2Q 2022 GMO Quarterly Letter

Executive Summary

The U.S. dollar has been on a tear in recent months, bringing it to its highest valuation versus other major developed currencies in more than 35 years. While higher interest rates in the U.S. make shorting the U.S. dollar in currency forward markets a potentially tricky proposition, that interest rate differential is not an issue for holders of equities. An overvalued currency is a negative influence on the performance of equities in that country. By contrast, a cheap currency is a strong equity tailwind in the developed world, leaving developed markets like the Euro area and Japan poised to benefit from their undervalued currencies. To date, the effects of the expensive dollar have not been that noticeable for the U.S., but the impact has been quickly felt in other countries. The strong dollar and high commodity prices have pushed some less developed countries into distress. While a cheap currency seems to be an unalloyed good in the developed world, things are somewhat more nuanced in the emerging world where the benefits of an undervalued currency can be undermined by poor policy choices. Still, the valuation of currencies in the emerging world today are attractive enough that even allowing for some poor decision making, they should still be a source of equity market support over the next few years. Today’s combination of cheaper stocks and cheaper currencies outside the U.S. seems a promising backdrop for a reversal of the U.S. equity dominance of the last decade.

One of the most famous sentences ever uttered by a U.S. Treasury Secretary was John Connally’s November 1971 G-10 meeting quote that “The dollar is our currency, but your problem.” It’s a wonderful line, and the sentiment certainly resonated with European governments that were seriously annoyed with the fact that the Nixon administration had just ended the U.S. dollar’s (USD) convertibility into gold, thus unilaterally ushering the world into the age of purely fiat currencies. But despite the lasting fame of his quip, what Connally said was wrong, or at least its implicit message was wrong. In November 1971 the USD was most assuredly a problem for the United States, as a half-decade of rising inflation and a fixed conversion rate to gold had left the dollar massively overvalued versus its peers. It was a simpler world back then, though, and the act of moving off the gold standard started a major devaluation of the dollar, relieving the pressure on the U.S. economy. Today, the USD again is looking strikingly overvalued on many measures, and the impact is rippling around the world. The questions that equity investors need to be asking themselves today are whose problem that overvalued dollar is and how, if at all, should they be adjusting their equity portfolios in light of today’s currency environment?

Measuring Currency Valuation

Most versions of currency valuation models are some riff on “The Law of One Price,” which says that goods and services should cost the same irrespective of the currency in which they are priced. As the Economist’s famed model suggests, a Big Mac in Tokyo should cost the same as one in New York, or New Delhi. 1 As a quick glance at the Big Mac index would show, that “law” fails materially almost everywhere at any given point in time, and it does so particularly strikingly for countries whose development levels are meaningfully different. But despite this problem, currency valuation models are reasonably predictive and – given the lack of many better alternatives – widely in use in finance. According to the Bank of International Settlements’ Real Effective Exchange Rate model, 2 the dollar looks more expensive than in all but two events in the last 51 years – the levels in 1971 that signified the end of the Bretton Woods Agreement and the mid-1980’s dollar bubble that led to the Plaza Accord. 3 We can see all three periods clearly in Exhibit 1.


Data from August 1971 to June 2022 | Source: Bank of International Settlements

Exactly why the USD has gotten so strong lately is not entirely clear, but one can point to a couple of different drivers. The USD tends to be a safe-haven currency – it rises in tough times for risk assets and falls in boom times. That can help explain the most recent upward jag, but not really the move from 2012-20 that got us from some of the lowest levels in history to quite elevated. Another recent driver seems to be carry. The Federal Reserve has been more aggressive in raising rates than other developed central banks and currency speculators do like betting on carry, as my colleagues in GMO’s Systematic Global Macro team discuss – and caution against – in their recent paper “Let’s Not Get Carried Away.”