The Dollar Is Evening Out

Have you heard? The dollar has weakened, prompting all sorts of talk about what comes next for the global economy. Some point to the implications for Emerging Markets currencies, breathing a sigh of relief that central banks throughout developing Asia and Latin America can ease off rate hikes. Others spout age-old myths about currency moves’ impact on economic growth and trade. And of course, just about everyone is trying to divine what the dollar will do over the next two, three, four, five or more years. We think that is a misguided effort, not least because currency moves are typically tied to interest rates, which central bank moves influence, which are unpredictable. Mostly, the dollar’s slide this year just reverses its rise during last year’s bear market, which (as usual) spurred a flight to quality. But that raises an interesting point about how currencies and stock markets intersect.

Currencies aren’t a stock market driver, per se. Stocks have done well and poorly during periods of dollar strength and weakness alike. US stocks have also outperformed and trailed non-US stocks during strong-dollar and weak-dollar stretches. Yet currency moves do affect portfolio returns. When US investors own international stocks, their return is the stock’s return in its home currency plus or minus the currency’s move against the dollar. When the dollar strengthens, it detracts from returns on international securities. When the dollar weakens, it adds—you are getting the stock’s return plus the other currency’s appreciation.

Last year, the dollar detracted to such a degree that global stocks didn’t even hit bear market territory (down -20% from the high) in euros, British pounds and other currencies. Not only did international stocks not hit bear market territory in local currencies, but international investors’ returns on US stocks got a strong-dollar buffer. But for Americans, the strong dollar subtracted over 12 percentage points from international returns during the bear market. Exhibit 1 shows this, displaying MSCI World Ex. USA Index returns in local currencies and USD, both indexed to 100 at the bear market’s beginning. At the October 12 low, the index was down -15.1% in local currencies versus a painful -27.5% in USD.^[i] Ouch.

Exhibit 1: The Strong Dollar’s Downside

Source: FactSet, as of 7/18/2023. MSCI World Ex. USA Index returns in local currencies and USD with net dividends, 1/4/2022 – 10/12/2022. Indexed to 100 at 1/4/2022.

This has reversed during the young bull market. As Exhibit 2 shows, international stocks in US dollars have outperformed returns in local currencies from the outset, with the margin widening as the dollar weakened. Through Monday’s close, the MSCI World Ex. USA Index was up 19.4% in local currencies and a whopping 33.1% in dollars.^[ii]

Exhibit 2: The Weakening Dollar’s Upside

Source: FactSet, as of 7/18/2023. MSCI World Ex. USA Index returns in local currencies and USD with net dividends, 10/12/2022 – 7/17/2023. Indexed to 100 at 10/12/2022.

As a result, the new bull market has erased most of the bear market’s currency effect. Most of what the dollar took during the downturn, it has now given back. You can see this narrowing for yourself in Exhibit 3.

Exhibit 3: Currency Effects Are Evening Out

Source: FactSet, as of 7/18/2023. MSCI World Ex. USA Index returns in local currencies and USD with net dividends, 1/4/2022 – 7/17/2023. Indexed to 100 at 1/4/2022.

We have seen some commentators argue this is a good reason to load up on international stocks now. We get the enthusiasm, but we think the logic is flawed. For one, US stocks make up over two-thirds of global market capitalization. If you hold much less than this, that is some pretty big country risk. Two, markets outside the US have some significant blind spots to Tech and Tech-like industries within Communication Services and Consumer Discretionary. Sector fundamentals matter a lot to country returns, and if you let currency factors dictate your regional positioning, you risk getting pretty far afield of what is most important. Note that even with currency effects, US stocks have outperformed international markets in US dollars plenty of times during bull markets. Currency factors play into relative returns but are far from the sole or even main driver.

Lastly, as this article demonstrates, currency effects tend to even out over time. In our view, success isn’t about chasing them, but about staying disciplined to reap that evening-out. Trying to chase them basically amounts to chasing your tail in circles, forever repositioning based on what just happened without any regard to forward-looking fundamentals.