Part one in a series. Paresh Upadhyaya is Senior Vice President, Director of Currencies, US.
The US dollar (USD) bull market entered its fourth consecutive year in 2016 and we believe factors are aligning for the rally to enter its fifth consecutive year, a potentially significant one. There are three factors that will fuel the USD rally in 2017: fiscal stimulus proposal, US rate normalization and idiosyncratic factors. The degree to which these factors materialize will determine the intensity of the USD strength.
Fiscal Stimulus Policy and the USD
We expect much easier fiscal policy to be one of the two biggest drivers rejuvenating the USD rally in 2017. However, it is also the factor with the greatest upside risk. There is a strong relationship between a looser fiscal policy and the USD. Some prior USD bull rallies have been associated with easier fiscal policies, such as 1981 to 1986 and 1997 to 2002. The recent rally has drawn parallels to the 1980 to 1984 record USD bull market in which the US implemented a very tight monetary policy and easy fiscal policy.
The Donald Trump administration is proposing an ambitious economic plan consisting of $1 trillion of infrastructure spending over the next 10 years, a cut in personal income taxes and a reduction in corporate taxes from 35% to 15%. The Center for Budget Responsibility estimates Trump’s tax plan will cost $6 trillion in revenue over 10 years. We will not know the final details of the tax plan in the first quarter of 2017, but preliminary projections from the Tax Policy Center estimate a 1.5% boost to gross domestic product (GDP) in the first year while ABN AMRO Group projects a 2.5% boost to gross domestic product over two years.
Historical Strength of the Dollar
Source: Datastream and Pioneer Investments. Last data point 12/15/16.
Potential Benefits to the USD
We anticipate the USD to benefit from easier fiscal policy in a number of ways. First, we expect the US to grow solidly above trend. This should lead to a widening in growth differentials against G10¹ economies. The estimations of Pioneer Investments’ Macroeconomic team suggest that, in case of full implementation of announced policies, US growth could notably accelerate over the course of the next several quarters. Should this occur, it will likely force the Federal Reserve to accelerate its pace of monetary tightening.
Additionally, as part of the overall corporate tax reform and possibly to fund the fiscal stimulus program, there is a proposal for a repatriation tax holiday. The one-off tax holiday would give multinational corporations a low tax rate to repatriate offshore earnings. A similar proposal, named the Homeland Investment Act (HIA) in 2005, brought in around $300 billion (USD and non-USD). There are between $2.5 trillion to $3 trillion in earnings kept overseas.
Cumulative Repatriated Earnings Since 1990
Source: Bureau of Economic Analysis, Westpac, Pioneer Investments. Last data point 12/31/15.
Conservatively, I believe we may see a repeat of the inflows seen in 2005. In 2005, US corporations repatriated 30% of total US earnings. If that percent holds true again, it could equate to $780 billion. Most currency strategists estimate that 80% of offshore earnings are in USD. Therefore, the potential offshore earnings denominated in non-USD that are repatriated could amount to $156 billion, compared to an estimated $60 billion in 2005. According to a Westpac analysis, European states account for the bulk of US offshore earnings, exceeding $1 trillion, followed by Canada, the United Kingdom, Switzerland, Singapore, Mexico and Japan.2 Therefore, we believe the euro, Canadian dollar, British pound, Swiss franc, Mexican peso and Japanese yen are most vulnerable to repatriation.