The Great Rotation: Why International Diversification May Finally Pay Off

GW&K Insights | June 2025

• The US dollar’s extreme overvaluation has created conditions for sustained weakness that could benefit international stocks.
• Historical patterns show international equities outperform US markets during dollar decline cycles, with currency translation effects amplifying returns for American investors.
• Trade tensions, pressure on emerging markets to strengthen their currencies, and easier Fed policy suggest the dollar’s 13-year upswing may be ending.

A FUNDAMENTAL SHIFT TO DOLLAR WEAKNESS

After more than a decade of US stock market dominance, a fundamental shift may be underway. International equities are showing signs of life, emerging markets are stirring, and the catalyst driving this potential “great rotation” sits right at the heart of global finance: the US dollar’s long-overdue decline.

The numbers tell a compelling story. While US stocks have delivered spectacular returns since 2011, international markets have until recently lagged dramatically — not because of inferior business fundamentals, but largely due to currency headwinds. As those headwinds finally reverse into tailwinds, investors may be witnessing the early stages of a multi-year shift that could reshape portfolio strategies worldwide.

UNDERSTANDING THE CURRENCY CONNECTION

To grasp why the dollar matters so much for investment returns, consider what happens when currencies move. A “strong” dollar means it takes more foreign currency to buy one dollar — making US exports expensive overseas while keeping imports cheap for Americans. A “weak” dollar flips this equation: US goods become bargains abroad, but foreign products cost more at home.

For investors, these currency shifts create powerful translation effects. When US investors buy foreign stocks and the dollar subsequently weakens, their returns get amplified. A 10% gain in European stocks becomes 15% when the euro strengthens 5% against the dollar. Conversely, during the dollar’s long rise from 2011 to early 2025, international investments faced a persistent currency headwind that masked otherwise solid underlying performance.

The impact on multinational corporations works similarly. When Apple or Microsoft report quarterly earnings, their overseas revenues get translated back into dollars. A weaker dollar means those foreign sales are worth more in dollar terms — providing an earnings boost even if local market performance remains unchanged.

THE FOUNDATION: HISTORIC DOLLAR OVERVALUATION

The stage for this potential rotation was set by one of the most extreme currency overvaluations in modern history. After a 13-year climb that boosted the dollar’s real trade-weighted value by 47%, the greenback reached a level that historically has proven to be unsustainable (Figure 1).

 

As of May 2025, the Federal Reserve’s broad dollar index sat 16% above its long-term average — a level reached only 6% of the time since 1973. More striking still, International Monetary Fund (IMF) data showed the dollar was 105% overvalued on a purchasing-power basis in 2024, eclipsing previous peaks from 1985 and 2002 (Figure 2).

This overvaluation shows up in everyday terms through metrics like The Economist’s Big Mac Index. A burger costing $5.79 in America sold in January this year for the equivalent of just $3.11 in Japan, suggesting the yen was undervalued by 46% against the dollar (Figures 3 and 4).

Using a broader measure of purchasing power parity (PPP) maintained by the IMF, similar patterns exist across major currencies. For example, for developed market (DM) currencies captured by the MSCI World Index, the median overvaluation of the dollar in 2024 was estimated to be 23% (Figure 5). For emerging market (EM) currencies captured by the MSCI Emerging Markets Index, the median overvaluation of the dollar in 2024 was estimated to be a whopping 114% (Figure 6).

Such extreme imbalances cannot persist indefinitely. Currency markets, like stretched rubber bands, eventually snap back toward equilibrium. The question isn’t whether the dollar will weaken, but how much and how quickly.

WHY THIS TIME MAY BE DIFFERENT

Several structural changes suggest the dollar’s decline could be more sustained than previous corrections. The most significant involves the shifting weight of emerging markets in the global economy.

Since 1995, emerging markets’ share of global GDP on a purchasing-power basis has surged from 40% to 60% (Figure 7). This massive economic bloc has systematically undervalued their currencies to maintain export competitiveness and build dollar reserves. As their collective economic influence grows, the structural demand for an overvalued dollar that financed America’s twin deficits becomes harder to sustain. Political pressure on emerging market nations to strengthen their currencies seems likely to intensify.

