Although predicting major foreign exchange (FX) trends is never easy, the potential for a major dollar bull market suggests FX could influence investment planning in the coming months. In this light, we examined how various equity risk factors have performed in a strong dollar environment, and found that the momentum factor historically outperformed.
The dollar rally and backdrop
The US Dollar Index (DXY) has risen over 8% from its May low driven by relatively strong US economic growth and favorable interest rate advantage.1 Dollar strength is well discussed in the market and the long dollar trade could be getting crowded in the short term, but fundamental factors are supportive to a sustained dollar uptrend. The Federal Reserve is ending QE3, while the European Central Bank and Bank of Japan (BOJ) continue with aggressive monetary stimulus. In fact, the BOJ was willing to buy T-bills at a negative rate in September. At the same time, global Purchasing Managers Index (PMI) data highlights the outperformance of the US economy. Recent manufacturing PMI numbers showed the US at 57.5 compared to 52.8 for Japan and 50.3 for the eurozone.2
As a review, there are four factors or equity risk premiums that were popularized by academics Eugene Fama, Kenneth French and Mark Carhart. These can be examined using the Kenneth French Data Library:3
- Market Return (Mkt – RF): Excess return of the market over the risk-free rate using all NYSE, AMEX and NASDAQ stocks, and the one-month T-bill.
- Momentum (MOM): Average return of two high prior return portfolios minus the average return of two low prior return portfolios.
- Small Minus Big (SMB): Average return of three small portfolios minus the average return of three big portfolios.
- High Minus Low (HML): Average return on two value portfolios minus the average return on two growth portfolios.
The US terminated the gold standard in August 1971 and allowed the dollar to be a fiat currency. A study was performed to examine factor returns during strong dollar periods. The table below highlights factor returns during periods of material dollar strength. Dollar gains based on DXY were measured from monthly trough to peak (the return was not annualized). Factor returns were annualized with values calculated from the corresponding troughs and peaks of DXY. The dollar rallied over 10% in each time periods measured. Results include:
- Momentum was the strongest-performing factor with a median annualized gain of 12.61%. Momentum rose in each occurrence. After a double take, momentum was even able to perform well during the financial crisis in 2008 when the dollar was strong. This suggests that investors may have been quick to pare lagging names from their portfolios during the crisis.
- Value outperformed growth in five of seven strong-dollar periods, or 71.4% of the time with a median return of 7.29%. Value performed poorly during the financial crisis as investors sold to raise cash. It should be noted that the Russell 1000 Value Index outperformed the Russell 1000 Growth Index between 1995 and 2002, displaying some of the difference between academic factors and market indices.1
- Small-cap outperformed large-cap in six of seven periods, or 85.7% of the time with a median return of 4.48%. Large caps are more currency-exposed than small caps, which have tended to have a greater domestic influence. Outsized returns in 2013 coupled with the potential for mean reversion and a weak trend in earnings estimates are current headwinds to small-cap sector performance.
- The market risk premium was positive in five of seven periods, or 71.4% with a median return of 7.06%. Returns were poor in the ‘73/’74 and ‘08/’09 period. Both periods were consistent with the market pricing recession. Oil prices surged and stagflation was present in ‘73/’74, while the collapse of the housing and mortgage markets damaged market returns in ‘08/’09.
Ideas for gaining exposure
Those focused on factor performance in a strong dollar environment can talk to their advisors about PowerShares’ suite of momentum ETFs based on Dorsey, Wright & Associates relative strength methodology. Click here for more information.
This articles was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.