In 2009, the U.S. Federal Reserve introduced its Quantitative Easing engine, which injected significant liquidity into the monetary system and helped reaccelerate U.S. economic growth. With non-U.S. economies well behind in the economic cycle, the United States dominated global capital flows. From a foreign exchange perspective, the U.S. Dollar (USD) was the place to be.

But 2017 finally brought a period of synchronized global growth, as developed non-U.S. and emerging market economies have gotten their cyclical legs under them. With this development, capital flows have begun to shift, international currencies have started gaining on the USD, and recent talks of trade wars have brought currency fluctuations front of mind again.

How Do USD Moves Impact Equity Returns?

Since the mid-1990s, the world economy has rapidly globalized, affecting trade and capital flows. American companies have taken advantage of this trend, expanding multi-national business operations globally that are increasingly affected by the pulse of non-U.S. consumers. As that pulse quickens, demand for goods produced by these American companies increases, a dynamic that has evolved the relationship between USD moves and home country equity returns. The same dynamic does not yet exist in other, less globalized home country stock markets.

Looking back over the past 20 years, we identified short periods of abnormal USD strength and weakness within the slower-moving, longer-term USD cycle. Because equity factors have precise explanations for risk and return, we can analyze their performance during these short periods and develop return expectations for times when the USD accelerates more quickly than normal around a longer-term trend.

When the USD Is Strong, Defense Wins

During periods when the USD experiences swift strengthening, equity factor performance reveals defensive behavior among market participants. Companies with predictable business models, steady return streams, and low leverage tend to perform quite well. Conversely, stocks that are trading at a significant discount to the market and smaller companies tend to underperform during these periods as participants observe weakness abroad and potential income losses for American companies with an increasingly global reach. For this reason, participants tend to move defensively, seeking companies with low debt and steady business models as they anticipate decreased demand for U.S. goods and services from abroad.

In Weak Dollar Environments, Cyclicals Do Best

During weak dollar environments, factors that offer more cyclical exposure, such as value and size, tend to perform well. The reason: When international currencies gain on the USD, global risk appetite is generally rising and market participants are comfortable taking on increased risk at the stock level. In these environments, low volatility underperforms, as investors look to more opportunistic parts of the market at the expense of more stable corporations. The worst-performing factor during periods of rapid USD weakening is momentum. During these environments, when riskier stocks gain speed, participants abruptly abandon recent winners to chase these more cyclical parts of the market.

Spotlight on the Size Factor

One relationship worth exploring further is the performance of small companies during strong dollar periods. An analysis of revenue sources for large multinational and small companies might suggest that small companies should outperform when the dollar is strengthening. Large multinational companies generate more revenues abroad than small companies and, when the dollar reprices higher, foreign currency revenues are worth less. Meanwhile, small companies with domestically oriented business operations are less exposed to foreign currencies, and have less to worry about when the dollar strengthens. This relationship is confirmed by analyzing revenues for broad Russell indices: Approximately 70% of revenues for Russell 1000 Index companies come from inside the United States. That figure jumps to nearly 80% for the small-cap Russell 2000 Index.1

However, we saw weakness among small companies during our identified strong dollar periods, suggesting that weakening global risk appetite is more front of mind with investors than this revenue source effect. In fact, Exhibit 4 shows that, while there are times when the USD and small companies are positively correlated, this relationship has been highly inconsistent over the past 15 years.

What’s Next?

With international economies improving relative to the United States, capital flows have shifted in the direction of non-U.S. markets. Despite rising interest rates, USD weakening began in 2017 and has continued into this year. If the dollar weakens further, and with strong velocity, it may signal strong global risk appetite that could propel investors into pro-cyclical stocks, such as value or smaller companies. However, if the USD moves suddenly and swiftly higher, possibly because the Fed tightens interest rates at a quicker pace than the market expects, investors may take on a more defensive posture.

  1. ^Source: Factset, as of 2/28/18.