What’s So Good (and Bad) About a Strong Dollar
There is no shortage of headlines discussing the U.S. dollar’s rise. Through year-end 2016, it rose about 4% against a basket of currencies that included the British pound and the euro. That’s good news, right?
Dollar strength versus other currencies is often touted as a positive. But whether the resultsare broadly positive or negative depends on the reasons for strength and how high the dollar rises. In itself, a strengthening dollar is a signal pointing to factors that include economic fundamentals and financial market dynamics:
Fundamental
- Economic strength
- Inflationary pressures from an overheating economy
Technical
- The level (and direction) of interest rates relative to those of other developed countries
- Global supply/demand dynamics; the dollar’s value reflects not just fundamentals but its desirability as an investment versus other currencies
The currency market is global. The dollar might rise in anticipation of faster economic growth or rising interest rates in the United States versus in other developed countries only to reverse course when they don’t ultimately play out. Monetary and fiscal policies, and expectations about them, are two other major factors that drive its exchange rate. As the world’s reserve currency, in times of rising geopolitical risk and especially when financial markets experience a shock—the Brexit vote is a recent case in point—the dollar tends to rise temporarily as investors flock to perceived safety.
Recently, the combination of a reinvigorated economy, higher interest rates in the United States versus in the European Union and Japan, plus expectations the Federal Reserve will keep raising rates have pushed the dollar higher. A new presidential administration promising major spending on infrastructure and tax cuts is an additional support.
Short- and long-term effects of a strong dollar
Strength that reflects positive economic fundamentals should benefit company revenues and stock prices, at least initially. For exporters though—who must compete in global markets—a rising dollar makes their goods seem more expensive to overseas customers, putting them at a competitive disadvantage. A dollar that trades too high relative to other currencies will ultimately hurt U.S. companies’ sales and profits, eventually negatively affecting valuations and stock prices. Over time, and as we’ve seen, it can exacerbate the trade deficit, and ultimately lead to lower economic growth rates.
On the flip side, European and emerging-market economies should benefit as their multinational companies gain a pricing advantage, boosting corporate earnings, stock prices, and local-currency investment returns. This is true, to a degree, for emerging-market economies too. But for companies with a large percentage of debt priced in U.S. dollars, a rising dollar also raises credit risk.
How might dollar strength impact our portfolios?
We are exposed to regional emerging-market currencies through our positions in emerging-market stocks. We also have exposure to the euro through our European stock position. In the shorter term, these can be a drag on performance because of the impact a strong U.S. dollar has on investment returns generated in relatively weaker foreign currencies once those are translated into dollars. However, since we manage globally diversified portfolios, we expect a net benefit from currencies over the long term.
Why don’t we just hedge currencies to avoid the impact of a strengthening dollar (or a weakening euro, British pound, and Chinese renmimbi)?
Currencies are some of the most difficult financial markets to predict; there is no reliable, widely accepted way to arrive at fair value. We do take the impact of differences in currency valuations (along with other factors) on expected performance into account in assessing the relative attractiveness of different stock markets. We also monitor currency effects and adjust portfolio positioning accordingly. For example, with our tactical position in European stocks we balance the risk of a further decline in the euro with the view that it appears cheap versus the dollar by maintaining both a hedged and an unhedged position.
Lastly, our managed futures strategies, which try to exploit trends in prices and market relationships across assets, take positions in currencies. These may play out positively (e.g., when the British pound fell after the Brexit vote) or negatively in the short term, but we expect them to add value and diversification benefits over the long term.