Is The U.S. Stock Market At Risk Due To A Weakening Dollar?

Despite U.S. stocks continuing to break new highs, Morgan Stanley recently issued a new warning that a correction may be on the horizon for U.S. equities.

On Monday, Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management, issued a warning to U.S. equity bulls that structural forces that suppress the U.S. dollar may be spreading to U.S. stocks.

Shalett warned that the end of Japan's yield curve control (YCC), as well as the rise in Bitcoin and commodity prices, indicate that the dollar's strength might be hitting its limit, so Investors should consider preparing for a US dollar regime shift.

Is the U.S. Dollar's Strong Momentum Weakening?

Despite benchmark U.S. stock indices hitting new highs recently, Shalett and a few other Wall Street individuals have issued warnings about the recent rally in the stock market.

In her report, Shalett highlighted the correlation between the strength of the U.S. dollar and the rise in U.S. stocks. She wrote in the report: While correlation is not causation, the correlation of US dollar strength to P/E ratios is worth monitoring now that the greenback's bull market cycle may be maturing.

After falling nearly 3% overall in 2023, the dollar strengthened at the beginning of this year as traders delayed expectations of Federal Reserve rate cuts. However, even though U.S. inflation has cooled, betting on the pace of the Fed's rate cuts has been pushed back further, the dollar's rally has stalled.

Since the beginning of March, the Bloomberg Dollar Index has fallen by 0.5%, while Bitcoin and gold prices have hit near-term record highs.

Shalett says that the strength of the dollar has long been at the core of the U.S.'s loose monetary system - as the dollar rises, inflation related to imports is suppressed, as are energy prices, which had been boosting U.S. stock performance. However, as the dollar's strong momentum decreases, U.S. stocks may also lose upward momentum.

The U.S. Dollar's Weakness Could Drag Down U.S. Stocks

With the U.S. dollar seeming to weaken, Shalett recently encouraged investors to look beyond the U.S. to hedge against a potential pullback in the U.S. stock market.

As major G10 countries cut interest rates, the Bank of Japan could tighten policy, boosting the yen and putting pressure on the dollar, and attracting funds to flow out of the U.S. stock market, Shalett said. She also emphasized that the deterioration in China-US relations, especially during the U.S. presidential election, could also accelerate de-dollarization - a trend that may have already been reflected in the rise in gold prices.

Then a broad downward trend in the dollar will be transmitted to the U.S. stock market through price-earning ratios, which have a long-term positive correlation, meaning that a weak dollar will depress price-earning ratios. Higher price-earning ratios are the main drivers of the recent surge in U.S. stocks.

Shalett said: If global policy starts rebalancing toward a pre-GFC mix, or market euphoria ushers in a capital markets bust and a weaker dollar, investors may benefit from more asset and geographic diversification.