Op-eds

Greenback Gravity — how the mighty dollar shapes the global stage

Source: Prescient Investment Management, 23/01/2025

By Bastian Teichgreeber and Adam de Waal

5 Feb 2025

The interplay between a surging dollar, rising US yields and the opportunities in the South African markets highlights the importance of diversification in portfolio construction.

The US dollar has surged to a 40-year high, a development that underscores the evolving dynamics of global markets under shifting political and economic circumstances. While this appreciation might appear to signify strength, it poses challenges that resonate far beyond American borders, highlighting tensions between domestic policy objectives and global financial stability.

Even before assuming office, the incoming administration has already left its mark on global politics and markets. Announcements of unorthodox economic policies have disrupted expectations, and with promises of significant fiscal shifts – ranging from large-scale tax cuts to protectionist tariffs – the dollar’s rise is accelerating. According to the Federal Reserve’s Broad Real Dollar Index, the currency’s value has been steadily increasing since mid-2023, reaching levels not seen in four decades.

The strength of the dollar is not merely a reflection of domestic policies but also a product of its status as the world’s reserve currency. In times of uncertainty, whether economic or geopolitical, investors flock to dollar-denominated assets such as US Treasuries, further amplifying demand. Ironically, this dynamic persists even when the US is the source of that uncertainty.

Economic resilience fuels the dollar

America’s relative economic strength has been a key driver of the dollar’s recent performance. By most measures, the US has significantly outperformed its G7 peers since the pandemic. According to research, US GDP growth has been the strongest among advanced economies, even when adjusted for inflation and population.

Comparative GDP growth among G7 nations since 2020, adjusted for inflation and population, showcasing US leadership

Source: Prescient Investment Management, 23/01/2025.

What sets the US apart further is its productivity growth, which measures economic output per hour worked. Increases in productivity are the lifeblood of long-term economic health, supporting higher living standards and greater efficiency. While other G7 economies have experienced stagnation or even declines in productivity over the past few years, the US has bucked this trend with impressive gains.

Productivity growth trends in G7 nations over the last decade, emphasising US gains relative to its peers

Source: Prescient Investment Management, 23/01/2025.

However, this economic outperformance has not been evenly distributed. The US remains one of the most unequal developed nations, and much of this growth has not translated into improved prosperity for households in lower income brackets. Nevertheless, strong economic fundamentals have invited significant capital inflows, pushing the dollar higher.

Trump’s policies: fuelling the dollar

Much of the dollar’s recent rally can be tied to the policy expectations associated with the incoming administration. Markets began pricing in these shifts as early as October 2024, when electoral outcomes became clearer, and the dollar’s rise accelerated after the election.

The anticipation of tax cuts and tariffs has shaped the consensus that the new administration’s policies could drive notable economic shifts. Tax cuts are expected to bolster household spending, potentially increasing upward pressure on prices, while tariffs may raise the cost of imported goods and encourage consumption of domestic alternatives. However, the inflationary impact of tariffs is not guaranteed; rapid substitution and potential demand constraints could temper these effects, creating a scenario where the outcome leans more towards muted growth or even deflationary pressures.

This evolving outlook has made Federal Reserve policy a focal point. While fewer rate cuts have been priced in, discussions about potential rate hikes remain largely absent from current market expectations. Any shift towards higher interest rates would make dollar-denominated deposits more attractive to global investors, further fuelling the dollar’s strength.

Additionally, tariffs can exert downward pressure on the currencies of trading partners most affected, such as the Chinese yuan and the euro. As these currencies weaken, the dollar strengthens further, reflecting its valuation as a relative measure against other global currencies.

Winners and losers in a strong dollar world

For American households and importers, the dollar’s strength is good news. It increases purchasing power and provides disinflationary benefits, making imported goods and services cheaper. It also reflects Wall Street’s central role in global finance, reinforcing the financial sector’s dominance.

For the rest of the world, however, a powerful dollar introduces significant challenges, particularly for emerging market economies. First, it raises the cost of essential imports, such as oil, which are typically denominated in dollars. This fuels inflation in economies already grappling with fragile financial systems.

Second, a strong dollar makes it harder for other countries to access credit. As investors flock to dollar-denominated assets, capital availability diminishes elsewhere, tightening global liquidity. Higher borrowing costs exacerbate fiscal pressures in emerging markets, increasing the likelihood of austerity measures, tax hikes, or even defaults.

This dynamic is reminiscent of the 1980s debt crises, when a surging dollar wreaked havoc on global markets. While developing nations today rely less on dollar-denominated debt than in the past, vulnerabilities remain, particularly in countries with heavy reliance on external funding.

Tensions in domestic policy

Domestically, the dollar’s strength poses challenges for the incoming administration’s stated policy goals. A stronger dollar undermines American manufacturing by making US exports less competitive internationally and exposing domestic industries to cheaper imports. This tension is particularly acute given the administration’s ambition to reduce the trade deficit and revive manufacturing.

While policymakers might prefer a weaker dollar to support export competitiveness, the simultaneous goal of maintaining the dollar’s global reserve status creates an inherent contradiction. These conflicting priorities highlight the complexity of managing domestic objectives in a globally interconnected financial system.

Opportunities in South Africa

In contrast to the challenges presented by a strong dollar and rising US yields, South Africa offers a compelling investment narrative. Inflation in South Africa has remained subdued, with headline inflation recently falling below 3%. Core inflation has also stayed well within the Reserve Bank’s 6% ceiling over the past two decades, reflecting prudent monetary policy and structural economic resilience.

South African government bonds, yielding about 11%, present an attractive opportunity. With inflation projected to remain below the Reserve Bank’s 4.5% mid-point target, real yields are exceptionally high, offering significant risk-adjusted returns compared with global fixed-income markets. Factoring in curve rolldown and modest yield curve adjustments, total returns for 2025 could reach 12%.

While developed markets grapple with low real yields and high inflation risks, South African fixed-income assets provide a rare combination of high nominal returns, positive real yields and manageable duration risk.

Navigating the global landscape

The interplay between a surging dollar, rising US yields and the opportunities in the South African markets highlights the importance of diversification in portfolio construction. Investors must balance the stability of dollar-denominated assets with the higher potential returns offered by emerging markets like South Africa.

As global macroeconomic dynamics evolve, understanding these opportunities and risks will be critical for achieving strong, risk-adjusted returns. South Africa’s bond market, with its favourable yield environment and inflation dynamics, represents a rare opportunity for investors seeking to navigate today’s complex global financial landscape. DM

Bastian Teichgreeber is CIO and Adam de Waal is a quantitative analyst at Prescient Investment Management.

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