fall in emerging market stocks. Unsurprisingly, such outperformance draws in foreign investors for, over this same period, foreign holdings of US equities have risen from USD6.7tr to USD12.5tr; an increase of nearly 90% according to Fed data.

In very broad terms, this increase in the value of US equity holdings by foreign accounts is close to the combined valuation effects from the rise in equity prices and the rise in the dollar, which has been around 1.5% over the period in broad trade-weighted terms. What this says to us in very general terms is that equity markets might have been pulled through the wringer this year but there’s limit ed evidence that foreign accounts are pulling out on mass and we think that’s helping to support the greenback.

This inevitably leads to the issue of why US equities have generally outperformed other stock markets. We might be able to think of all manner of reasons for this but the one that we think is perhaps most relevant relates to the pricing power of firms. For there seems to be quite a bit of evidence that competition in the US, or at least in a number of US industries, is relatively low and this gives firms significant pricing power compared to their peers in many other parts of the world.

The tech sector for instance, which has long been the darling of equity investors is a case in point with lots of accusations that the big tech firms prevent effective competition through actions such as gobbling up any potential rivals that push their heads above the parapet. We have also seen government pressure to increase competition in many sectors. An example here would be the pressure the Trump-led government tried to bring to bear on drug companies to lower prices.

In Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, their inability to bring this pressure to bear in a significant way has kept profitability robust and helped mark out differences between the US and other countries. While robust profitability might appear good, there are some drawbacks. First, if it sucks in capital and lifts the dollar it can damage the earnings and profitability of US firms that operate overseas. Secondly, and perhaps most importantly at the moment, the better pricing power of US firms relative to many foreign competitors could help maintain higher inflationary pressure as US firms are better able to pass rising costs on to their customers.

In this regard the comparison with Japan is notable. Competitive pressure in Japan means that, while PPI prices are rising an annual 9.2% right now, the CPI is up just 2.4%. In the US the figures are 11.3% and 9.1% respectively. Looking ahead, if US firms use the relative lack of competition to maintain profitability levels then it could not only suck in more foreign capital to the US stock market and lift the US dollar but also raise the greenback as the Fed will have to hike rates by far more than other nations to try to get inflation under control.