The recent rise of the U.S. dollar has impacted U.S. equities, with small-capitalization stocks benefiting the most. But some sectors are driven when the dollar falls.
Small-cap companies tend to outperform mid-cap and large-cap stocks when the dollar is rising because the majority of their revenue is derived from the U.S. The S&P SmallCap 600 has 78.8 percent of its revenues derived from the U.S., while the S&P MidCap 400 has 73.3 percent and the S&P 500 has the lowest percentage at 70.9 percent.
During the past 10 years on average, for every 1 percent of the dollar rising, small caps gained 95 basis points compared to mid caps advancing by 82 basis points and large caps gaining by 71 basis points, says Jodie Gunzberg, managing director, head of U.S. equities at New York-based S&P Dow Jones Indices.
[See: 7 Small-Cap ETFs to Help You Win a Trade War.]
Some sectors have better returns — small caps in financials have outperformed their bigger counterparts with rising rates while the financial large caps derive about 20 percent of their revenues internationally.
“Smaller banks are likely more local so they do better with a rising dollar and with rising rates, but when the dollar falls, large banks have fared batter,” she says. “The bottom line is that a rising dollar is not harmful for most stocks, especially small caps.”
The materials, technology and energy sectors tend to rise more when there is a falling dollar than a rising one. A rising dollar is more advantageous to the consumer staples, health care and utilities sectors.
One sector which stands out is energy since it remains “too sensitive to the downward pressure on oil with a strengthening dollar,” Gunzberg says. “The energy sector underperformed with a rising dollar and falling oil prices, magnified by relatively low revenues from the U.S., but many companies hedge against oil price moves to reduce volatility of revenues.”
The largest misconception that investors tend to believe is that when the dollar declines, large-cap stocks tend to perform best. That is not the case because large companies already conduct a lot of their business globally and a larger portion of their revenue is derived from those countries. The reality is mid-cap stocks do best because of the growth abroad.
Although stocks experience sensitivity to movements in the dollar, investors should not attempt to predict whether it will rise or fall in the future, says Greg McBride, chief financial analyst for Bankrate, a New York-based financial data and content company.
“Either roll with the ebb and flow of currency movements or invest in currency-hedged funds and ETFs, but trying to time the currency market is about as futile as trying to time the stock market,” he says.
Small caps have performed “so well and recently reached record highs” because they are not exposed to the headwind of a strong dollar, McBride says.
“Smaller companies don’t have the same level of international operations as their larger counterparts and therefore don’t have the exposure to currency movements — for better or worse,” he says.
[See: 10 Smart-Beta ETFs That Will Help You Get Your Alpha.]
The strength of the dollar can prove to be a double-edged sword, says Michael Antonelli, managing director, institutional equity trader at Baird, a Milwaukee-based investment bank. While the U.S strives to achieve a strong dollar in order to remain being the reserve currency of the world, the effect on portfolios can have a negative impact.
“Yet as investors, especially with the rise of passive investing centered around large caps, a strong dollar can bite into returns, which is why some level of diversification makes sense,” he says. “You can’t just buy SPY ( SPY) and QQQ ( QQQ) and call it a day.”
The dollar is likely to strengthen over the next six months to a year, but predicting its path is challenging.
Investors who had stocks with international exposure reaped the rewards of the dollar falling in 2017 since the returns were boosted once the assets were translated back to U.S. currency, says Edison Byzyka, chief investment officer of Credent Wealth Management in Marshall, Michigan. Domestic large caps also benefited “tremendously from the simple fact that a weaker dollar can boost their exports and drive costs lower,” he says.
Yet the dollar remains a tricky driver in its impact to returns. The likelihood of the dollar continuing to rise appears to outweigh the probability of a further weaker dollar because of rising interest rates and a protectionist trade policy from Washington, Byzyka says.
The dollar has strengthened too quickly from a technical standpoint and this may cause a short-term sideways cycle before a cyclical upside starts.
Retail investors whose portfolios include a large allocation to large-cap stocks should reconsider, he says. Mid-cap and small-cap stocks may prove stronger in 2018 since they are not immediately affected by the swings in the dollar.
Small-cap stocks are likely to outperform this year because year-over-year earnings growth expectations are projected at 30 perent for small-cap indices compared to the 20 percent for large caps, he says.
[See: 8 Ways to Buffer Your Portfolio From a Market Slide.]
The most confusing aspect of a rising dollar to investors is its impact on the performance of non-dollar securities, says Todd J. Lerner, a registered investment advisor with LBW Financial Services in Valencia, California.
Investors often tend to chase performance and when the dollar is falling, they allocate more to international stocks and bonds. Concern about a rising dollar does not mean that investors should sell their international positions, but to remain diversified by moving 50 to 100 percent of their international allocation to a currency-hedged exchange-traded fund, he says.
“Earnings estimates and analyst price targets on European Union company stocks are far more achievable and realistic compare to those of U.S. companies,” Lerner says. “I’m urging my own clients to continue to favor large- and mega-cap stocks in their retirement accounts at this phase of the bull cycle.”
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A Rising Dollar Can Impact Equities Negatively originally appeared on usnews.com
