The expensive position of US stocks seems to be borne out by surveys of investors that show a clear preference for non-US equities over those in the States.

One is that the US’s need for capital inflows continues to rise, and quite sharply. The current account deficit is more than double its pre-Covid level. A second factor is that the US dollar is overvalued. The IMF’s most recent estimates of the extent of dollar overvaluation are in the region of 9%. That was for 2021 and the US dollar has risen much further since then. The dollar’s broad trade-weighted index is up by close to 40% from its lows in 2011 in spite of the fall in recent months.

So, whatever way you cut it, US assets seem to be expensive on an unhedged currency basis if you assume that this overvaluation will work its way out in time. Speaking of valuation, US equities retain their high P/E status compared to peers, and the expensive position of US stocks seems to be borne out by surveys of investors that show a clear preference for non-US equities over those in the States.

On the fixed income front, the very inverted US yield curve would seem to leave longer-term treasuries rather expensive to hold in local terms and doubly expensive in hedged foreign currency terms because high cash rates in the US imply a high cost of currency hedging, particularly against the yen where the key policy rate is still below zero.

Another negative factor with respect to treasuries is that the supply of these on the market will increase as the Fed reduces its assets. At the current pace, the Fed will shed over USD700bn per year from its treasury assets.

In the euro zone, a huge amount of debt has now moved out of negative territory while, in Japan, investors have seen yields rise and anticipate higher rates ahead as the BoJ becomes the last major advanced nation’s central bank to tighten policy. While higher Japanese yields could make the JGB market look enticing for local investors relative to treasuries, the flip side is that higher BoJ policy rates could reduce funding costs for those Japanese investors considering hedged treasury purchases.

This being said, while the BoJ may allow longer-term yields to rise relatively soon, it could still be some time, even years, before short-term cash rates are allowed to move up. Yet another factor we can add to the mix is that central banks seem to be keeping up their diversification from US assets with gold and even minor currencies becoming assets that the central banks increasingly want to hold.

In addition, the cost of currency defence for many emerging market currencies has resulted in a depletion of reserves and hence reduced resources for investment in overseas assets, notably treasuries. The Swiss national Bank is arguably the most important amongst the advanced currencies as its withdrawal from active currency intervention means a reduction in the huge demand that it had for US assets, notably equities.

Surely, given all these reasons why foreign investors should run a mile from US assets, Mr. Steve Barrow, Head of Standard Bank G10 Strategy expects US yields to rise and the dollar to fall. But it is nowhere near as simple as this. For a start, all of these negative factors that we’ve listed for US assets have already been in place for some time. Data shows that central banks are divesting, Japanese investors are ditching treasuries, the Fed is reducing its balance sheet and more. And yet the US dollar has not fallen materially and US yields have not risen dramatically (apart from the very short end, but that’s due to Fed tightening). Why is this?

Mr. Steve Barrow thinks it is because the global asset market backdrop has been very poor. That helps retain the safe-asset allure of the treasury market and the US dollar for foreign investors and, as we’ve explained before, the funding of investments in US assets, often through the FX swap market, can lend itself to a stronger dollar when those assets lose value because investors become short of the US dollar and have to buy it back. Looking ahead, this suggests to us that the US dollar will only fall in response to this poor outlook for US assets if there is a healthier, or risk-on, sentiment pervading global asset markets. Perhaps fortunately, this is what’s most likely to happen.