These Factors Outperform When the Dollar Appreciates

The last three times this has happened, large-cap and quality stocks have beaten the broader market.

Illustration by II (Paul Yeung/Bloomberg)

Illustration by II

(Paul Yeung/Bloomberg)

If history is any indication, stable large-cap companies will generate the most outsized returns as the U.S. dollar becomes more expensive.

The quality factor has outperformed the market by an average of 34 basis points during periods of dollar appreciation, according to the latest report by Investment Metrics, a Confluence company. The size factor, defined by IM as a measure of how much large-cap companies outperform smaller ones, also beat its benchmark by an average of 38 basis points during these periods. The volatility factor, however, lagged the market by an average of 80 basis points when the dollar became more expensive — the worst performance across all factors.

IM based its results on a study of factor performance during the periods of March 2008 to March 2009, July 2014 to March 2015, and May 2021 to June 2022 — all times when the U.S. dollar appreciated against currencies traded in other developed economies. According to the report, the U.S. currency is largely treated as “a haven in times of turmoil.” In the past year, the dollar has gained more than 15 percent against other major currencies amid rising geopolitical tensions and the lingering effects of Covid. Last month, the dollar hit parity with the Euro for the first time in 20 years.

Almost all sub-factors in the quality category have tended to outperform as the dollar appreciated, according to the report. The outsized returns generated by companies with earnings growth stability and sales growth stability were 61 basis points and 60 basis pints, respectively. Companies with solid return-on-equity ratios also outperformed by 43 basis points. The only sub-factor that underperformed in the quality space was the debt-to-equity ratio, which lagged the market by 13 basis points.

Size matters, too. During the Great Financial Crisis, the size factor outperformed by 44 basis points, according to the report. It has earned excess returns of 72 basis points since the Russia-Ukraine war broke out in February.

According to Jim Monroe, senior consultant at IM, quality and size factors are the “most sensitive to risk-on and risk-off environments.” He added that the dollar’s strengthening can be viewed as a sign of investors becoming more risk-off, as they seek protection from the safe-haven currency.

The return profiles look a lot more neutral for value and growth stocks. During periods of dollar appreciation, value earned 4 basis points in excess returns, while growth lost 8 basis points relative to the benchmark, according to the report.

As for volatility, all sub-factors in that category failed to beat the benchmark. Stocks with high daily volatility underperformed the market by 97 basis points when the U.S. dollar appreciated, while stocks with a high market beta underperformed by 68 basis points. “These factors tend to suffer during down markets and are inversely correlated with quality,” according to the report.

“Across all periods of market unrest and U.S dollar appreciation, our findings suggest that investors tend to prioritize mature, large-cap, and low volatile equity stocks,” the report concluded.