Dollar Diversification: Why Now?

The United States buys more from other countries than it sells to them, creating a gap called an external deficit. To fund that deficit, it requires significant inflows from foreign investors. That has not been problematic over the last decade due to the attractiveness of U.S. markets. However, if that were to structurally change, the result could be a weaker dollar and reduced U.S. asset outperformance. We saw this play out in the UK back in 2022 as it faced financial stability concerns.

That shift in portfolio holdings and currency allocations won’t happen overnight though. U.S. dominance has been the theme of the post-financial crisis era, and has seen the U.S. weighting in the MSCI World rise to its highest on record. Foreign investors have also been hedging a smaller portion of their currency exposure among those U.S. holdings.

Therefore, it is important to differentiate between the investors that are driving the dollar’s recent moves: 1) speculative traders that have been selling the dollar so far this year, and 2) institutions and other ‘real money’ investors shifting their structural allocations.

To the latter point, recent flow data had showed that while domestic investors have bought the dip in stocks, foreign investors have been selling U.S. equities at a record pace – surpassing even the COVID shock¹. And it’s not just stocks. International investors (especially in Europe) have broadly been selling U.S. assets in an atypical way. That said, we don’t think the dollar’s status as the global reserve currency is at risk any time soon, but a continuation of that asset rotation could turn the current cyclical downturn in the dollar into a more structural weakening.

For context, previous sustained periods of dollar weakness (1970-80, 1985-92, 2002-08) have typically resulted in a 40% depreciation over a 5-10 year period. We aren’t saying that is on the horizon today, but we want portfolios to be positioned accordingly in the event that it materializes. 

The U.S. economy and markets have outperformed for a number of years. This has built up large U.S. and dollar weightings in portfolios over time, often without investors even knowing.

2025 has highlighted the potential risks this can pose. Consider an investment made into a global portfolio with 60% equities and 40% bonds at the start of this year. For a euro-based investor that had not considered their currency exposure, that portfolio would be down more than -10% in local currency terms as of April 10^th. However, if they had hedged the investment back to euros, those losses would be cut in half to around -5%. Still not a good outcome, but certainly a less bad one.

With our view that the risks to the dollar are now skewed to the downside, we think that investors (particularly those who think of their wealth in another currency) should revisit their currency allocations as part of an overall goals-based plan.

Each situation is different depending on an individual’s day-to-day spending needs. However, from a pure diversification standpoint, we look to central bank reserves as a starting point. Like many investors, central banks have very long time horizons, a primary objective to preserve purchasing power, and a priority for liquidity and safety while also seeking out some return. With nearly $13 trillion in assets under management, their bias is to have a higher allocation to currencies with deep, liquid financial markets that have a large universe of investable assets. Their largest non-U.S. dollar allocations are to gold and securities denominated in euros, Japanese yen and British pounds, along with a few others for diversification purposes like the Chinese renminbi, Swiss franc, Australian dollar or Canadian dollar.

We might consider a larger weighting towards alternative reserve currencies with a lower correlation to global growth. To that end, we think that the euro and Japanese yen are the most obvious candidates to benefit from a rotation of U.S. portfolio holdings. European investors, for example, hold north of $4.5trn in U.S. corporate stocks as of November 2024. 

We also think that gold can continue to act as a good diversifier against dollar weakness as it has done historically. Given its nature as a physical store of value, gold has grown in popularity as geopolitical tensions have flared. For individual investors though, the metal’s nature as a non-yielding asset means that considering the importance of income in a portfolio is crucial when deciding upon an appropriate allocation.

There is no perfect way to go about diversifying currency exposure. However, for illustrative purposes, from a starting point of a 100% dollar portfolio, we might consider building towards a non-dollar exposure of 30% over time. That’s roughly in line with the non-U.S. exposure in the MSCI World.

We would allocate the greatest portion of that 30% into euro-denominated securities, where we see opportunities across both the equities and fixed income space. Outside of that, the next largest allocations would go towards gold as mentioned above (either in physical format or other) and the Japanese yen (considering select equity opportunities). The remaining holdings would be smaller in nature, but could provide some much-needed diversification with higher yields.

There is no perfect way to go about diversifying currency exposure. However, for illustrative purposes, from a starting point of a 100% dollar portfolio, we might consider building towards a non-dollar exposure of at most 30% over time, but it depends on the client’s situation. That’s roughly in line with the non-U.S. exposure in the MSCI World.

We would suggest allocating the greatest portion of that allocation into euro-denominated securities, where we see potential opportunities across both the equities and fixed income space. Outside of that, the next largest allocation to consider could go towards gold as mentioned above (either in physical format or other) and the Japanese yen (considering select equity opportunities). The remaining holdings can be smaller in nature, but could provide some much-needed diversification with higher yields.

With a potential softening trend for the U.S. dollar materializing looking forward, it is reasonable to consider how heavily weighted portfolios are to the United States. We think that complementing U.S. exposures with global asset and currency positioning makes sense in this environment.

Please do not hesitate to reach out to your J.P. Morgan team to discuss what this means for you.