Finance & Banking
As anyone who has vacationed in Europe lately can attest, you don’t have to be a king or a queen to receive the royal treatment. The powerful appreciation of the U.S. dollar has made this one of the best times in years to book a chateau in Switzerland, snap up fashions in Paris or explore landmarks in Rome. This may be the most desirable effect of the dollar’s multiyear rally, especially its percussive surge over much of the past two years.
But as with many things currency related, the dollar’s upward march comes with a less than ideal flip side. The brawny dollar has strained the global economy and weighed on the investment results of U.S. shareholders in foreign-based companies.
The most visible tradeoff is that investment returns earned in weak foreign currencies take a hit when converted to dollars. On average over the past decade, the robust dollar has sliced a painful 3 percentage points a year from returns, estimates Steve Caruthers, a Capital Group equity investment director. That comes on top of the other factors dragging on international returns, including subdued overseas economies and the outsize influence of big technology stocks in U.S. indices.
Nevertheless, it’s essential to put both currency effects and the challenges facing international equities into perspective. The obvious impulse — to minimize exposure to international markets — could backfire by causing investors to miss out on the many successful companies that lie beyond U.S. shores. Instead, detailed research and agile portfolio management can help identify promising opportunities regardless of currency or economic trends.
A case in point: Despite the conventional wisdom that a strong dollar hurts overseas investments, that’s not always the case. In fact, foreign companies that generate significant revenue in the U.S. — such as European luxury goods makers and Japanese factory automation providers — can benefit from the dollar’s strength.
Indeed, a host of factors bode well for overseas investing. Among them: There are compelling dividend opportunities overseas. Also, non-U.S. companies could benefit from an expected revamping of global supply chains and energy infrastructure. And valuations of foreign businesses are often significantly more attractive than those of their U.S. counterparts.
Of course, the global economy faces many questions in 2023, starting with the risk of recession. That’s especially true in Europe as governments reckon with the impact of the Ukraine war and the resulting energy crisis. But for many investors, the opportunities are tantalizing.
“Investors should be looking to where they can find value and where they can find good world-beating companies,” says Capital Group European economist Robert Lind. “The fact is that Europe still has a lot of good companies. For all of the bad politics and challenged economics of the last two decades and the continuing war in Ukraine, there are some excellent companies in Europe that produce things many people around the world want to buy.”
The dollar’s commanding rally has stood out in both magnitude and duration. Currency cycles typically last for years, a reflection of the underlying economic and financial forces driving them. But the current cycle has been particularly long-lived. The greenback plummeted in the lead-up to the 2008 global financial crisis as the U.S. housing market melted down. It then launched into a generally steady incline as the U.S. economy bounced back more quickly than Europe’s and Japan’s.
The rally hit a crescendo in the past two years — initially as the U.S. economy boomeranged after the COVID downturn, and more recently as the Federal Reserve torqued interest rates more aggressively than other central banks in hopes of blotting out inflation. Last year, the dollar briefly hit parity — a one-for-one swap — with the euro for the first time in two decades. It climbed to a 24-year high against the Japanese yen and a record peak against the British pound.
“Tighter U.S. monetary policy is pushing up the dollar while the cost-of-living crisis is pushing the euro lower,” Capital Group currency analyst Jens Sondergaard says. “Add the two together and the dollar’s strength is not surprising.”
The dollar rally is expected to give way at some point — perhaps if the Fed throttles back rate hikes and other central banks intensify theirs. Indeed, the dollar has eased back lately as other countries have hoisted rates to quell inflation and defend their currencies. Nevertheless, Sondergaard believes the dollar will maintain its edge in the near term, particularly as Europe works through the energy-related impacts of the Ukraine war.
The dollar’s strength may boost select companies across industries. Consider French consumer discretionary giant LVMH, which owns luxury goods maker Louis Vuitton and counts about 27% of its revenue in dollars. In a recent shareholder presentation, LVMH noted that currency effects boosted its profit by more than 400 million euros in the first half of 2022. The currency impact alone accounted for about 19% of the company’s improvement in operating profit on a year-over-year basis.
