Whether it was by luck or by design, if you had the foresight to hold onto your old vinyl records while everyone else was selling theirs for pennies, you’re undoubtedly pretty happy now. Likewise, investors who have continued to hold onto their international equities despite a decade of underperformance may be on the cusp of finally being rewarded for their patience thanks to a weakening dollar.
For a variety of intricate reasons, non-US stocks have tended to outperform domestic equities during nearly every recent period of dollar weakness. Conversely, periods of relative dollar strength have tended to favor domestic outperformance. The 5-year monthly rolling returns for US versus international equity returns between 1975 and 2020 illustrate this notable correlation (FIGURE 1).
International Equities Have Tended to Outperform When the Dollar Is Weak
US Equity vs. International Equity 5-Year Monthly Rolling Returns
Sources: Morningstar, FactSet, Russell, MSCI, and Hartford Funds, as of 12/31/20. US Equity is represented by S&P 500 Index. International Equity is represented by MSCI World ex USA Index. The chart shows the values of the S&P 500 Index’s returns minus the MSCI World ex USA Index’s returns. When the line is above 0, domestic stocks outperformed international stocks. When it is below 0, international stocks outperformed domestic stocks. Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. For illustrative purposes only.
Figure 1 also shows that the dollar’s relative value has gone through a series of multi-year bull-and-bear cycles dating back to the early 1970s. The dollar (as measured by the DXY US Dollar Index) has had three long-term cycles of weakness since 1970 (1970-1980, 1985-1995, and 2003-2011) as well as an equal number of strong-dollar cycles (1980-1985, 1995-2003, and 2011 to early 2020).
But there are signs the dollar’s most recent bout of weakness may be providing fresh momentum for cyclical, international, and emerging-market equities. With COVID-19 vaccines fueling optimism for a worldwide economic recovery, some investors may now find themselves tempted to take a closer look at foreign opportunities at a time when other nations’ currencies are rising in value versus the dollar.
It's safe to say that one currency's weakness logically becomes a rival currency's strength.
While most economists wisely caution against simplistic explanations for the cyclical nature of international outperformance, it’s safe to say that one currency’s weakness logically becomes a rival currency’s strength. For example, the same weak US dollar that raises the price of foreign imports for US customers (think German cars or French wines) is also likely to lift the purchasing power for holders of foreign currencies—at least for those consumers and companies that happen to be in the market for US imports priced in dollars.
Likewise, US investors in foreign assets can directly benefit from currency fluctuations. If, for example, a hypothetical US investor were to buy 100 shares in Nestle S.A. for 100 Swiss francs (CHF) apiece at an exchange rate of $1.05 per CHF, the investor’s stake is initially worth USD$10,500. But when the dollar weakens, making the Swiss franc equal to $1.13 (while the Nestle share price stays the same), the investor’s initial 10,000-Swiss-franc investment is now worth USD$11,300—a gain of USD$800.
It’s often difficult to pinpoint the precise impact of currency fluctuations on the profits of foreign companies. Global supply chains, varied product offerings, uneven exposure to dollar-denominated trade, and currency-cost hedging strategies all have an impact on company profitability. That said, investors who in the past have paid attention to the dollar’s historical value cycles have often benefitted from allocations to international and emerging-market equities (see FIGURE 2).
|The Dollar's Impact on Equity Asset Classes 2001-2021
Average Annual Net Returns (%)1
|Equity Asset Class||Strong Dollar||Weak Dollar|
|S&P 500 Index2||5.43||13.49|
|MSCI EAFE Index3||-2.67||18.04|
|MSCI ACWI ex USA Index4||-3.06||20.69|
|MSCI Emerging Markets Index5||-2.38||33.23|
Source: MSCI and Hartford Funds. See bottom of page for index and net-returns definitions.
The Dollar: Past, Present, and Future
Notably, as the US economy recovered from the Global Financial Crisis (GFC), investors flocked to the relative safe haven of the US dollar, boosting its value. But the coronavirus pandemic prompted the imposition of rock-bottom interest rates by the Federal Reserve (Fed), helping to knock the dollar on its heels by more than 10%. As the Fed lowered interest rates, investors searched for better yields from alternatives to US bonds.
With the Fed currently committed to continued low interest rates for an indefinite period, and with the Biden administration pushing a Democratic-controlled US Congress for trillions of dollars in stimulus and infrastructure spending, investors have already started bidding up the value of more risk-on global currencies, putting greater downward pressure on the dollar.
One important question for investors: Did last year’s drop in the dollar represent the start of a new five- to 10-year weak-dollar cycle? A number of analysts think it’s a strong possibility.
“I believe the dollar will continue to weaken,” says Nanette Abuhoff Jacobson, managing director and multi-asset strategist at Wellington Management Company LLP and global investment strategist for Hartford Funds.
“I believe the dollar will continue to weaken,” says Nanette Abuhoff Jacobson, managing director and multi-asset strategist at Wellington Management Company LLP and global investment strategist for Hartford Funds. As in other recent weak-dollar investment cycles, Abuhoff Jacobson foresees more capital moving to risk-on markets such as Brazil, Europe, China, and Japan. Corporate borrowers in some of these countries have been using US debt extensively to finance their economies; a weak dollar now makes those loans less expensive to repay—providing a modest updraft to their bottom lines.
Weak Dollar-Strong Dollar: There Are Benefits to Both
|A Strong Dollar Benefits...||A Weak Dollar Benefits...|
|Non-US investors in US capital markets||US investors in foreign markets|
|Domestic- and foreign-based companies that sell mostly to US-based consumers||Emerging markets with US debt|
|US buyers of foreign goods and services||Big multinational companies|
|Investors in US fixed income||Countries that export commodities|
|US tourists traveling abroad||US employment|
It should be noted, as the post-GFC era showed, that the dollar remains the world’s foremost reserve currency and continues to be the safe harbor of choice in times of significant turbulence.
That said, the current dollar slump may be providing a rare opportunity for active managers who know where to find the potential international equity winners in a world eager to move past the pandemic.
US Investors Are Underweight International Equities
Source: Investment Company Institute. As of 12/31/20.
And here's one more reason investors may want to consider increasing allocations to international: The typical US portfolio exposure to international equities sits at just 13% (FIGURE 4). A weaker dollar could be the tailwind international equities need to finally catch up to US equities after a decade of underperformance.
View more timely international insights in our Market Perspectives section.
Hartford Funds 4- and 5-Star International Funds
1 Net returns reflect reinvested dividends net of withholding taxes but reflects no deduction for fees, expenses, or other taxes.
2 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. Indices are unmanaged and not available for direct investment.
3 MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted-capitalization index that is designed to measure developed market equity performance, and excludes the US and Canada.
4 MSCI ACWI ex USA Index is a broad-based, unmanaged, market capitalization-weighted, total return index that measures the performance of both developed and emerging-stock markets, excluding the US.
5 MSCI Emerging Markets Index is a free float-adjusted market capitalization-weighted index that is designed to measure equity market performance in the global emerging markets.
Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic, and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets or if a fund focuses in a particular geographic region or country.
Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.