The reports of my death are greatly exaggerated

Hardly a day goes by without seeing a headline in a financial publication about the decline of the U.S. Dollar. Making the case for a weaker dollar and How to avoid greenback grief are two articles that appeared on the same page of the commentary section of the Financial Times on the same day this week. Last week, The Independent published a story titled The demise of the dollar. There are a variety of reasons for this which have been discussed at length in these and other articles (for example, OPEC countries threatening to price oil in a currency other than USD, low interest rates in the U.S. vs. other countries, low expected growth rates in the U.S. vs. the rest of the world, etc).

In recent posts, Sean Carr spoke about the rise of currency risk in portfolios and what would happen if the dollar strengthened. Oh, how times change. After a bit of resurgence from the end of July to middle of August, the greenback looks to be in a downward spiral. Public opinion (or at least many of those expressing their opinion in the press) seems to expect this to continue.
A weaker dollar will no doubt help many American exporters and foreign tourists who wish to visit the U.S. But how will it affect the equity markets? Using FactSet’s stress testing tools, I’ll examine the effects of a 30% decline in the $, from the perspective of a U.S. investor. I’m using a dollar index against a handful of currencies, as published by the Fed Reserve. I’ll use the R-Squared Global Equity model, using Northfield and Barra will produce similar results.

This stress test shows the S&P 500 increasing almost 27% in this scenario. The Materials and Financials sectors are the big beneficiaries. Materials companies benefit from higher commodity prices due to a weaker dollar. Defensive sectors such as Health Care and Consumer Staples are poor performers on a relative basis.
Moving to the MSCI World ex U.S. index, the stress test predicts an increase of about 50%, significantly more than the U.S. market. The sector story is similar to the S&P. Materials and Financials benefit, Health Care and Consumer Staples underperform.

On a country basis, Hong Kong and Japan underperform, while Europe outperforms. The strengthening Euro helps many European stocks. A weakened dollar will hurt Japanese exporters, as the U.S. consumer accounts for a quarter of exports from Japan. Many Hong Kong stocks have significant operations in China, and the Chinese Renminbi is of course currently pegged to the dollar.
Now that we have a general sense of what will happen in the event of a large decrease in the dollar, how are portfolio managers positioning themselves in case of a dollar decline? Using the Lipper Active Indices, we can get an idea of how the average active fund manager in a given strategy is positioning their portfolios. Let’s use the Lipper International Active index against the MSCI World ex US benchmark. Here, in the $ decline scenario, the active index would underperform its benchmark by about 4 percentage points. On a sector basis, significant underweights in Materials and Financials contribute to the underperformance. On a country basis, overweights in underperforming USD stocks, cash, and Hong Kong stocks and underweights in outperforming Canadian and European stocks are major contributors to this underperformance.

Many in the financial press believe that the dollar is on its last legs and expect a continued decline in the greenback. From this analysis, I draw two conclusions. One, the average fund manager may not be adequately positioned for large decline in the dollar. Or two, he/she may think all the reports of the dollar’s death are "greatly exaggerated,” stealing a line from Mark Twain when he heard about his obituary in the paper.

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