How the Prolonged Dollar Slide Reshapes the Investment LandscapeBy
U.S. multinationals outpace small caps as FX turns to tailwind
Emerging markets, commodities boosted by greenback weakness
It’s been seven months since the dollar surged to the highest level since at least 2005 -- long enough for the prolonged bout of weakness in the world’s reference currency to reshape the trading landscape.
The reasons behind the dollar’s swoon have been analyzed at length. Here’s a look at how the softer greenback has forced investors in markets from equities to emerging assets and commodities to rewrite their trading theses.
A softer dollar boosts the purchasing power of overseas customers looking to pick up American-made goods and increases the value of profits that U.S. companies earn abroad. That’s shown up in the earnings and share prices of large, internationally focused companies.
A Goldman Sachs basket of stocks with international exposure has beaten its domestically oriented peer by about 11 percentage points in 2017. It’s on course for the best year of outperformance since 2009. Similarly, the S&P 500 Index is beating the Russell 2000 Index of small caps by five percentage points.
The dollar’s 3.2 percent slide in the second quarter was a boon to multinational companies’ bottom lines, according to Savita Subramanian, Bank of America’s head of U.S. equity and quantitative strategy.
“Two times as many mega caps have positively surprised versus the smallest stocks, and earnings for the small cap benchmark are coming in below expectations (where analysts already expected a year-on-year earnings decline), with less than 30 percent beating on earnings per share and sales,” she wrote in a note to clients.
The inverse has been true in the rest of the developed world, where firming economic growth prospects have driven currency gains. European analysts have trimmed earnings estimates, citing the strong euro’s impact on overseas earnings and exports.
Resources denominated in dollars quite naturally have benefited from the greenback’s weakness, though strengthening demand from China hasn’t hurt. Industrial metals have surged to the highest since 2015, led by copper and iron ore. And crude briefly reclaimed the $50-a-barrel mark even as signs mount that a global glut is showing few signs of abating.
That’s lured equity investors in droves -- Bank of America Merrill Lynch’s clients poured $212 million into energy equities, primarily mid-caps, for the week ending July 24. They’ll be rewarded if the dollar continues to weaken, according to Jim Paulsen, chief investment strategist at Leuthold Group.
“Should the U.S. dollar break below its recent trading range, it seems likely the price of crude oil will rise toward $60 at least and energy stocks could be market leaders again for a period,” he wrote in a client note Aug. 1.
The dollar’s swoon hasn’t had as clear an impact on the global bond market -- not altogether unsurprising since currencies are driven by interest rate differentials, giving bonds the leading role.
While some have argued that a weak dollar may export deflation to the rest of the world, boosting bonds abroad, that notion “gets precisely backwards domestic inflation dynamics and the links between dollar strength or weakness and global activity,” said Bespoke Investment Group macro strategist George Pearkes.
Instead, local currency gains versus the dollar lead to a lending boom, according to Hyun Song Shin, head of research at the Bank for International Settlements.
“When the local currency appreciates, local borrowers’ balance sheets become stronger, resulting in lower credit risk and hence expanded bank lending capacity,” he said in a 2014 paper.
Neil Dutta, head of U.S. economics at Renaissance Macro Research, similarly suggests that dollar weakness that makes Treasuries more attractive to overseas buyers will ultimately boost yields abroad.
“The causality runs from U.S. to the rest of the world,” he said. “So, if a weak U.S. dollar pushes up U.S. yields through growth and inflation effects, I’d think global yields rise too."
Currency weakness serves as a double dose of good news for domestic corporate bonds -- evident in spreads that have tightened to near-record lows.
First, foreign buyers are showing an increased appetite for the asset class -- which had recently been dominated by domestic investors -- as American corporate debt goes on sale.
And the unexpected boon to commodities has offered relief for what had recently been the sick man of the corporate debt world -- energy bonds.
Nowhere has the dollar’s weakness been met with more investor enthusiasm than in emerging markets. Five straight monthly drops for the greenback have led to an equal streak of gains in developed-nation stocks, pushing MSCI Inc.’s measure to the highest since 2014. It wasn’t meant to be that way, of course, with Trump’s America First agenda expected to promote protectionism that would roil emerging markets.
Instead, government debt from South Africa to Brazil has also enjoyed a strong run, since a falling greenback means lower costs to service any bonds denominated in dollars -- though the benefit has been lessened since the mid-1990s as governments hedge the exposure.
“A weaker dollar means easier financing conditions, especially for EMs, who are effectively short the dollar,” Pearkes said.
It’s also expected to contribute to the next leg of the emerging bond rally by giving some central banks more room to ease policy.
“A weaker dollar -- and therefore stronger local currencies -- has helped provide a cap to local inflation. That has kept inflation expectations low locally, which has been supportive for bond prices,” said Mike Moran, head of economic research for the Americas at Standard Chartered Plc.
— With assistance by Lu Wang, Tracy Alloway, Rita Nazareth, Isabella Cota, George Lei, and Aline Oyamada