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Monetary Policy and the Federal Reserve
How the Dollar’s Volatility Affects International Investing
By Eric Weiss, CFP®
Financial Planner, Chadwick Financial Advisors
For U.S. investors, the notion of "globalization" isn’t some vague political theory. It’s an economic reality reflected in the strength of the U.S. dollar and manifested in their investment portfolios.
Since 2004, the dollar has been on a steady slide against major world currencies, particularly the surging euro, which is beginning to rival the U.S. dollar as a currency of choice in international trade. At the same time, U.S. equities have lagged behind their international counterparts in a trend that is expected to continue into the foreseeable future, says Nasser Ali, Regional Director of Financial Advisory Services at Lincoln Financial Advisors.
This trend reflects a sea of change in the balance of economic power around the globe, Ali says. U.S. investors who have previously been reluctant to invest outside their home shores may now need to rethink their asset allocation strategies in the face of this evolving world economy, Ali says. "Long term, with globalization continuing to snowball, international investing is going to become increasingly important for all investors," Ali adds.
Seeing the Glass as Half Full and Half Empty
While the media tends to gravitate toward quick sound bites - depicting a strong dollar as "good" and a weak dollar as "bad" for the U.S. economy - those thumbnail analyses oversimplify a very complex situation, Ali says. In fact, the relative strength or weakness of the dollar affects parties in different ways.
A strong dollar benefits local consumers who buy foreign goods because the goods are then available at cheaper prices locally. The increased spending spurs certain sectors of the domestic economy, such as retail, but hurts U.S. exports because then American goods and services become far more expensive by comparison. The end result - while a delayed effect - is that U.S. corporate earnings can be depressed overall by a strong dollar.
In contrast, a weak dollar limits local consumers because foreign goods are more expensive locally, while U.S. corporations become more competitive abroad.
U.S. investors who hold foreign investments may have a different experience depending on the amount of foreign investments held in a portfolio. "A weakening dollar would benefit you immediately because it helps drive those international returns higher as international assets would appreciate in value relative to the dollar," Ali says.
Impact of Inflation and Booming Foreign Economies
Rather than focus solely on the dollar’s value, investors should first try to understand the broader economic issues that drive down its value. The first, of course, is inflation. Typically, when inflation is higher, it erodes the value of the country’s currency as well as consumer spending power.
The Federal Reserve has been able to keep U.S. inflation in check with a steady stream of interest rate hikes, but that hasn’t been enough to offset mounting pressure on the dollar from the U.S.’s skyrocketing trade and budget deficits. The weak dollar hasn’t been enough to stem the record flow of foreign goods coming into the country, and the escalating U.S. budget deficit is keeping foreign investors out of the U.S. market.
And while the U.S. economy is growing at a measured pace, emerging economies abroad have strengthened, due in large part to the economic rebound in Asia, which is being driven by China’s strong economic growth. "What has hurt the U.S. currency the most is what is happening in the global economy," Ali explains. "Relatively, it is expected that the U.S. dollar will stay low and continue to weaken."
Ali expects the dollar to decline another 10% to 15% against the euro. In fact, the relatively new currency is increasingly being used in international trade, potentially replacing the U.S. dollar as the primary exchange for the global economy at some point in the future. The dollar could sink further if China makes good on its threat to uncouple the yuan from the dollar.
Historically, China has tied its currency directly to the U.S. dollar in order to maintain the yuan’s strength in international markets. But with its own economy booming and the U.S. dollar weakening, China is moving toward separating its currency and allowing it to float on the open exchange. The result of such a move would be even more pressure on the dollar, because the Chinese economy is on a much stronger growth trajectory than the U.S. economy, Ali says.
Consider Globalizing Your Asset Allocation
The U.S. markets are already feeling the gravitational pull of expanding foreign economies. Foreign investors who previously viewed the U.S. markets as a safe haven are increasingly shifting their assets to countries with stronger economies and currencies. This will have a long-term dampening effect on the U.S. markets, Ali says. "It won’t happen immediately, but the impact will evolve," he says.
For this reason, it may be advisable for U.S. investors to position themselves for these projected long-term shifts by considering international investments as part of their asset allocation, either through international stock or bond funds. Investors holding assets that are counted in another country’s currency can expect to see a direct and immediate impact on their holdings if that currency appreciates. However, keep in mind that the risks associated with investing on a worldwide basis include differences in regulation of financial data and reporting, currency exchange differences, as well as economic and political systems that may be different from those in the United States.
Still, this doesn’t mean you should abandon your core U.S. holdings. "We still live and breathe in the United States," Ali says. "We still buy things in U.S. dollars, and the majority of things that we purchase are American-made, so you still need a big piece of your portfolio in U.S. investments."
This article is an assessment of the market environment at a specific point in time and is not intended to be a forecast or promise of future events. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the results contained in the forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on any forward-looking statements as a prediction of actual results or a projection of earnings.
CRN200603-1006549
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