While the dollar’s relationship with the economy as a whole is relatively “murky,” the relative performance of U.S. and foreign equities against the dollar is more distinct, writes Ritholtz Wealth Management’s Ben Carlson in a recent Bloomberg article.
“When you own shares from other countries around the globe, the diversification benefits come mainly from your currency exposure,” says Carlson. That is, he explains, unless you are hedging against currency risk, you are exposed to exchange rates when converting back into dollars.
From the perspective of a U.S. investor, stocks tend to outperform international equities when the dollar is strong, and international stocks tend to outperform when the dollar is weak:
A stronger dollar, Carlson says, “tends to lead to weaker sales overseas” and the converse is also true. So, he argues, when the dollar is weak you can expect international stocks to outperform U.S. equities since foreign currencies will be appreciating and your investments in those countries will get “more bang for the buck in terms of earnings and dividends.” [Carlson notes, however, that short-term currency fluctuations tend to “cancel each other out over the long-term.”]
Given that U.S. stocks valuations are now higher than in most foreign stock markets, Carlson argues that if the dollar weakens we could see “substantial outperformance of foreign stocks in U.S. investor portfolios.”