A declining dollar means more international exposure

It’s often said that concentration builds wealth and diversification protects it. On the heels of an unprecedented run up in concentration, fueled by the exceptionalism of U.S. companies, we believe now is the time to consider increasing diversification.

The first half of the year underscores our view: U.S. equity markets were trounced by their international counterparts in one of the largest performance gaps in decades. The returns follow a supportive mix of fiscal and monetary policy abroad, a weaker dollar, and a large drag from Q1’s tech underperformance.¹

Key Takeaways

1. Dollar in decline – A weakening U.S. dollar may turn currency exposure into a return enhancer for unhedged international investments.
2. Diversify – International equities can serve as a better diversifier to U.S. large caps than the small cap overweight most advisors currently hold.²
3. Differentiate – International markets have tended to provide unique factor exposures and stronger alpha potential through active management.

Figure 1: U.S. vs. International performance:

1. Dollar in Decline…

The dollar is down nearly 10% year to date.³ Still, we believe it has further to fall. The dollar has long benefited from a cycle of robust U.S. growth and investment, attracting foreign capital which in turn strengthened the dollar. A stronger dollar tends to fuel further growth and investment, creating a virtuous cycle. However, we think the structural bull market that has persisted since 2014 may be coming to an end as American exceptionalism is challenged. Unpredictable trade policy, a reorientation of global growth, or demand for alternative reserve currencies could all weaken foreign inflows (or increase hedging demand), putting further downward pressure on the dollar.

BlackRock’s Systematic Macro team has developed foreign exchange (FX) signals that cut across different time horizons:

• Fast-moving insights, like price-based reversals
• Medium-term insights, such as changes in growth expectations, policy rates, or current account balances
• And slower moving equivalencies like purchasing power parity.

At present, we feel that all three signal speeds suggest potential further declines for the dollar. As a result, the systematic platform holds their largest short USD position since 2020, a position that is similar in relative magnitude to that held during the structural bear market of 2003-2008.⁴

Over the last decade, a strong dollar has dampened international returns for a U.S.-based investor. Consider Figure 2 where an unhedged MSCI EAFE holding benefited from currency impacts in just two of the preceding 10 years. Should our expectations for further dollar weakness be realized, U.S. investors could face a sea change in their experience of international investing, where currency becomes a tailwind to bolster returns rather than a headwind to diminish them.

While we still believe many U.S. companies are exceptional, and we continue to believe in the growth potential of the artificial intelligence (AI) theme, we see reasons to consider reconfiguring portfolios around this extraordinary shift in global sentiment and in multi-year currency trends. Historical evidence underpins our view that FX moves in sustained, longer-term cycles: since the end of Bretton Woods in 1971, we’ve observed six completed dollar cycles, with an average duration of just over eight years. The shortest lasted nearly five years.⁵

Figure 2: Dollar strength has historically been a drag on international equity returns

2. …A mounting need for diversification.

The Magnificent Seven stocks have delivered remarkable returns over the past three years, fueled by the promise of AI and the unrivaled ability of U.S. corporations to generate outsized profits.⁶ Strong performance from the top has also improved the quality attributes of broad indexes, reducing average leverage and increasing profitability metrics.⁷ In a world of structurally higher interest rates, this continues to underpin our preference for high quality, primarily large cap, U.S. companies.

The flip side to this remarkable performance, however, is a historic rise in concentration: market cap-weighted indices like the S&P 500 are as concentrated as they have ever been. Thirty years ago, the top 20 names in the S&P 500 represented about 28% of the total index. Today, the top 20 names account for over 40%.⁸

The same phenomenon is happening at a global level as well, where the share of U.S. equities in global indexes has also reached record highs. In 2005, the U.S. made up just 50% of the MSCI ACWI universe (Figure 3). Twenty years of American exceptionalism later, that number has climbed to 64%. The skew is even more striking when evaluating investor portfolios: our analysis of more than 20,000 showed that, on average, advisors allocate as much as 77% of their stock sleeves to U.S. companies.⁹

While an overweight position in U.S. large caps has paid off over the last decade and a half, concentration risk is still a top cited concern amongst investors we speak to. As leadership narrows, headline-level returns are increasingly beholden to a smaller list of constituents and countries, potentially making portfolios riskier overall. Advisor portfolio data shows that many investors have sought diversification in U.S. small caps.¹⁰ We believe international equities may be a better bet.