Meanwhile, the Federal Reserve’s policy stance has begun to normalize after several years of aggressive tightening (Figure 8). Interest rate differentials that previously attracted global capital to dollar assets have narrowed since the Fed pivoted toward easing in September 2024. This removes a key pillar supporting the dollar’s recent strength.

Perhaps most importantly, America’s trade policies are accelerating these trends. Tariffs and trade tensions, rather than strengthening the dollar as traditional theory might suggest, have instead undermined confidence in US economic leadership. Policy uncertainty has prompted investors to diversify away from dollar assets, while the growth-dampening effects of protectionism reduce America’s economic attractiveness relative to other regions.

The dollar’s traditional role as a “safe haven” during global stress is also showing cracks. Recent market turbulence saw the dollar fall alongside stocks — a rare occurrence that suggests investors are questioning America’s automatic appeal during crises.

THE INVESTMENT PLAYBOOK

History provides a roadmap for what happens when the dollar enters sustained declines. During previous periods of significant dollar weakness — such as the 2002 – 2011 cycle when the dollar fell roughly 30% — international stocks notably outperformed their US counterparts (Figure 9).

The pattern makes fundamental sense. Dollar weakness typically accompanies improving global growth and easier global financial conditions. International markets, with their heavier weightings in cyclical sectors like banks, materials, and energy, tend to benefit more than the growth-heavy US market during such periods.

When the dollar has been extremely overvalued historically, as it is now, the Fed’s Trade-Weighted Index has tended to decline over the subsequent five years at an average pace of 2.6% annually (Figure 10). If that pattern holds, international investors could enjoy years of currency tailwinds on top of any underlying market gains.

Within the US market itself, dollar weakness creates clear winners and losers. Large multinational corporations — particularly in technology, industrials, and consumer goods — benefit as their overseas earnings translate into more dollars. Companies generating 50% or more of revenues abroad often see significant earnings boosts when the dollar declines.

Conversely, purely domestic companies miss out on these translation gains while potentially facing higher input costs from more expensive imports. This dynamic has already begun playing out, with internationally diversified large-cap stocks outperforming smaller, domestically focused companies as the dollar’s decline accelerated through 2025.

Emerging markets represent perhaps the biggest opportunity. Many emerging economies carry substantial dollar-denominated debt, making them highly sensitive to currency movements. A weaker dollar reduces their debt service costs while making their exports more competitive globally. Combined with their already attractive valuations relative to developed markets, emerging market stocks could see sustained outperformance if dollar weakness persists.

The commodity complex also benefits from dollar decline, as most raw materials are priced in dollars globally. A weaker greenback typically translates into higher commodity prices, benefiting resource-rich countries, and materials sectors worldwide.

RISK FACTORS AND TIMELINE

Not all dollar weakness scenarios are created equal. A gradual, orderly decline driven by natural economic rebalancing represents the best-case scenario for international diversification. However, if dollar weakness stems from a sharp loss of confidence in US economic management, the resulting financial instability could overwhelm any currency benefits.

Trade policy remains a wildcard. While recent tariffs have accelerated dollar weakness by undermining confidence, a dramatic escalation could trigger broader global recession fears that might temporarily restore the dollar’s safe-haven appeal. Conversely, an unexpected de-escalation could improve US growth prospects and slow the dollar’s decline.

The Federal Reserve’s policy path will be crucial. If inflation proves stickier than expected, forcing the Fed to maintain higher rates longer than other central banks, dollar weakness could stall. However, if global growth accelerates while US growth lags, the dollar’s decline could accelerate beyond comfortable levels.

Based on historical precedents, investors should think in terms of multi-year cycles rather than quick reversals. Previous dollar peaks have led to sustained weakness lasting seven to nine years, suggesting patience will be required for international diversification strategies to fully pay off.

CONCLUSION

After more than a decade of US market dominance, the conditions are aligning for a potential changing of the guard. Extreme dollar overvaluation, shifting global economic weights, and changing policy dynamics all point toward sustained dollar weakness ahead.

For investors, this suggests the era of overwhelming US outperformance may be ending. International diversification — long dismissed as a drag on returns — could finally deliver the benefits portfolio theory promised. The great rotation may not happen overnight, but the foundations are firmly in place. Smart investors would be wise to position accordingly, before everyone else notices the tide has turned.

 

 

William P. Sterling, Ph.D.

Global Strategist