- The dollar’s ongoing weakness looks highly likely to drive a reversal in the outperformance of U.S. stocks relative to the rest of the world that has taken place since 2008.
- The continued outperformance of U.S. equities in the face of the dollar’s decline reflects two factors: the incredible outperformance in corporate fundamentals in local currency terms, and near-record valuation multiples.
- We expect this recent breakdown in correlation to prove temporary as a slowing of revenue growth in the U.S. causes investors to reassess the growth potential in U.S. stocks.
- The last time the valuation divergence between the U.S. and international stocks was as wide as it is currently, the latter outperformed by double-digits on an annual basis for a decade.
The dollar’s weakness has transformed from a counter trend pullback to a fully-fledged bearish trend, with the strength in both developed and emerging market FX showing no signs of ending. The dollar’s weakness looks highly likely to drive a reversal in the extreme outperformance of U.S. stocks relative to the rest of the world that has taken place since 2008. We believe there is a generational opportunity in being short U.S. stocks and long a basket of international stocks. As we argued in April (see ‘The Clock Is Ticking On U.S. Outperformance‘) we expect double-digit annual total return outperformance in international stocks over the next decade.
Dollar Weakness A Major Headwind For Continued Equity Outperformance
The relative performance of U.S. stocks versus the rest of the world tends to in part track the performance of the U.S. dollar. The chart below shows the strong correlation between the U.S.’ share of the MSCI World and the U.S. dollar index since the 2008 low. While a stronger dollar may undermine U.S. corporate overseas revenues relative to the rest of the world, the direct impact of a stronger currency tends to dominate. This has been the case for the majority of the past 13 years, but the past few months have seen a sharp drop in the dollar fail to dent the trend of U.S. equity outperformance.
The continued outperformance of U.S. equities in the face of the dollar’s decline reflects two factors: the incredible outperformance in corporate fundamentals in local currency terms, and near-record valuation multiples. The chart below breaks down the performance of the SPX relative to the MSCI World Ex-U.S. into currency performance, sales, and the price-to-sales ratio.
Source: Bloomberg, Author’s calculations
On a relative basis investors are paying record multiples for U.S. companies at a time when sales have already outperformed to a staggering degree. We expect this recent breakdown in correlation to prove temporary as a slowing of revenue growth in the U.S. causes investors to reassess the growth potential in U.S. stocks.
Weak Dollar Partly Reflects Deteriorating Growth Prospects
As we have showed in a number of articles over recent weeks, the U.S. dollar’s declines entirely reflect the decline in inflation-linked bond yields, which in part reflect weaker expectations for long-term growth. Given the U.S. technology sector is priced for continued rapid growth, it is difficult to reconcile these two markets. The bullish argument is that the weaker dollar may support tech sector revenues, over half of which come from overseas. However, not only would continued dollar weakness act as a direct drag on U.S. equity outperformance, it would also likely require a significant decline in the dollar to provide any meaningful rise in profits. Furthermore, a weaker dollar would likely undermine the more domestic-focused sectors in the SPX.
While economists often see currency weakness as positive for a country’s economic growth, this likely reflects the outsized focus on the export sector as well as the tendency for activist monetary policy to lead to a simultaneous boost in economic activity and a decline in the currency. In reality, a weaker dollar undermines the U.S. economy by making imports more expensive for any given level of exports and therefore undermining profit margins for every sector of the economy outside of the export-dependent sectors.
International Stocks Set For Double-Digit Outperformance
With this in mind, continued dollar weakness looks highly likely to lead to a reversal in the multi-year U.S. equity outperformance relative to the rest of the world. We continue to hold short positions in U.S. stocks and offset long positions in a basket of U.K., Mexico, Chile, Colombia, Italy, Spain, Poland, Czech Republic, Turkey, Russia, Korea, Singapore, and Indonesia.
Our favourite valuation metric is the payout-adjusted dividend yield, which adjusts the trailing dividend yield to account for the fact that dividend payments tend to fluctuate more aggressively than sales or book values. This gives a truer reflection of the sustainable level of dividend payments. In the U.S., for instance, the SPX dividend payments as a share of sales, book values, and GDP are extremely high relative to historical high in part due to elevated profit margins which are highly likely to mean revert over time.
Source: Bloomberg, Author’s calculations
The chart above shows how closely these valuation metrics have correlated with equity returns in the past. The last time the valuation divergence was as wide as it is currently, the long portfolio went on to outperform the short portfolio by ~20% annually for a decade.