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Dollar could be about to hit an inflection point, Wells Fargo says

  • Disappointing economic data, political uncertainty and positive developments abroad have sent the U.S. dollar lower
  • Differences among global interest rates, economic growth and inflation; further political risks in the euro area; and investors becoming too negative on the greenback will revert the trend

The U.S. dollar index has fallen by around 9 percent since the start of the year but that could be about to change, according to strategists at Wells Fargo, who suggest the stocks and sectors which could be positively affected amid the move higher.

Disappointing economic data, political uncertainty and positive developments abroad have sent the U.S. dollar lower despite two rate hikes by the Federal Reserve. "We review the recent selling as overdone and expect a stronger U.S. dollar from current levels by year-end 2017, a reversal of the current trend," Sameer Samana, global quantitative strategist at Wells Fargo, said in a note on Monday.

The update in the forecast was due to three reasons: differences among global interest rates, economic growth and inflation; further political risks in the euro area; and investors becoming too negative on the greenback.

While in the U.S. the Fed is raising rates and shrinking its balance sheet, in Europe, the central bank is unlikely to deviate from negative rates soon. At the same time growth and inflation in the U.S. have recovered at a faster pace than in Europe. "While that lead has narrowed as growth and inflation in the euro area have rebounded, it still favors the U.S.," the bank said.

"Put another way... it seems that expectations for the U.S. government to get anything done are too low and for the euro are too high." -Sameer Samana, Global quantitative strategist at Wells Fargo

Furthermore, Wells Fargo recognizes the lower political uncertainty in Europe following the French presidential vote – which could push the euro higher - and a U.S. administration that hasn't delivered on some of its campaign pledges.

However, it sees the upcoming Italian elections as a large political and economic risk to the euro area. "Put another way, at current levels on the currency pair, it seems that expectations for the U.S. government to get anything done are too low and for the euro are too high," Samana said. The euro was trading at 1.188 against the dollar early on Tuesday morning.

Lastly, analysts at Wells Fargo said that investors have become the most negative on the U.S. dollar since 2014, "which sets the stage for positive surprises in the U.S. dollar's favor in the second half (of the year)."

"The most important implications for investors at this point would be to reduce positions in commodities and developed-market debt towards our current tactical underweight stance," Wells Fargo suggested.

Wells Fargo believes that earnings growth in the second half of 2017 will be lower than in the first six months but suggests that four sectors are set to outperform the wider market: consumer discretionary, financials, health care and information technology.

"We recommend investors use any pullbacks as opportunities to average into shares of quality cyclical companies," the note said.