HOW TO MANAGE U.S. ASSET DOMINANCE IN PORTFOLIOS / THE FINANCIAL TIMES MARKETS INSIGHT

How to manage US asset dominance in portfolios

Dollar hedges will continue to be in demand but investors may have to consider other options too

Christian Mueller-Glissmann

There is concern over an unusually high concentration of S&P 500 performance and market capitalisation in a few technology stocks © Bloomberg

US assets are increasingly dominating investor portfolios, now making up roughly half of global equity and bond markets. 

Sustained outperformance since the Great Financial Crisis and a strong dollar have spurred this shift, with investors steering capital flows to the US in search of better returns.

But since the beginning of the year investors have increasingly questioned their US exposures, looking at strategies for international diversification and currency hedging.

Investor concerns include US fiscal risks, questions over the independence of the Federal Reserve, potential lingering tariff impacts and elevated US equity valuations. 

Plus, there is concern over an unusually high concentration of S&P 500 performance and market capitalisation in a few technology stocks.

Against the backdrop of US asset outperformance and a stronger dollar, American asset dominance in global portfolios has not been a major concern in recent years. 

However, the dollar has trended down this year and there have been more instances of combined sell-offs in the S&P 500, 10-year Treasuries and the US currency.

Simultaneous declines in all three have been rare since the late 1990s. 

These patterns were more common in the 1970s and 1980s, reflecting stagflation or US-specific rate and growth shocks. 

They also emerged around the UK’s fiscal concerns.

In 2022, when global equity/bond correlations also turned more positive with prices falling on the back of rising inflation, the dollar served as a hedge for US assets by strengthening following aggressive tightening of monetary policy by the Federal Reserve.

Now without that strength, the pressure to manage US asset dominance in benchmark-driven global portfolios has increased. 

However, reaping benefits from international diversification has been difficult this year due to the size, liquidity and opportunities in US markets.

After global equities underperformed in the first quarter, the S&P 500 has fully recovered since then (in local currency terms), helped by a strong earnings season, AI optimism and more dovish interest rate expectations. 

European stocks have lagged behind since the second quarter, with a mixed earning season (outside of financials) and recently renewed political uncertainty in France. 

But the negative dollar trend, while slowing, has not reversed.

Thus, currency hedging has been a more effective and popular strategy to address US asset dominance for international investors and increased foreign exchange risk more broadly in recent months.

In Japan, currency risk in unhedged multi-asset portfolios has generally tended to be higher, for example, following the sharp yen declines post the Covid-19 pandemic. 

The same is true for countries with cyclical currencies, such as Australia and Sweden — but usually the dollar damps risk in their portfolios. 

And it is a new phenomenon for European investors with 30-40 per cent of portfolio risk driven by currency. 

The weaker dollar has been a key drag for US equity returns in euro terms in the year to date.

This puts more pressure on international asset owners to increase dollar hedges. 

This is particularly the case for equity investors which have tended to do this less in the past, partly because currency moves usually mean-revert in the medium-term, reducing hedging benefits. 

And in general, currency moves are a smaller driver of overall risk in an equity portfolio — foreign exchange risk tends to be a larger contributor in fixed income which is why it is often managed more actively already. 

Also, large cap companies are often already regionally diversified in terms of revenue exposure.

With more expected dollar downside, currency hedging will remain in demand. 

This might change, though, if the costs of this become too much of a drag on returns and international diversification benefits pick up in the medium-term — particularly given long-term return predictions for US equities are more uncertain.

Investors should become more flexible beyond equity and bond benchmarks and more creative with parts of their portfolios. 

Diversifying into areas such as China tech stocks, for example, might reduce disruption risks for large cap US tech companies. 

Likewise allocations to gold and emerging markets assets, which are negatively correlated with the dollar, can help diversify risk of a continued weaker trend for the US currency. 

More generally, investors need to consider whether large weightings in US assets remain a good default position for their portfolios.

The writer is head of asset allocation research at Goldman Sachs