The dollar’s bearish run is likely to affect U.S. equity markets.
Michelle Weaver, our U.S. Thematic & Equity Strategist, and
David Adams, our Head of G10 FX Strategy, discuss what investors
should consider.
Read more insights from Morgan Stanley.
----- Transcript -----
Michelle Weaver: Welcome to Thoughts on the
Market. I'm Michelle Weaver, U.S. Thematic and Equity strategist
at Morgan Stanley.
David Adams: And I'm Dave Adams, head of
G10 FX Strategy here at Morgan Stanley.
Michelle Weaver: Our colleagues were
recently on the show to talk about the impact of the weak dollar
on European equities. And today we wanted to continue that
conversation by looking at what a weak U.S. dollar means for the
U.S. equity market.
It's Thursday, July 17th at 2pm in London.
Morgan Stanley has a bearish view on the U.S. dollar. And this is
something our chief global FX strategist James Lord spoke about
recently on the show. But Dave, I want to go over the outlook
again, since Morgan Stanley has a really differentiated view on
this. Do you think the dollar will continue to depreciate during
the remainder of the year?
David Adams: We do, and we do. We have been
dollar bears this whole year, and it has been very out of
consensus. But we do think the weakness will continue and our
forecasts remain one of the most bearish on the street for the
dollar.
The dollar has had its worst first half of the year since 1973,
and the dollar index has fallen about 10 percent year to date,
but we think we're at the intermission rather than the finale.
The second act for the dollar weakening trend should come over
the next 12 months as U.S. interest rates and U.S. growth rates
converge to that of the rest of the world. And FX hedging of
existing U.S. assets held by foreign investors adds further
negative risk premium to the dollar. The result is that we're
looking for yet another 10 percent drop in the dollar by the end
of next year.
Michelle Weaver: That's really interesting
and a differentiated view for Morgan Stanley. When I think about
one of the key themes that we've been following this year, it's
the multipolar world or a shift away from globalization to more
localized spheres of influence. This is an important element to
the dollar story.
How have tariffs impacted currency and your outlook?
David Adams: Tariffs play a key role in
this framework. Tariffs have a positive impact on inflation, but
a negative impact on U.S. growth. But the inflation impact comes
faster and the negative impact on growth and employment that
comes a bit later. This puts the Fed in a really tough spot and
it's why our economists are pretty out of consensus in calling
for both no cuts this year, and a much faster and deeper pace of
cuts in 2026.
The results for me in FX land is that the market is
underestimating just how low the Fed will go and just how low
U.S. rates will go, in general. Tariffs play a big role in
helping to generate this rate convergence, and rate differentials
are a fundamental driver of currencies. The more that U.S. rates
are going to fall, the more likely it is that the dollar keeps
falling too.
Michelle Weaver: Tariffs have certainly
impacted heavily on our view for the U.S. equity market and it's
something that no asset class is not impacted by really. Given
the volatility and the magnitude of the move we've seen this
year, are foreign investors hedging more?
David Adams: We do think they've started
hedging more, but the bulk of the move is really ahead of us.
Foreign investors own a massive amount of U.S. assets. European
investors alone own $8 trillion of U.S. bonds and stocks, and
that's only about a quarter of total foreign ownership of U.S.
assets.
Now when foreign investors buy U.S. assets, they have to sell
their currency and buy the dollar. But at some point, you're
going to have to bring that money back, so you're going to have
to sell the dollar and buy back your home currency again. If the
dollar rises over this period, you've made a gain,
congratulations. But if it falls, you've made a loss.
Now a lot of foreign investors will hedge this currency risk, and
they'll use instruments like forwards and options to do so. But
in the case of the U.S., we found that a lot of foreign investors
really choose not to hedge this exposure, particularly on the
equity side. And this reflects both a view that the dollar would
appreciate; so, they want to take that gain. But it also reflects
the dollar's negative correlation to equities.
