The US stock market reached record highs in the past year, coinciding with the dollar’s most significant appreciation in nearly a decade, a 7% rise on a trade-weighted basis. This dollar surge was largely fueled by investor optimism surrounding Donald Trump’s 2024 election victory. However, this strong dollar presents a potential risk to US equities. A stronger dollar could exacerbate the US trade imbalance, potentially prompting Trump to implement higher tariffs, a scenario which historically has negative repercussions for the stock market. While current market valuations are reminiscent of the dot-com bubble of the late 1990s, the dollar’s strength mirrors levels last seen in the mid-1980s. This combination is unusual, as stock markets typically thrive under a weaker currency, which enhances international competitiveness. A strong currency, conversely, hampers exporters and domestic producers.
The mid-1980s serves as a cautionary tale of the negative impacts of a strong dollar. At that time, the robust dollar significantly hindered US competitiveness, leading to a ballooning current account deficit. The dollar’s decline began in 1985 as investors recognized its detrimental effect on the economy. This period also witnessed US multinationals shifting production overseas to capitalize on cheaper labor costs, a trend that contributed to the decline of the US manufacturing sector and substantial job losses. The Plaza Accord, signed in 1985 by the Reagan administration and several other major economies, aimed to weaken the dollar through coordinated currency market intervention, highlighting the global concern surrounding the dollar’s strength.
In contrast to the 1980s, US companies have performed remarkably well since the 2008 Global Financial Crisis. This success can be attributed to several factors, most notably improved productivity driven by technological advancements, particularly in the tech sector. US output per hour worked has significantly outpaced that of Europe and Japan, demonstrating a widening productivity gap. Furthermore, US multinationals occupy dominant positions among the world’s largest corporations. Consequently, US corporate profit margins have reached all-time highs, reflecting this increased productivity and global market share. The US stock market’s outperformance compared to international and developing markets is also linked to its leadership in technology, with the tech sector comprising a significantly larger portion of the S&P 500 than its European counterpart.
Trump’s 2024 election win has injected renewed optimism into the market, with investors anticipating that his policies on tax cuts and deregulation will stimulate economic growth. This “animal spirits” effect could prolong the stock market rally, mirroring the post-2016 election market behavior. However, two key risks warrant careful consideration. Firstly, the lofty earnings growth expectations baked into current tech stock valuations, driven by the promise of artificial intelligence, might not materialize. This scenario would echo the tech bubble burst at the turn of the century, when inflated expectations collided with reality, leading to a significant market correction and a subsequent decline in the dollar.
Secondly, Trump’s protectionist tendencies pose a substantial threat. His focus on the US trade imbalance as a measure of fair trade, coupled with his zero-sum view of international trade, could lead to further tariff implementation. This concern is amplified by the widening US current account deficit, which has doubled since the start of the Covid-19 pandemic and is projected to increase further due to stronger US economic growth compared to other developed nations and the dollar’s continued appreciation. Should Trump impose tariffs on China and other trading partners, retaliatory measures are likely, potentially escalating into a protracted trade conflict with significant consequences for the US economy and consumers. This scenario would be reminiscent of the trade disputes of the late 1980s, which ultimately contributed to the 1987 stock market crash.
While some might dismiss Trump’s tariff threats as mere negotiating tactics, history suggests they shouldn’t be ignored. His administration is reportedly exploring “universal tariffs” on critical imports from all countries, a less sweeping but still impactful measure compared to his campaign proposals. Further tariff increases on imports from China, Mexico, and Canada also remain on the table. Investors must recognize the potential for these threats to become reality, particularly if the US current account deficit continues to grow. Therefore, it is crucial to develop strategies to mitigate portfolio risk should a trade conflict erupt. A prudent approach would consider the historical impact of trade wars, the potential for retaliatory measures, and the interconnectedness of global markets. Ignoring these risks could lead to significant portfolio losses if the current optimistic market sentiment gives way to a trade-driven downturn.
