Barron’s – December 2, 2020
The dollar has weakened and could continue doing so. That has implications across various classes of stocks.
The U.S. Dollar Index (ticker: USDX) has fallen about 10.2% against a basket of currencies since March 18, the height of the market’s aggressive, fear-driven move into safe assets as the coronavirus pandemic set in. That trend has continued in the past month.
On Tuesday, the dollar slipped 0.3% against the yuan as the reading on China’s purchasing managers Index came in above estimates and above its previous reading. Meanwhile, the U.S. economic recovery is slowing and the ISM manufacturing index reading came in at 57.5, missing estimates of 58 and below the prior reading of 59.3. A reading above 50 indicates expansion.
It has been that type of trend—the U.S. economic recovery slowing while other economies gain traction—that has done the dollar in. Many on Wall Street expect more of the same.
“The relative growth advantage enjoyed by the U.S. in the near term is likely to fade as Covid-19 vaccinations raise global GDP growth prospects,” economists at Citigroup wrote. “This is likely to…generate dollar depreciation pressures.” Sure, vaccines will be a positive for the U.S. economy, but it will also boost other economies.
“Global economic recovery should benefit pro-growth currencies against the USD: The world is on the cusp of a major inflection point—a vaccine rollout and subsequent economic normalization—that we expect to prove positive for the currencies of exporters,” Mark Haefele, chief investment officer of global wealth at UBS, wrote in a note. “Dollar set for further weakness in 2021.” Haefele also mentioned that the dollar might lose some support as the Federal Reserve’s 2020 interest rate cuts have brought the U.S.’ Treasury yields to a lower premium over those of other countries. The difference in yield between the 10-year Treasury and the 10-Year German bund is now just 1.5 percentage points, a differential that has consistently trended downward from 2.1 points in January 2018. This dynamic makes the dollar less attractive against the euro.
Economists at Capital Economics also cite economic momentum abroad as a dollar headwind.
To be sure, one reason the U.S. recovery has slowed is because Covid-19 cases have soared since October, spurring new lockdowns, while Eurozone cases have declined sharply since mid-October.
If the dollar keeps weakening, this could act as a drag on U.S. small-cap stocks that have recently enjoyed an impressive run.
Case in point: Between Dec. 1, 2016, and March, 1, 2018, the U.S. Dollar Index fell 10%. At the same time, the Russell 2000, an index of small-caps, underperformed the S&P 500, rising 13% against a 22% gain. That is because large companies that make up the S&P often derive more of their revenue abroad, and a weaker dollar means they pocket more money when converting foreign-currency revenue into dollars than when the dollar is stronger. Small companies, on the other hand, generate more revenue at home. Plus, when they have to import materials they have higher foreign-currency costs, while larger companies have sophisticated currency hedging strategies against that occurrence.
Still, the Russell 2000 has outperformed the S&P 500 from Sept. 23—the beginning of a fresh stock market rally—through Tuesday. The former is up 26% against the latter’s 13.3% gain. That is because the economic momentum over than span and vaccine announcements have brightened the economic outlook significantly, which benefits smaller companies more, as those companies are more endangered when the economy sinks and more revived when it stabilizes. Currencies are just one part of the equation.
As for a weakening dollar and small-caps going forward, “over time, it’s something to watch,” said Wedbush Securities analyst Chris Svezia, who covers several U.S. small-cap brand apparel companies. He mentioned Calares (CAL), a $450 million, by market cap, footwear maker, has risen 19% since Sept. 23, but Svezia acknowledges it is somewhat sensitive—negatively so—to a weakening dollar. The company derives 93% of its revenue from the U.S. and sources more than one-third of its materials from China, making the cost of importing higher when the dollar is weaker.
Consistent with this dynamic for small-caps, analysts of large-cap stocks point out that a strengthening dollar is a notable risk to their stocks. Morgan Stanley says one key downside risk to Philip Morris International (PM), with a market cap of $118 billion, is a strengthening dollar. The company draws revenue from four continents and more than 40% from Europe. A weakening dollar is a tailwind to Philip Morris.
These analysts also say a 5% pop in the dollar would meaningfully contribute to their downside case on the $83 billion Mondelez International (MDLZ). Importantly, in order for the full 48% downside on the stock to be achieved, pricing and volumes in emerging markets would have to fail to recover from pandemic lows and operating profit would have to slow to 1.5% year-over-year growth from a current estimate of 5.5% for 2021.
A weakening dollar would also have negative implications for growth stocks. As is typical in bullish economic environments, value stocks hold their own against growth. The Russell 1000 Growth Index has risen 12% since Sept. 23, lower than the index’s value counterpart, which is up 16%. “If the dollar weakens that could trigger a disruptive decline in Growth relative to Value,” Barry Bannister, Stifel’s head of institutional equity strategy, wrote in a note. His chart shows that, since 1995, as the dollar has weakened, so have growth stocks’ performance against value. That is consistent with a strengthening view of the global economy.
If the dollar weakens, be aware of its impacts, but also be cognizant of the other market forces.
By Jacob Sonenshine
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
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