The firm’s Q4 Market Outlook says fears of a US recession earlier this year, driven by policy uncertainty and volatility, have weighed on the reserve currency.
“Although these fears proved unfounded with growth remaining resilient, persistent hedging against the greenback suggests lingering aversion to dollar exposure,” the report said.
Principal Asset Management (PAM) said the US dollar’s share of global reserves continues to erode amid rising institutional concerns, and that both cyclical and structural factors suggest further weakness is likely.
“The USD may have further to slide amid institutional concerns and growing global interest rate differentials,” the report said.
Meanwhile, concerns remain over the credibility and independence of US institutions, including the Federal Reserve, which PAM believes has also contributed to the dollar’s demise.
“Lingering concerns around US institutional stability and its geopolitical posture may have structurally weakened the US dollar.”
“In addition, as Chair Powell’s term nears its end, renewed scrutiny of Fed independence could reinforce bearish dollar sentiment,” the report noted.
A combination of diverging global monetary paths – including the ECB nearing the end of its cuts, the BoJ hiking, and the Fed easing – points to further US dollar downside, according to PAM.
“In conjunction with these cyclical and structural dynamics, gold’s surge reflects its appeal as a hedge against both US policy uncertainty and upside inflation risks,” the report said.
Despite this, PAM is confident the US dollar’s position as the world’s reserve currency is secure.
Tariffs will deliver a “one-off modest inflation shock in the US”, it said, keeping core CPI near current levels before easing slightly in late 2026.
“The risk of a more sustained inflationary episode cannot be ruled out, which may prompt the Fed to adopt a more cautious approach to easing.”
The fresh report does not take into account President Donald Trump’s recent move announcing plans to implement 100 per cent tariffs on imports from 1 November in response to new export curbs on China’s rare-earths industry. President Trump has since indicated he would take a softer approach, while Beijing has accused the US of hypocrisy.
While the introduction of US import tariffs was expected to weigh heavily on the global economy, PAM admits growth has held up relatively well. However, early 2025 policy disruptions have left lasting marks on economies.
“Tariffs are reshaping global trade dynamics, likely keeping inflation elevated and persistent,” the report stated.
PAM believes tariffs are likely to move higher as the administration shifts toward a more sector-focused approach, stabilising above early-2025 levels but remaining well below the peaks seen after Liberation Day in April.
“While tariff-related noise will persist as they are deployed as a negotiation tool, their overall drag on growth has been largely contained,” the report noted.
The offsetting forces of tariff increases and fiscal tax relief are predicted to be broadly “growth-neutral” through 2026.
“Tariffs have nudged inflation slightly further above target in recent months to around 3%, with the impact most visible in core goods,” the report said.
Meanwhile, rising global fiscal concerns are threatening to keep long-term government borrowing costs elevated, limiting the scope for future fiscal stimulus and potentially undermining the effectiveness of monetary policy.
“The near-term picture is robust, but underlying vulnerabilities are forming,” the report said.
Despite “dire” post-Liberation Day fears, Principal said the US economy has proven broadly buoyant.
“Apart from the labor market, broad US economic data has been resilient. Stimulative policy could revive broader economic indicators,” the report said.
“Robust consumer spending and capital expenditures have been key drivers of economic activity, with AI-related investment emerging as a significant growth engine.”
PAM said that forecasts originally anticipated a rise in headline CPI inflation to around 3.5 per cent by year-end. However, the inflation pass-through has so far been more muted than anticipated, likely due to a combination of margin compression, inventory front-loading, and trade diversion.
“While these factors have helped cushion the initial impact, they are inherently temporary. As inventories deplete, trade routes narrow, and margins continue to shrink, firms may be forced to pass on higher costs to consumers. As such, upside risks remain. If pricing pressures spill over into services, it could signal a broader and more persistent inflationary trend,” the report said.
“Inflation pressures from tariffs have remained surprisingly limited in aggregate so far, but it’s still too early to completely dismiss their eventual impact.”
In resuming its rate-cutting cycle, Principal Asset Management said the Fed is responding primarily to signs of weakening labor demand.
But chief global strategist Seema Shah believes the Federal Reserve does not need to cut policy rates below neutral yet.
“Resilient US growth and persistent inflation pressures are likely to prevent the Fed from easing policy aggressively. At the same time, the One Big Beautiful Bill Act and recent deregulatory measures point to mildly stimulative fiscal policy in 2026,” she said.
The firm is anticipating a total of three 25bps cuts this year, followed by further easing in 2026.
“Overall, this should be a gentle cycle, offering enough stimulus to stabilise the labor market and support more vulnerable sectors,” the report noted.
“The apparent softening in the jobs market appears to have prompted a pre-emptive move to prevent further deterioration, with September’s rate reduction likely marking the start of a sequence of cuts.
“It’s worth noting that Jerome Powell’s term as Fed chair ends in May 2026. Given President Trump’s preference for a more dovish FOMC, rate decisions for 2026 may lean dovish – regardless of whether the macro backdrop warrants it.”
Globally, a common concern across major economies is deteriorating fiscal health, steepening yield curves, and tightening financial conditions despite rate cuts.
“While not at crisis levels, without serious reform, fiscal issues may weigh on long-term growth,” the firm said.
As for equity markets, they may still have further upside, supported by policy and AI-driven capex.
“The Fed’s non-recessionary rate-cutting cycle underpins a constructive outlook for 2026 U.S. earnings and equity performance. U.S. small-caps and segments of global markets offer compelling valuations and solid fundamentals,” Shah said.
Principal Asset Management believes it’s key for investors to focus on balance and diversification.
“The outlook for risk assets remains constructive, but stretched valuations underscore the need for balance and diversification. Opportunities may be found among second-order beneficiaries of major investment themes, attractively valued global markets, and selective private market exposures,” she said.
