2015 might go down in history as the year of the dollar. Whether causal or coincidental, the movement of the dollar has been front and center in characterizing the movements of equity markets this year, particularly in the US and Europe. While the effects on broader US and European markets seem relatively straightforward, as a depreciating home currency is generally seen as a positive for domestic markets due to the increased competitiveness of their goods and vice-versa for a strengthening currency, currency movements can also have interesting effects where the relationship may be less obvious. To wit, the effect the EUR/USD exchange rate has had on the relative performance of US small caps versus large caps this year. Although the year-to-date returns of the Russell 2000 and the S&P 500 are very similar (4% vs. 3.2%, respectively, through the end of May), their paths have not been consistent. Beginning in March, we observed that the EUR/USD exchange rate was affecting small caps and large caps differently.
Source: Bloomberg, PAAMCO, Dow Jones Industrial Average Total Return Index, S&P 500 Total Return Index, Russell 2000 Total Return Index, Euro/USD Exchange Rate
Although the euro weakened considerably in January, the currency did not appear to have an effect on the relative performance of the major US indices until early March, when small cap stocks as measured by the Russell 2000 showed marked outperformance following the March unemployment report. The strong employment report signaled robust US growth, and therefore increased expectations for hawkish action from the Fed. This manifested itself in the currency markets as a stronger dollar and weaker euro. The weaker euro is thought to have a disproportionately larger effect on the sales of large cap US companies than small cap US companies. The oversimplified explanation is that large cap companies in the US have more exposure to Europe given their larger footprint, while small cap companies are more levered to US domestic growth. That the outlook for US domestic growth was deemed to still be strong was seemingly confirmed by the strong unemployment report. This relative outperformance of small caps ended by late April, as the exchange rate returned to its pre-March levels, following a disappointing 1Q15 GDP reading. The reading reversed the market’s expectations for a hawkish Fed, which in turn weakened the dollar, which had a larger positive effect on large cap stocks. At that point, small caps and large caps were back to performing relatively in line with each other.
In mid-May, however, once again we saw small caps begin to outperform as the dollar began to strengthen again. As of the time of this writing (June 8, 2015), the dollar has approached the highs reached in March. The latest move has been spurred on by the decision by the ECB to front-load some of its QE, combined with the release of minutes from the Fed that showed that many members thought the weak Q1 GDP numbers to be transitory. The combination of an increasingly accommodative ECB with a still hawkish Fed led to a reversal of the weakening dollar with a sharp downturn in the euro. This once again hit large cap stocks more than it hit small cap stocks.
What does this mean?
We are not attempting to make broad market calls on either the movement of the dollar or the significance of the EUR/USD exchange rate. What we can observe is that a factor which up until a few months ago had relatively little importance has emerged as a very significant factor in the US equity markets.
While it may be noted that many companies hedge short-term currency exposure and that therefore the link between equity market performance and currency is debatable, during very short observation periods and in times of large moves, the market does not always discern which firms have hedged and which have not. Additionally, the relationship may indeed be becoming more fundamental and long term. At the risk of stating the obvious, the hedges put in place by companies are only good until they expire. This leaves most companies exposed to longer-term directional moves in currency markets, such as the continual rally in the dollar that has been observed since May of last year. Once the hedges expire, the companies must face the new fundamentals within the market, which in this case is the lost competitiveness of goods created in dollars and sold in euros. For this reason, longer-term currency movements can significantly change the outlook for a company’s ability to generate sales and also can result in fundamental changes in a firm’s operations. Both of these factors can lead to a diminished outlook for the future profits of companies selling into a deprecating currency.
Regardless of the nature of the relationship, currency moves do appear to be affecting large cap and small cap stocks in the US differently. While some investors may have benefited from being long the dollar this year, albeit to a much lesser extent in April, we do not recommend relying too heavily on one risk factor to generate performance . The movement of the EUR/USD exchange rate and the changing of its importance illustrate the utility of having a well-diversified portfolio that has “many ways to win.”
Andrew Ross, CFA, CQF, FRM, CAIA , is an Associate Director at PAAMCO. He is actively involved in the top-down strategy and asset allocation for the firm’s flagship Moderate Multi-Strategy portfolios. He previously served as the chairperson of the Portfolio Solutions Group where he assisted in the portfolio construction of custom account mandates. Andrew began his career at PAAMCO focusing on investments within corporate and consumer credit with an emphasis on structured opportunities as well as fixed income strategies.
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