Alongside the tailwind of a declining dollar, we favor international indexes as a diversification tool precisely because they have bucked the concentration trend. The three largest countries in MSCI ACWI ex USA Index as of 2005 have steadily ceded ground over the past two decades, with their combined weight declining as leadership has broadened out.¹¹

Figure 3.1: Concentration swells in the U.S.

Figure 3.2: While declining elsewhere

As investors look to build more balanced portfolios – with H1’s performance a stark reminder of why – we prefer international equities as potential diversifiers to large-cap U.S. stocks. International equities have delivered both lower volatility and lower correlation relative to the S&P 500 than small caps over the last decade here. That relationship is emphasized in drawdown periods: since 2010, when the S&P 500 posted negative quarterly returns, small caps underperformed significantly - posting nearly double the losses of developed markets. In fact, since 1999, in months when the S&P 500 was down, small caps were always down by more than international equities.¹²

In addition to their dimmer diversification prospects, the macro outlook also remains a headwind for small caps. Smaller, riskier companies have tended to perform best when we are coming out of a recession – not when we see U.S. growth slowing in the quarters ahead.¹³ Structural changes in the U.S. equity markets also argue for a reduced role in advisor portfolios (the Model Portfolio Solutions team's recent blog).¹⁴ And yet, we continue to see small caps appear as a forever favorite in advisor holding data, where the average advisor holds nearly three times the share of small caps as broad benchmarks would suggest.¹⁵

Figure 4: Volatility and correlation to U.S. large caps

3. Beyond the benchmark: differentiated international implementation

International markets often have different drivers of risk and return than U.S. ones. One way to quantify these differences is by factor breakdown. The U.S. has long benefitted from its inherent growth tilt, while both developed and emerging markets often exhibit higher exposure to the value factor, with higher dividend and earnings yields than their U.S. counterparts.

By incorporating international equities, investors may benefit from structural geopolitical or thematic forces, while also offsetting some of the inherent growth bias within their U.S. equity sleeves.

Figure 5: International equities offer differentiated factor exposures

The alpha generated by factor tilting is even greater in international markets than it is in U.S. ones, making factor investing a compelling implementation style for those looking to add exposure. Currently, we favor the quality factor in international markets, which screens for companies that have the earnings stability and cash flows to weather a volatile geopolitical backdrop. The quality factor also exhibits an asymmetric up/down capture profile – meaning it has historically participated to a greater degree on the upside than on the downside.¹⁶

^{Figure 6: IQLT performance}

Systematic strategies such as the BlackRock Advantage International Fund (BROIX) may be especially equipped to seek alpha opportunities, particularly amid volatile and rapidly changing markets. By leveraging data and technology, the fund is designed to convert complex information into actionable insights ahead of market shifts. Our systematic approach draws on more than 1,000 data-driven signals—including company fundamentals, sentiment-based measures, and macroeconomic indicators—each aimed at identifying opportunities with greater speed, scale, and precision than would otherwise be possible. The fund’s style-pure international exposure excludes U.S. and Emerging Markets, further contributing to consistent outcomes by increasing diversification while seeking to avoid certain risks associated with EM markets.

CONCLUSION:

Home country bias is a perennial theme among U.S. investor portfolios. The average advisor is overweight U.S. equities, with allocations continually increasing over the past decade. Our analysis of more than 20,000 portfolios showed that, on average, advisors allocate as much as 77% of their stock sleeves to U.S. companies¹⁷– compared to a 64% weighting in MSCI All Country World Index.

But recent polling data suggests that trend may soon reverse.¹⁸Many advisors see opportunity in international equities – with 43% are considering adding to international stocks in the next 3-6 months. Increased demand could be a catalyst for a further move higher.