We will continue from the last article about the causes of the strong dollar. Today we will discuss the implications of a strong dollar and what it means for investor. I really like this quote about the health of the U.S. economy: When America sneezes, the world catches a cold. As the dominant currency in the international market, the surging of the dollar’s value has both positive and negative implications not just on the U.S. domestic economy but also on the global economy.
The first major implication of a surging dollar is its adverse effect on the earnings of U.S. multinational companies which has a large proportion of revenue generated from foreign market. Given a strong dollar in exchange rate, the sales of companies in foreign currency is discounted when it is converted into U.S. dollar term. This is known as “currency risk”. The Washington Post reported that Johnson & Johnson, whose sales from international operation account for more than half of its total sales, posted a drop in sales of 0.6 percent in the fourth quarter, although there was an increase in prescription sale. Figure 1 shows that 46.3 percent of the total sales of the S&P 500 companies are generated from outside the U.S.
The fact that the earnings of U.S. companies are lowered due to a strong dollar is only one side of the argument. A strong dollar benefits those U.S. companies who import materials from foreign countries. Because of a surging dollar, the materials can be bought at a cheaper price, thus reducing the cost of production and increasing the profits margins, according to Keith Lerner. The Washington Post also reported that the aluminum supplier company Alcoa posted a solid profit in the fourth quarter of 2014. Thanks to the strengthening dollar, Alcoa imported its materials at a lower price from Australia, Brazil and Jamaica. Despite a rising dollar, Alcoa sales were not significantly discounted, since most of its sales are generated in the U.S.
Figure 1: S&P 500 companies’ foreign sales as a percentage of total sale
Source: Mackenzie Investments
One positive benefit of a strengthening dollar is that it drives down price of imported goods to the U.S. and keep inflation at a low rate. Cheaper goods can improve the purchasing power of American consumers and grow the demand in the economy. The U.S. low inflation rate, despite the Federal Reserve’s past aggressive bond-buying program and increase in money supply, is partly attributed to the low oil price. The low inflation below the Fed’s target of 2 percent has prevented the Fed from raising the interest rate which could bring about volatility in the market and increase the cost of borrowing.
Implication on international trade
A rising dollar could also jeopardize the competitiveness of U.S. export companies in the world market which could lead to increased trade deficit. Given that goods in a strong currency is more expensive in countries with depreciated currency, the U.S. export products become less attractive to foreign consumers which would reduce the sales of American products. Furthermore, a strong dollar also makes it more difficult for U.S. producers to compete domestically with cheaper imported goods from countries with weaker currencies when converted from a weak currency into a strong currency. Such disadvantage could force U.S. producers to lower its selling price and profit margin, affecting the earnings of the company. A strong dollar could be a major hindrance against full employment recovery, wage growth and the U.S. economic growth rate. While it can adversely affect the U.S. producers, foreign producers can reap the benefit by boosting their exports to the U.S. even further.
However, while the U.S. producers face barriers in competing against other countries with weak currencies, the U.S. consumers are the winners whose surplus and purchasing power are increased. According to the World Bank’s data, the U.S. export of goods and service relative to its total GDP was only 13.5 percent in 2013. As a consumption-based economy, the U.S. should gain from a strong dollar in an aggregate effect.
Implication on investment
Return of investors from foreign market is also diminished due to a strong dollar. Although the return is high, it will be reduced once converted into dollar, thus reducing the overall returns. For example, the MSCI EAFE index or Europe, Australasia and Far East of developed market stock has risen 4.5% by September in its local currency. The return once converted into U.S. dollar was negative 1 percent (Kelly, 2014). Thus, investors who aim to diversify their investment portfolio by investing in foreign stocks should take into account the currency risk as a result of currency depreciation against the dollar in Europe, Japan and other markets and the fact that their return in foreign currency is reduced significantly when converted to the U.S dollar term.
Mackenzie Investments advised its investors that in a strong dollar climate it is wise to invest in U.S. equities but selectively pick the U.S. companies that benefit most from a rising dollar. Those companies should not have much exposure to currency risk and have most of their business operation in the U.S. and generate most of the sales within the U.S. Moreover, those companies should benefit from the cheaper import material from abroad. The recommended sectors are utilities, consumer staples, healthcare and telecommunication. Moreover, Mackenzie Investments also encouraged investors to favor mid- and small cap companies, since most of these companies’ businesses are operated domestically and do not face with currency risk significantly.
Emerging markets may suffer the most from a strong dollar. Flanders and Dryden (2014) claimed despite relishing the boost in exports to the U.S., some nations of the emerging markets may face high inflation rate and foreign capitals diverted from within the countries to other stable markets which could results in “serious market volatility” as experienced during the Asian financial crisis in the 1990s. The two J.P. Morgan’s analysts also stated that equity prices in emerging market economies are negatively correlated with the trade-weighted dollars. This phenomenon may be explained by the fact that the dollar generally depreciates when the commodity price is low and foreign capitals flowing out of the emerging economies. They also found that countries of EMEA (Europe, Middle East and Africa) and the U.S. dollar have a -0.31 correlation, MSCI Emerging Markets Index and the U.S. dollar has a -0.82 correlation and Latin America economies and the dollar has a -0.86 correlation.
