“American investors have been the largest dollar diversifiers over the last decade,” said UBS’s Syed Mansoor Mohi-uddin in a new research note.
“That has cut US home bias to historically low levels,” he continued.
However, he also observed that investor capital going into foreign markets have leveled out since the financial crisis.
More recently, decelerating growth in the emerging markets led by slowing growth in China seems to have investors spooked about investing in these once high-growth regions.
Massive capital outflows from these markets are causing various emerging-market currencies to see their values tumble. And the prospect of normalizing U.S. monetary policy, which means a stronger dollar and higher interest rates, only seems to be making things worse.
Emerging market crises and capital outflows are not a new phenomenon. Mohi-uddin reviews past instances where crises collided with capital flowing back to the U.S. From the note:
In the early 1980s and late 1990s, US bond fund managers sharply cut the proportion of foreign assets in their portfolios as higher US interest rates at home and crises in emerging markets reduced the attractiveness of investments abroad.
The 2008 financial crisis and the start of the Eurozone debt crisis from 2010 has also led episodes of US investors pulling back from foreign markets over the last few years. But with the Fed setting interest rates almost at zero since the end of 2008, domestic fund managers have still largely kept the proportion of foreign assets in their portfolios at high historic levels over the last years as Figure 4 shows…
“This year’s weakness in emerging market and commodity currencies suggests US investors may be starting to shift capital back home in anticipation of tighter monetary policy,” he said.
Unfortunately, the Federal Reserve’s data on these flows come once per quarter and on a two-month lag. So we won’t know what happened until well after the fact.
Mohi-uddin doesn’t expect inflows back to dollar-denominated assets to lead to major home bias in investor portfolios. However, he does believe these flows will lead to a stronger dollar.
“In short, increased home bias would strongly impact our already bullish dollar forecasts,” he said. “We expect the euro to end 2014 at 1.25 and the yen at 110 against the greenback. Renewed repatriation as occurred in the early 1980s and late 1990s would cause the dollar to overshoot our targets for this year.”