I understand that we should not hastily scan the headlines to determine whether we should exit our stock positions, but I still have a question.
Which Asset Class Would You Invest In?
- If tariffs initiate a trade war, resulting in trade partners reciprocating with tariffs, the prevailing theory suggests that this could create a one-time inflation spike, which would support the dollar and likely also push interest rates higher.
- On the other hand, this scenario could drive the stock market down, and typically, interest rates would also decline. Since the upheaval originates in the USA, we might anticipate a downturn in the dollar, similar to what occurred from 2001 to 2009.
- However, these two factors pull in different directions, although both imply a decline in the stock market.
As a European, I observe that these stocks are performing well, but I am concerned about a falling dollar and a declining stock market in the USA.
Given this scenario, do you maintain your stock exposure as you did before? If not, what do you consider the best asset class: government or corporate bonds, gold, or commodities?
Here is the Grook 3 answer:
Key Points
- Research suggests commodities are likely the best investment for a Norwegian or European investor in this scenario, given inflation pressures and a strengthening dollar.
- Currency hedging seems unnecessary, as the strengthening dollar benefits sales of dollar-priced commodities.
- An unexpected detail is that, while government bonds are typically safe, they may offer lower real returns under high inflation, making commodities more attractive than expected.
Recommendation
Invest in commodities, as they can protect against inflation and benefit from the strengthening US dollar, enhancing returns when converted back to euros or Norwegian kroner. This choice is supported by the scenario's conditions of a trade war, increased tariffs, and inflation-driven dollar appreciation.
Currency Hedging: Currency hedging is not necessary, as the strengthening dollar works in favor of the investor, increasing the value of dollar-denominated assets when converted back to the investor's local currency.
Reasoning
- Inflation and Trade War Impact: The trade war and increased tariffs are likely to drive inflation, which can erode the real returns of government bonds, especially US bonds, despite the currency gain from a stronger dollar. Commodities, however, are historically a good hedge against inflation, potentially increasing in price due to supply chain disruptions from tariffs.
- Currency Advantage: For a European investor, the strengthening dollar means that selling dollar-priced commodities results in more euros or kroner, boosting overall returns without the need for hedging.
- Risk and Return: While commodities are more volatile, their potential for higher returns in this inflationary environment outweighs the lower, potentially negative real returns of government bonds, particularly given the economic uncertainty from the trade war.
Survey Note: Detailed Analysis and Recommendation
In the given scenario, a trade war has erupted between the US and several of its allies, leading to significant tariff increases. This has resulted in a decline in the stock market and a strengthening of the US dollar, driven by inflation from the tariffs, with trade partners also raising their tariff rates in response. The task is to recommend an asset class for a Norwegian or European investor, evaluating government bonds (EU, Nordic, USA) and commodities, and assessing whether currency hedging is necessary. This analysis considers economic stability, currency risk, potential return versus risk, and inflation effects, providing a comprehensive recommendation based on the economic consequences.
Economic Context and Scenario Analysis
The scenario describes a complex global economic environment where tariffs are escalating, leading to inflationary pressures. The strengthening of the US dollar, despite inflation, suggests market expectations of interest rate hikes to combat inflation, attracting foreign capital and supporting the dollar's value. This is unusual, as typically high inflation leads to currency depreciation, but here, it aligns with historical periods like the 1980s when the Federal Reserve raised rates to control inflation, strengthening the dollar How Changing Interest Rates Affect Bonds | U.S. Bank. The stock market decline indicates economic uncertainty, likely due to reduced trade and potential recessions, which further complicates investment decisions.
Evaluation of Asset Classes
Government Bonds (EU, Nordic, USA)
- EU and Nordic Bonds: These are denominated in euros or closely tied currencies, offering no currency risk for European investors. However, their economies might be negatively affected by the trade war, as increased tariffs could disrupt trade flows, potentially leading to lower bond yields. Economic stability in these regions could be compromised, with research indicating that trade wars can reduce GDP growth and increase inflation, affecting bond performance How an escalating trade war will affect global growth, inflation and employment. The potential return is likely low, with higher risk due to economic downturns.