Will the dollar continue to rise?
The recent trend of the dollar appreciation caused currency experts and investor to bring their concerns on “Dollar-Euro Parity”. When two currencies is at parity, it simply means that both currencies have the same value and are traded 1:1. Robin Brooks, a strategist at Goldman Sach, predicted that Dollar-Euro parity will take place in the fourth quarter of 2015. The strategist even further forecasted that the Euro could be traded at a low 0.80 dollar by the end of 2017, which will be the lowest exchange rate since the inception of the Euro currency.
Predicting the movement of the currency exchange rate is a challenging analysis. Whether the dollar will continue to rise takes into account many factors. First, it depends upon the state of the U.S. economy, that is, whether the U.S. economy can still outperform the developed market. The outcome of the ECB’s version of quantitative easing and expansionary monetary policy still remain to be seen and it is too early to judge whether the QE could attain its goals. Forbes reported that if Europe’s economy showed sign of positive economic data, the dollar-euro parity will unlikely happen. Second, the strength of the dollar also depends upon the decision of the Federal Reserve of when to raise the interest rate and by how much. Given the current positive data from the labor market and price stability, the Federal Reserve’s interest rate hike is imminent and is likely to happen by the end of 2015 which is predicted by many analysts.
Hedging against the U.S. dollar
In the climate of a rising dollar and foreign currencies depreciation, hedging against the dollar has been popular among investors who aim to mitigate the currency risk of investing in foreign markets. Hedging currency can take many different forms, including sophisticated derivatives, that is, forward contract, foreign exchange swap, currency options, purchase of a currency-hedged mutual fund or exchange traded fund (ETF).
The method of forward and option to hedge is sophisticated. Since the currency-hedged ETF is more convenient, investors start to pour fund into ETFs to protect their investment from a surging dollar. The Wall Street Journal (WSJ) reported that currency-hedged ETFs, mainly offered by WisdomTree Investment and Deutsche Bank, is currently worth 50.3 billion dollar thanks to the growing concerns of the recent trend of a rising dollar. The figure below from the WSJ also showed that the returns of currency-hedge funds consistently beat the returns of unhedged funds since 2014. However, it should be noted that the performance of a fund within just a short period of time does not represent a full and complete picture of the returns in the long run nor does it indicate that a currency-hedged fund will continue to exceed the return of an unhedged fund in the coming years. Since the currency-hedged ETF is new to the market and hedging can be expensive and reduce the return when the global economic condition and world market change.
The WSJ also presented an argument against currency hedging. Hedging against the dollar can yield benefits in the short run given that the dollar is rising at the moment. However, currency movement goes in both directions - a currency can appreciate and depreciate over a period of time. In the long run, the currency risk is minimal and returns should be generally the same for hedged and unhedged funds. However, there is a cost incurred when you decide to hedge which could diminish your overall return in the long run.
Figure 2: Currency-hedged ETFs asset, one year return of hedge and unhedged funds
Source: The Wall Street Journal
Whether or not to hedge against currency, investors are advised to gauge the magnitude of the currency risk and its degree of likelihood, understand your time horizon in holding the securities, weigh the potential benefits and costs of hedging.
Conclusion
As a dominant international currency, the value of the dollar against other foreign currencies results in several implications which bring concerns to investors and the world market. Several factors are attributed to the rise of the dollar value in relative to other foreign currencies, including the relatively more impressive U.S. economic growth compared to other developed nations, the potential of the Federal Reserve’s interest rate hike, the quantitative easing program of the ECB and BOJ, capital inflow to the U.S. market and the U.S. energy revolution.
Major implications include the decrease in earnings of U.S. companies whose sales are mainly generated in foreign countries, the decrease in the return of investments in foreign market once converted to the U.S. dollar, the negative impacts on the competitiveness of the U.S. producers, the more expensive U.S. export products and the cheaper import products to the U.S.
Against the backdrop of the current economic condition, a currency strategist at Goldman Sachs predicted that the dollar and the euro would be traded at parity by the 4th quarter of 2015 and the euro-dollar exchange rate could even further drop to the lowest rate at 0.80 dollar per euro by the end of 2017. However, the prediction would not remain valid if positive economic data in the eurozone start to emerge in the near future. In the time being, investors need to pay attention to whether or not the ECB’s quantitative easing program is a success.
In the current rising dollar climate, currency hedging can yield higher return and protect investments in the foreign markets in the short run. However, the returns of hedged and unhedged funds are generally the same in the long run because the value of a currency can either appreciate or depreciate. Investors need to take into account the cost associated with hedging which could affect their overall returns. Investors should also understand the magnitude of the currency risk, time horizon of the investment whether investors opt for a short term investment or a long term investment and weigh the costs and benefits of hedging before deciding whether to hedge against the dollar.
