The US dollar is having another tough go today after it spent the first part of June working off an oversold condition and rallying modestly. It turns out that all that work was for naught as today’s 1% selloff brings the USD index to a level not seen since last October (chart 1). Meanwhile, economic data have disappointed to a degree rarely seen outside of recessions. The Citi Economic Surprise Index just hit a six year low of -78.6, a level equivalent to that seen in the fall of 2011 as the prospect of the US defaulting on its debt was a real possibility (chart 2). The confluence of these two events – a USD that is obviously going down and economic surprises at historic lows – is a setup that continues to favor an overweight to foreign vs domestic stocks and an overweight to cyclical vs defensive stocks.
Starting with the USD first, it’s useful to remember that changes in the level of the USD affect liquidity conditions abroad, and especially in the emerging markets. When the dollar rallies, USD denominated debt issued by foreign corporations and governments gets more expensive to repay in local currency terms. Alternatively, when the USD falls those same debts become cheaper to repay in local currency terms. That is just another way of saying that a falling USD tends to loosen financial conditions abroad and provides the fodder for foreign stock outperformance. Similarly, a falling USD tends to act as a boon to other liquidity sensitive assets such as highly cyclical stocks. So in sum, as the dollar continues to fall (and we see ample reason to expect it to do so given the likelihood of a widening current account deficit), we should favor foreign over domestic stocks and cyclical over counter-cyclical stocks. The four charts below support this view. In each of these charts the USD index is the red line plotted on the right, inverted axis and the blue line represents the relative performance of various baskets of the foreign equity market.
Moving on to economic surprises, it may seem counter-intuitive to suggest that economically sensitive assets like cyclical stocks should rally even as the economy appears to be faltering. But, it’s important to remember that the market is a discounting mechanism and should, in theory, have already assimilated the disappointing data. Indeed, unless we expect the economy to tip into recession in the near future (which we don’t), the recent dip in the econ data may be an opportunity to increase exposure to the stocks which would benefit from even modest economic outperformance relative to expectations. As the final chart below shows, the relative performance of DM Americas cyclical stocks (blue line, left axis) is highly correlated to the level of the Citi Economic Surprise Index (red line, right axis). An uptick in the Citi Economic Surprise Index toward zero should produce a period of cyclical stock outperformance.