“If you can identify non-U.S. companies where a lot of the revenue is in dollars but the cost base is in a local currency, the currency effect works in your favor,” Sondergaard says. “There are a number of those companies, and we keep a close eye out for them.”
A muscular dollar also bodes well for industrial automation providers. The COVID pandemic and trade tensions with China are prompting many manufacturers to move some production closer to home. That means building expensive new factories, heightening the need to minimize costs elsewhere.
That may add to the appeal of industrial robots, which have become increasingly sophisticated and affordable. Many automation businesses are based in Japan and have customers around the world, including in the U.S.
“As companies increase manufacturing capacity across the world, they’re going to go straight to factory automation technology,” Caruthers believes.
Regardless of which way the dollar moves, there are reasons to venture overseas. One is that good businesses can excel despite supposed geographic headwinds. Since 2013, the 50 companies with the best annual returns each year have been overwhelmingly based outside the U.S. That’s due partly to multinational businesses that generate revenue around the world and thus are less tied to conditions in their home countries.
There are also substantial dividend opportunities outside the U.S. It was easy to overlook dividends when tech stocks bounded higher during the long-running bull market. But dividends may assume a more important role in coming years as the global economy adjusts to higher rates and inflationary pressure.
Dividends have historically been a big part of the investment landscape outside the U.S. As of October 31, 2022, about 600 companies headquartered in international and emerging markets offered hefty dividend yields of 3% to 6%, compared with only 121 in the U.S. International companies that have paid steady and above-market dividends can be found across sectors, including financials, consumer staples, health care and materials.
The nature of bull markets also may lift non-U.S. businesses. Historically, and perhaps counterintuitively, the industries and companies that dominated bull markets haven’t spearheaded the subsequent upturns. Instead, a fresh set of leaders has come to the fore. Tech dominated for much of the past decade, but its recent struggles suggest that a new crop of leaders may emerge in the next advance.
Some old economy industries such as materials and industrials may start to shine. Many companies in those sectors are based outside the U.S. Europe’s energy crisis, coupled with mounting concerns about climate change, is expected to bring heavy spending on energy-related infrastructure.
“This could spur the type of significant investment program that we’ve really not had since the end of the Second World War,” Lind observes. “You are going to have to effectively rebuild energy systems and transport systems across large parts of Europe and, indeed, across large parts of the world. Europe has exactly the kind of companies that can benefit from that.”
Finally, consider corporate valuations and potential currency shifts. Given the comparative underperformance of non-U.S. markets in recent years, foreign company valuations tend to be compelling. Separately, investors could benefit from currency movements in two ways. First, the strong dollar boosts the buying power of investors acquiring shares of foreign companies, Caruthers says. Second, those holdings could benefit from an eventual softening of the dollar, he notes.
“A lot of risk has been taken out of these markets because of the double whammy of compressed valuations relative to the U.S. and an extremely long currency cycle,” Caruthers says. “The strength of the dollar won’t last forever. This feels like the right time to build up international exposure.”
To be sure, the global economy is full of unknowns that could weigh heavily on stocks. Fed rate hikes could tip the U.S. into recession. Global supply chains could suffer if the loosening of pandemic restrictions in China triggers a large COVID outbreak. And Europe could be further squeezed by onerous inflation, higher interest rates and weak growth.
On a positive note, Europe has been surprisingly resilient to this point. Thanks partly to government assistance to consumers grappling with high energy costs, a European recession could be far milder than during the 2008 global financial crisis or the pandemic, Lind says. Still, a downturn remains likely.
“Perhaps it won’t be as deep as some people imagine, but I think there will be a recession,” Lind says.
Nevertheless, attractive valuations and other factors could turn sentiment more positive as the year unfolds.
“The valuation discount is now so extreme that investors may think, ‘We should be looking at Europe and at specific world-class companies that have perhaps become too cheap,’” Lind says.
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