An Easing of the Dollar May Lift International Portfolios
By Mark Brett
Capital Group Currency Analyst
Over the past five years, the dollar has been on a tear. Comparatively high interest rates in the U.S. have pushed the greenback up against virtually every other currency. The shift has had widely varying effects around the world, boosting the prospects of some economies and companies while rattling those of others. It’s been tough on U.S. investors who own shares of foreign companies, as overseas investment returns are negatively affected when converted back into dollars.
I believe the dollar’s lengthy rally may now be nearing an end, especially in relation to the euro and the yen. Though the dollar probably won’t decline noticeably, I think it is about to enter a period of generally sideways movement. Currency trends often run in multiyear cycles that give way as the conditions that brought them about begin to change. The current bull run in the dollar, which began in 2011 and intensified in mid-2014, is likely to follow such a pattern.
For investors, a flattening of the dollar against the euro and yen could help to ease some of the pressure that has weighed on global stock and bond portfolios. In recent years, the investment returns of many overseas markets have been sharply reduced when their weakened currencies were translated into dollars. For example, from 2012 to 2015, the MSCI Japan index rose 88% when measured in yen but only 34% when converted into dollars. The MSCI EAFE index advanced 43% in euros during that span but only 18% in dollars. Depending on how much the dollar eases, currency translation could even become a tailwind for dollar-based investors in the eurozone and Japan.
Higher interest rates don’t always lead to stronger currencies.
My expectations for a softening dollar cut somewhat against conventional wisdom. It’s widely assumed that the dollar will remain elevated because U.S. interest rates are likely to keep hovering above those of other countries. Even as the U.S. contemplates a further tightening of monetary conditions, central banks in the eurozone and Japan are loosening their policies to combat middling economic growth. Many overseas rates have even sagged into negative territory.
Dollar bulls subscribe to the popular notion that capital always flows to economies with the highest interest rates. That certainly was the case in the 1980s, when a roaring U.S. economy stood out from the stalled growth afflicting other parts of the world. At the time, high inflation overseas allowed the dollar to appreciate without hampering U.S. competitiveness. However, a close reading of history shows that higher rates don’t necessarily push up a currency’s value. In fact, forces such as corporate capital spending can have a greater impact. As an example, the start of the dollar bull market in 2011 stemmed partly from some American companies returning manufacturing operations to the U.S. from overseas.
More important is the fact that today’s economic backdrop is vastly different from what it was three decades ago. The global economy and financial markets are far more intertwined. China’s clout is greater. Global inflation is low. And many currencies already have suffered such punishing declines that further setbacks are less likely. Indeed, the euro and the yen both appear to be undervalued against the dollar. This is measured through a calculation known as purchasing power parity, or PPP, which gauges the exchange rate at which two currencies would have identical purchasing power in their respective economies. The euro began this year about 15% below its PPP value while the yen was about 25% undervalued. It’s very likely that this gap in rates will eventually narrow.
Beyond that, some of the forces that typically cause currencies to depreciate, such as inflation and trade imbalances, are not present in the eurozone or Japan.
China is playing an increasingly important role in currency markets.
It’s unclear how developments in China will affect foreign exchange markets, but there’s no doubt they will. That was evident in January, when China caught the markets flat-footed by unexpectedly devaluing its currency, the renminbi. China’s economic deceleration — and the government’s ongoing attempt to recast the country’s economy from investment-driven to consumer-led — have battered the currencies of commodity-exporting nations such as Australia, Brazil, Indonesia and South Africa. Given the sheer size of its economy, China’s impact extends beyond currency-producing nations. For example, Asian nations whose economies are closely tied to China, either because they rely on Chinese demand or compete against Chinese companies in export markets, could be at risk of further currency weakness.
The slowing Chinese economy could even exert downward pressure on the dollar. Chinese demand plays a bigger role in U.S. corporate earnings growth than it did a decade ago. Anything clouding that growth could prompt the Federal Reserve to raise interest rates less than it otherwise might have. A deeper threat could even induce the central bank to cut rates or resort to another round of bond buying known as quantitative easing. Either of those steps would almost certainly sap energy from the dollar.
Despite the attention that currency shifts draw, the underlying fundamentals of individual companies are far more important to investment returns over the long term. In other words, superior stock selection outweighs currency fluctuations. Companies with disappointing earnings frequently blame their misfortunes on currency swings, but that’s often just a subterfuge to mask deeper problems. I am working closely with our equity analysts to assess the true impact of currency gyrations in order to identify companies with strong potential that should fare well regardless of conditions in the foreign exchange markets.
Mark Brett is a fixed-income portfolio manager who focuses on currency analysis. Based in London, he has 37 years of investment experience and has been with Capital Group since 1994.