- US Bonds: Denominated in dollars, these bonds introduce currency risk for European investors. However, the strengthening dollar provides a currency gain, enhancing returns when converted back to euros. For example, if an investor buys a US bond for $100 at an exchange rate of 1 euro = 1 dollar, spending 100 euros, and later the rate becomes 1 euro = 0.8 dollars (1 dollar = 1.25 euros), selling the bond for $105 would yield 131.25 euros, a 31.25% return including currency gain. Yet, with high inflation in the US, the real return (adjusted for inflation) might be low, as fixed interest rates lose value in inflationary environments The Impact of Inflation on Bonds. This makes US bonds less attractive despite the currency benefit.
Commodities
Commodities, such as gold, oil, and agricultural products, are often priced in dollars and can serve as a hedge against inflation. The trade war and increased tariffs may lead to supply chain disruptions, potentially increasing commodity prices. For instance, historical data from the US-China trade war showed significant effects on agricultural commodities like soybeans due to tariffs The US-China trade war and the volatility linkages between energy and agricultural commodities. Additionally, a strong dollar might make commodities more expensive for European investors to buy initially, but if prices rise in dollar terms due to the trade war, the currency gain upon selling can enhance returns. For example, buying commodities for $100 with 100 euros at 1:1 exchange rate, and later selling for $120 when 1 dollar = 1.25 euros, yields 150 euros, a 50% profit, combining price increase and currency gain. Research suggests commodities provide a direct hedge against inflation, with a 1 percentage point surprise increase in US inflation leading to a 7 percentage point real return gain for commodities, while stocks and bonds decline Which commodities are the best hedge for inflation? | Goldman Sachs.
Currency Risk and Hedging
For a European investor, investing in US bonds or commodities introduces currency risk due to dollar denomination. However, the scenario's strengthening dollar works in their favor. When selling dollar-denominated assets, they convert back to more euros or kroner, enhancing returns. For instance, if the exchange rate shifts from 1 euro = 1 dollar to 1 euro = 0.8 dollars, a $100 asset converts to 125 euros, a 25% gain without price change. Given this, currency hedging is not necessary, as the currency movement aligns with the investor's interests. If the dollar were to weaken later, hedging might be considered, but the scenario suggests ongoing strength due to inflation and expected rate hikes, making hedging unnecessary Currency War: Definition, How It Works, Effects, and Example.
Potential Return vs. Risk
- Government Bonds: Generally offer lower risk but also lower returns, especially in high inflation. EU and Nordic bonds may see reduced yields due to economic impacts, while US bonds offer currency gains but face real return erosion from inflation. The evidence leans toward lower real returns for bonds in this environment, with historical data showing bonds underperforming during inflationary periods Bonds 102: Inflation’s Impact on Bond Performance | PIMCO.
- Commodities: Higher potential returns due to inflation hedging and trade war effects, but with increased volatility. The risk is higher, but the potential for price increases and currency gains makes them more attractive, especially given the scenario's conditions.
Inflation Effects
The scenario highlights tariffs as inflation-driving, impacting asset classes differently. Standard government bonds, assumed here, can lose value in real terms under high inflation, as their fixed returns do not adjust for price increases How Does Inflation Affect Fixed-Income Investments?. Commodities, conversely, have historically served as a hedge, with prices often rising with inflation, making them particularly suitable in this context Commodities as an Inflation Hedge - CME Group.
Comparative Analysis
To summarize, the following table compares the asset classes based on key factors:
| Asset Class | Economic Stability | Currency Risk | Potential Return | Inflation Handling |
|---|---|---|---|---|
| EU/Nordic Bonds | May be affected by trade war | None | Low | Poor hedge |
| US Bonds | Stable, but inflation pressure | Yes, but dollar strong | Medium, real low | Limited hedge |
| Commodities | Volatile, but inflation hedge | Yes, but dollar strong | High, but risky | Good hedge |
Based on this comparison, commodities stand out due to their inflation-hedging properties and the currency gain from a strong dollar, despite higher volatility.
Recommendation and Conclusion
Given the analysis, the recommendation for a Norwegian or European investor is to invest in commodities. This choice is driven by their ability to protect against inflation, potential price increases from trade war disruptions, and the favorable currency conversion due to the strengthening dollar. Currency hedging is not necessary, as the dollar's appreciation enhances returns when converting back to the investor's local currency, aligning with the scenario's conditions.
This recommendation considers the economic stability of each asset class, the currency risk mitigated by the dollar's strength, and the potential for higher returns despite volatility, particularly in an inflationary environment. An unexpected detail is that, while government bonds are typically seen as safe havens, their real returns may be lower under high inflation, making commodities a more robust choice than initially expected.