If the U.S. dollar is falling in value, international equities trading via U.S.-listed ETFs should outperform U.S. stocks.
And when the U.S. dollar is rising, international equities should underperform U.S. stocks.
Sounds like a logical relationship, right? But as is usual in the markets, it’s not that simple.
Below is a weekly chart overlay of the Dollar Index (NYSEArca: DXY) and the ratio of the S&P 500 to All Country World Index (Ex-U.S.) ETFs (NYSEArca: VEU). Along the bottom is a rolling 52-week correlation between that ratio and the Dollar Index.
The ratio is generally positively correlated, sometimes more strongly than others, but there are also periods where this relationship disconnects and each do their own thing.
Significant tops and bottoms often occur around the same times, but I don’t think there’s enough here to trade solely on this one piece of data.
Instead, the way I like to think about this relationship is that when the dollar is weaker, it’s a tailwind for U.S. investors owning international equities.
But when the dollar is strong, it’s a headwind. It’s simply another factor to take into account when doing your analysis. It is not the end all be all.
When you’re looking at relative performance of Global Equity ETFs, I think people often forget that there are two components of its performance.
- The equity exposure (generally the primary driver)
- The currency exposure (generally the secondary driver)
You only see the final result of those two factors when looking at the ratio chart as both ETFs are priced in U.S. dollars.
One exercise that I find helpful is to analyze the equity and currency trends individually to better understand what’s driving the overall performance and form a stronger opinion on the ratio.
Let’s take the German DAX for example. You can analyze the DAX versus the S&P 500 in their local currencies (EWG/SPY ratio), which we can see is right near the 61.8% retracement of its 2002-2015 range as momentum diverges.
Some mean reversion can occur from current levels, but overall the structural trend is lower and targets the early 2000 lows, which sit 25% lower.
Now to the currency exposure. The Euro/Dollar ratio is sitting near the 61.8% retracement of its 2016 to 2018 rally.
Momentum hasn’t gotten oversold and the 200-day is beginning to flatten out, so being short if prices are above their year-to-date lows doesn’t make sense.
Being super bullish is tough, too, but trading back toward 1.17 is certainly possible over the short/intermediate term, while 1.05 or 1.25 over the long term is a coin flip based on current data.
So if I’m bearish on the primary driver (German equities relative to U.S.) and neutral on the secondary driver (EUR/USD direction), it’s safe to say that a neutral/bearish bias toward the EWG/SPY ratio is appropriate.
Now that I understand the drivers, I can go back to the EWG/SPY ratio and manage risk accordingly.
There is potential for some mean reversion if prices get back above their 2001 lows, but the structural trend remains lower. As long as prices are below their 2001 lows, then the bias remains to the downside and I want to be short.
This conclusion jives with the evidence that we saw by analyzing the components. Both the DAX/SPX local currency ratio and EUR/USD have the potential to rally from key support levels in the short term, but the structural trend in the former is bearish and the latter trend is neutral.
If you’re looking at ratio charts it’s important to understand the components and what drives that ratio.
In this case it’s both equity and currency exposure. In other cases it might be concentration risk because the ETF has six holdings, of which the largest is 50% of the weighting.
Whatever it is, be aware of it.
And don’t accept generalizations about the market just because the relationship sounds logical.
Look at the data and then come to a conclusion.
As we see here, if you expect U.S. equities to underperform solely because of a weakening U.S. dollar, you might not get the results you’re expecting.
To wise investing,
Editor, Big Market Trends