Surprise Surprise, Dollar Breaks Out, Small Caps Outperform, EM Underperforms
Last week we wrote how the US dollar could be in for a major move when it breaks up or down out of the major consolidation it has been in for the better part of six months. We wrote that given the setup of the utterly depressed level of FX volatility, a break up or down could be furious when FX volatility mean reverts, as it always does.
Well, since then we’re beginning to see pretty clear signs that the direction of the move is going to be higher (that is unless this move is a false break, which it could still be). As readers can see from the first chart, the US dollar index has clearly moved up and out of the consolidation. The move higher in the US dollar index comes primarily at the expense of the euro, which is trading at the lowest level vs the USD since the middle of 2017. The 1.05 level seems to be the obvious next stop.
As for FX volatility, it is still yet to budge. A move even back to an average level of FX volatility would be all that is needed to push the US dollar index back to the highs of 2016. Beyond that, we have no opinion whatsoever as even further dollar strength could dismantle the EM recovery, put more pressure on US large cap corporate profits, and thus cause the Fed’s next move to be one of easing.
In the meantime, asset class responses to US dollar strength appears to be textbook. As the last two charts show, US small caps (first chart below) have started to outperform the S&P 500 and emerging market equities (second chart below) have started to underperform. Further dollar strength would only exacerbate that trend assuming the economic mechanisms at play remain the same. For US small caps, it the fact that more of their revenue is domestically sourced that causes them to be relatively more attractive than large caps in periods of US dollar strength. Simply put, the US dollar value of their revenue is not as affected by fluctuations in the dollar. On the other hand, EM stocks tend to underperform since interest payments on US dollar denominated debt become more onerous. In this case, US dollar strength tightens financial conditions across the EM government, corporate and household sectors. We’ll have a more in depth look at how the US dollar plays into EM capital flows in another post.