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This is what a declining US dollar means for the stock market

The US dollar looks shaky. Barring some sort of currency drop, a weaker dollar should be positive for equities, although foreign stocks are likely to benefit more, analysts said.

On Monday, the ICE US Dollar Index DXY,
a measure of the currency against a basket of six major rivals dropped to a two-year low below 94.00, after falling 1.6% last week.

That comes after reaching a more than three-year intraday high on March 22, just shy of 103, a day ahead of the S&P 500 stock index SPX,
+ 0.31%
reached its lowest point during the worst coronavirus pandemic. With the dollar down, equities have risen smartly again: the S&P 500 is now just 5% below its all-time high on February 21, following a 34% dip earlier this year.

Knowing exactly what the dollar should be can be confusing for investors. After all, a weaker dollar is generally viewed as positive for the US economy and for large multinationals that book a large portion of their earnings abroad, but bear most of their costs at home. However, equities have performed well during the recent dollar bull markets, which reflect the strength of the US economy relative to the rest of the world.

And a weaker dollar is not necessarily good for equities if it reflects major problems on the domestic front.

Over the past week, both the dollar and shares have been losing ground, and the currency has failed to reach much of the safe harbor due to a flare-up of tensions between the US and China. The S&P 500 SPX,
+ 0.31%
fell 0.3%, while the Dow Jones Industrial Average DJIA,
+ 0.27%
fell 0.8%.

But in the long run, the dollar and stocks showed a slightly negative correlation, meaning that a weaker dollar was marginally good for stocks. Since 1973, the correlation between the trade-weighted broad dollar index and the S&P 500 on a monthly basis has been -0.2, said Jeffrey Schulze, investment strategist at ClearBridge Investments.

However, that reverse relationship has been much stronger lately. Since 2000, roughly coinciding with China’s accession to the World Trade Organization, the correlation has been -0.35, Schulze said.

Meanwhile, it’s important to remember that the performance of each currency reflects what market participants think about the prospects of a given economy versus others.

“A weaker dollar does not necessarily reflect a weak US economy, but relatively reflects a stronger global economy,” Schulze told MarketWatch in an interview. While that doesn’t spell demise for US stocks, they are likely to underperform their global counterparts over the next six months, he said.

US equities may be particularly vulnerable to underperformance against Europe, where the COVID-19 pandemic appears to remain largely under control. European politicians were also able to come together last week and reach an important milestone in the form of a huge spending and rescue plan, while the European Central Bank has been aggressive in providing monetary stimulus. The euro EURUSD,
+ 0.92%,
which has a weighting of about 19% against the dollar in the trade-weighted index, has skyrocketed and rose 1.8% last week to trade at a 10-month high above $ 1.16.

The euro pick-up, which rose 3.6% in July, continued to rise even as US and global equities closed the week on a downward note. This could be a sign that investors are starting to view the euro through a different lens, and may consider it the next safe-haven currency, Paresh Upadhyaya, director of currency strategy at Amundi Pioneer, said in an interview.

The argument for the US underperformance is also supported by a look at the negative correlation between the dollar and non-US equities, which is stronger than the relationship between the currency and US equities, said Gaurav Saroliya, director of macro strategy at Oxford Economics, in a note on Thursday (see table below).

Oxford Economics

Some economists have warned that the dollar could be undone quickly and alarmingly, eroding its reserve currency status quickly and causing shock waves to hit the financial markets as the U.S. struggles to control the COVID-19 pandemic to get.

Read:The decline of the US dollar could happen with ‘warp speed’ in the era of the coronavirus, leading economist Stephen Roach warns

Saroliya argued that the dollar is unlikely to undergo such a bleak scenario, noting that the currency has experienced earlier bear markets in the 1970s, late 1980s and mid-2000s, serving as the world’s foremost reserve currency.

“These episodes were far from destabilizing global markets and the economy, but were quite positive for growth,” he said, noting that the inverse link between the dollar and global economic growth has been around for most of the era of free-floating exchange rates exist, while periods of rapid appreciation of the dollar threatened global financial stability more than major declines in the dollar.

The dollar’s behavior during the height of the global market turmoil caused by the pandemic earlier this year underscored the currency’s role as a refuge.

Nicholas Colas, co-founder of DataTrek Reseach, noted that the trade-weighted dollar index peaked the same day the S&P 500 bottomed out in both the 2008-09 financial crisis and the coronavirus panic earlier this year. On March 9, 2009, the index closed at 106.01, a level that was only reached again in 2015, he said, while the index reached a record high of 126.47 on March 23 this year. It has since fallen by more than 5%.

The takeaway is that “a weaker dollar is confirmation that global investors feel the worst of the COVID crisis is over and confirms the rally in equities from the March lows,” said Colas. In other words, don’t worry that a weaker dollar is a warning sign of a sudden drop in prices for US stocks. History testifies to the contrary. ‘