Amid fears of persistent U.S. dollar strength, many investors may be questioning the role of non-U.S. exposure within their broader equity allocations. But that may not be the wisest choice, as currency moves are notoriously difficult to predict.
Non-U.S. equity investors with unhedged U.S.-dollar-denominated assets have faced currency headwinds since the dollar began appreciating in mid-2014. As a result, many investors may be reconsidering their non-U.S. exposure altogether, or at least questioning its role within their broader equity allocations.
More recently, Donald Trump’s rhetoric about infrastructure spending and tax cuts, combined with accelerating U.S. growth and Fed rate hike expectations, have led many to believe the greenback will continue its climb unabated.
A reasonable case can be made that the U.S. dollar has become overvalued relative to many currencies. The Economist tries to simplify this concept with its Big Mac Index, which compares the price of a Big Mac in different countries. The index is based on purchasing-power parity: the theory that over time exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a McDonald’s Big Mac) in any two countries.
For example, the average price of a Big Mac in January 2017 was $5.06 in the United States and $2.83 in China, suggesting the dollar was overvalued by 79%. Accounting for the wide income disparity between the United States and China, the Economist also calculates the Index adjusted for GDP per person, which puts the dollar’s overvaluation at a more modest 7%. Among primary developed market (and less politically controversial) currencies, the dollar was overvalued by 25%, 22%, and 2% versus the yen, sterling, and euro using The Economist’s income-adjusted measure.
When the U.S. dollar appreciates relative to other currencies, unhedged dollar-based investors experience lower returns due to the foreign currency exposure embedded in their non-U.S. portfolios. Consider a U.S. investor who wants to buy stock of a Japanese company. If the Japanese company’s stock rises 10% and the yen depreciates 5% versus the dollar, that investor’s return would be 5%. To avoid embedded yen risk, the investor could defensively hedge back into the dollar (using currency forwards, for example). With a 100% dollar hedge, if the Japanese company’s stock rises 10% and the yen depreciates 5%, that investor’s return would still be 10%.
Although currency effects vary according to portfolio composition and hedging activity, we can broadly illustrate how much currency has impacted investor returns by comparing the MSCI EAFE Index (unhedged), which includes currency effects, to the MSCI EAFE 100% Hedged to USD Index, which takes currency effects out of the equation for dollar-based investors.
In 2016, for example, the MSCI EAFE 100% Hedged to USD Index outperformed the MSCI EAFE Index by 5.15 percentage points. It also outperformed from 2012 through 2015, as the chart below illustrates. In other words, non-USD “foreign” currency has detracted from the MSCI EAFE Index’s performance over the past five years.
It’s noteworthy that while the U.S. dollar has moved sharply higher since mid-2014 against the world’s major currencies, it was effectively range-bound from March 2015 until the U.S. election in November 2016, when speculation that Trump’s policies could benefit the greenback led it to reaccelerate. Conventional wisdom is that Trump’s promise to borrow money and spend it on domestic projects, such as upgrading the nation’s infrastructure, could spur higher interest rates, driving the dollar higher.
As illustrated by the 2002-2011 returns above, it is not a certainty that the dollar will naturally strengthen uninterrupted over time. It is difficult to predict when currencies will work for or against you. The long-term chart below illustrates just how much the U.S. dollar has fluctuated over time.
Many factors contribute to currency returns and volatility. There are the textbook economic factors, which tend to be longer-term drivers. Interest rate and inflation differentials are important determinants of currency movements over time, as are current account deficits (i.e. balance of trade).
In addition, short-term fluctuations in currency values can occur due to geopolitical events. Foreign investors naturally seek out stable countries with strong economic performance. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital away from that country. That’s what we’ve seen happen to the British pound in the wake of Brexit, and the Turkish lira following last year’s failed coup attempt.
There are different ways to approach foreign currency risk. While explicit currency hedging can play an important role in risk management depending on investors’ unique exposures and objectives, there are also implicit currency considerations for portfolio companies that are relevant. Unlike a passive manager, an active manager has a view into individual companies, and can better assess the impact of currency movements on revenues and costs.
Is the company export-oriented, for example, and to what extent? Such a manager could potentially position a portfolio more toward U.S. dollar earners if he or she anticipates a stronger dollar environment. This might result in a preference for higher exposure to European pharmaceutical or Japanese automotive companies with significant U.S. sales, for example.
The point is, an active manager can be nimble where a passive manager cannot. And currency considerations extend beyond explicit portfolio hedging.
The point is, an active manager can be nimble where a passive manager cannot. And currency considerations extend beyond explicit portfolio hedging.
In sum, while the strengthening U.S. dollar has generally detracted from non-U.S. equity returns in recent years, investors may want to resist the urge to reduce their non-dollar exposure based on recent trends. Doing so could lower overall portfolio diversification given the already significant dollar exposure inherent in U.S.-biased equity allocations.
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