So, what's changing now? Well, a lot of investors are starting to
rethink this decision and add those FX hedges, which really means
dollar selling. Now, there's a lot of factors motivating their
decision to hedge. One, of course is price. If U.S. rates are
going to converge meaningfully to the rest of the world – like we
expect – that flattens out the forward curve and makes those
forwards cheaper to buy to hedge.
But the breakdown in correlations that we've seen more broadly,
the uptick in policy volatility and uncertainty, and the sell off
in the dollar that we've already seen year to date, have all
increased the relative benefit of FX hedging.
Now, Michelle, I often get asked the question, that's a nice
story, but is hedging actually picking up? And the answer is yes.
The initial data suggests that hedging has picked up in the
second quarter, but because of the size of U.S. asset holdings
and given how much it was initially unhedged, we could be talking
about a significant long-term flow. We have a lot more to go from
here.
Michelle Weaver: Yeah.
David Adams: We estimated that just over half of
Europe's $8 trillion holdings are unhedged. And if hedge ratios
pick up even a little bit, we could be talking about hundreds of
billions of dollars in flow. And that's just from Europe.
But Michelle, I wanted to ask you. What do you think a weaker
dollar means for U.S. companies?
Michelle Weaver: The weaker dollar is a
substantial underappreciated tailwind for U.S. multinational
earnings, and this is because these companies sell products
overseas and then get paid in foreign currency. So, when the
dollar's down, converting that foreign revenue back into dollars,
gives them a nice boost, something that domestic only companies
aren't going to benefit from. And this is called the translation
effect.
Recently we've seen earnings revisions breadth, essentially a
measure of whether analysts are getting more optimistic or
pessimistic start to turn up after hitting typical cycle lows.
And based on our house view for the dollar, there's likely more
upside ahead based on that relationship for revisions over the
next year.
David Adams: Interesting. Interesting. And
is this something you're hearing about from companies on things
like earnings calls?
Michelle Weaver: No, this dynamic isn't
being highlighted much on earnings calls. Typically, companies
talk about foreign exchange effects when the dollar's
strengthening and provides a headwind for corporate earnings. But
when we're in the reverse scenario like we are now with the
dollar weakening and getting a boost to earnings, we tend to not
hear as much discussion, which is why I called this an
underappreciated tailwind.
And according to your team's forecast, we still have a
substantial amount of weakening to go and thus a substantial
amount of benefit for U.S. companies to go.
David Adams: Yeah, that makes sense. And
who do you think benefits most from this dynamic? Are there any
sectors or investment styles that look particularly good
here?
Michelle Weaver: Mm hmm. So generally, it's
the large cap companies that stand to gain the most from this
dynamic, and that's because they do more business overseas. If we
look at foreign revenue exposure for different indices, around 40
percent of the S & P 500’s revenue comes from outside the
U.S., while that's just 22 percent for the Russell 2000 Small Cap
Index. But the impact of a weaker dollar isn't the same across
the board.
Foreign revenue exposure and earnings revision sensitivity to the
dollar vary quite a bit, when we look at the sector and the
industry group level. From a foreign revenue exposure
perspective, Tech Materials and Industrials have the highest
foreign revenue exposure and thus can benefit a lot from that
dynamic we've been talking about. When we look from an earnings
revisions perspective, Capital Goods, Materials, Software and
Tech Hardware have the most earnings revisions, sensitivity to a
weaker dollar, so they could also benefit there.
David Adams: So, I guess this brings us to
the million-dollar question that all of our listeners are asking.
What do we do with this information? What does this mean for
investors?
Michelle Weaver: So as the dollar,
continues to weaken, investors should keep a close eye on the
industries and companies poised to benefit the most – because in
this multipolar world, currency dynamics are not just a macro
backdrop, but an important driver of earnings and equity
performance.
Dave, thank you for taking the time to talk.
And to our listeners, thanks for listening. If you enjoy Thoughts
on the Market, please leave us a review wherever you listen to
the show and share the podcast with a friend or colleague today.
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