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- The S&P 500 tends to weaken when the dollar is strong as U.S. companies have sizeable foreign revenues
- Recent U.S. earnings calls have increasingly cited “foreign exchange” as a risk
- U.S. equity investors can hedge this FX risk by using CME Group EUR/USD futures
U.S. companies, and hence U.S. stocks, are often very sensitive to foreign exchange movements. One reason is that around 30% to 40% of S&P 500 company revenues come from abroad. Therefore, if the dollar strengthens, those foreign revenues fall in value in dollar terms. Often, then, company CEOs prefer a weaker dollar – it raises the dollar value of foreign revenues and makes U.S. exports cheaper abroad.
Last year’s dollar strength was therefore a big challenge for U.S. stocks. CEO commentary on earnings calls reflected this. During the final quarter of 2022, we saw the most mentions of “foreign exchange” in recent memory (Chart 1).
Another reason the S&P 500 performs better with dollar weakness is that a weak dollar often reflects more benign global financial conditions. The dollar tends to perform especially well during crises as investors flock to it as a safe haven. In more benign times, investor flows become adventurous, and the dollar weakens.
Both factors have led to a positive correlation between CME Group S&P 500 futures and CME Group EUR/USD futures for the past few years. This means that when the euro is strong and the dollar weak, the S&P 500 goes up, while if the euro is weak and the dollar strong, the S&P 500 goes down (Chart 2). Using the CME Group Cross-Asset Correlation Tool, we find more recent correlations are also positive between EUR/USD and the S&P 500.
This suggests investors who are long CME Group S&P 500 futures could hedge this FX risk by going short CME Group EUR/USD futures. In this way, they have positive equity exposure, but in the event of dollar strength, which could lead to equity weakness, they would gain on their short EUR/USD exposure, which is long U.S. dollars.
2022 is a good example of this. The S&P 500 fell almost 20%. But the dollar strengthened 5% against the euro. Had an investor been long CME Group S&P 500 futures and short CME Group EUR/USD futures, the net loss would have been nearer 15% rather than 20%.
The bottom line is that U.S. equity investors can use FX futures to help manage risk exposures, especially given foreign exchange has tended to have outsized impacts on U.S. equity returns.
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