Background
The movement of currencies is a reflection on the conditions of one country relative to another. Whether one country’s outlook is rosier than another depends on three main factors: relative interest rates, inflation, and economic growth. This is all worth paying attention to because it can greatly affect investment performance. A strengthening currency is generally positive for domestic stocks, as it often reflects a growing economy and enables purchasing power abroad. Alternatively, investment returns denominated in a foreign currency will shrink when profits are converted from a weaker to a stronger currency. Currently, we are experiencing one of the longest US dollar strengthening markets since the US Dollar Index (USDX) was created in 1973, leading some to question if it’s time for a reversal.
What Drives the Dollar
During a strengthening market, the US dollar (USD) appreciates relative to other currencies. The USD tends to have long cycles with extended periods of strength and weakness. Over the past decade, we have seen a rising dollar due to stronger US economic growth, higher relative interest rates and the USD’s role as a safe haven during periods of geopolitical concern. The dollar’s upward trend came to a pause in early 2020 as the pandemic swept across the world, and we experienced unprecedented federal spending, strong forecasted growth from other countries, and concern regarding the USD’s reserve currency status. As this negative outlook persisted, betting against the dollar became a popular trade late last year.
Surprise Dollar Strength
Earlier this year, news in the US and abroad led to a surprise reversal in the weakening dollar trend. The Federal Reserve signaled its ultra-accommodative policy stance is nearing an end, leading to upward pressure on the 10-year Treasury yield. Rising rates may continue if the Biden administration’s recent stimulus package (and potential infrastructure deal) leads to earlier policy normalization by the Fed. Conversely, the European Central Bank is moving toward additional easing and approximately $12T of debt around the globe is still in negative yield territory. If we do see continued dollar strength, this could force many investors that have expected a dollar decline to unwind those positions, pushing its valuation even higher.
Investment Return Impact
Over the past five decades, we have seen three rising and three falling dollar markets; this has proven to be a meaningful indicator of asset class performance. US Equities (both large and small cap) have performed the strongest in a rising dollar environment, while Non-US Equities and Emerging Markets have performed best when the dollar was falling. Emerging Markets have had the greatest dispersion during the strengthening and weakening parts of the cycle, likely due to the heightened volatility of currencies in less established economies. Fixed Income has historically been less affected by currency movements than equity markets.
For investors seeking to minimize currency risk or take advantage of dislocations across currency markets, there are strategies that hedge and/or allocate money based on perceived arbitrage opportunities. Broadly speaking, however, managers often avoid such positions as currency management is expensive and can be a drag on performance over longer periods of time. As evidence of this difficultly, the number of active currency managers has declined by 66% since 2008. From an asset allocation standpoint, multiple currency exposures in your portfolio can be a benefit as it adds to the diversification of return drivers over time.
Our Position
Over time it has proven difficult to consistently add value by timing currency movements and over long time periods their movements will cancel out. For individual investors that have outsized currency exposure or liabilities denominated in another currency, management of this exposure may be customized to meet their return objectives and risk tolerance. For most investors, however, it is prudent to refrain from active currency management and maintain a well diversified portfolio that will provide resiliency and value throughout the currency cycle.
Disclosures:
The views expressed herein are those of Asset Consulting Group (ACG). They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. This report was prepared by ACG for you at your request. Although the information presented herein has been obtained from and is based upon sources ACG believes to be reliable, no representation or warranty, express or implied, is made as to the accuracy or completeness of that information. Accordingly, ACG does not itself endorse or guarantee, and does not itself assume liability whatsoever for, the accuracy or reliability of any third party data or the financial information contained herein.
Certain information herein constitutes forward-looking statements, which can be identified by the use of terms such as “may”, “will”, “expect”, “anticipate”, “project”, “estimate”, or any variations thereof. As a result of various uncertainties and actual events, including those discussed herein, actual results or performance of a particular investment strategy may differ materially from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in making investment decisions. ACG has no duty to update or amend such forward-looking statements.
The information presented herein is for informational purposes only and is not intended as an offer to sell or the solicitation of an offer to purchase a security.
Please be aware that there are inherent limitations to all financial models, including Monte Carlo Simulations. Monte Carlo Simulations are a tool used to analyze a range of possible outcomes and assist in making educated asset allocation decisions. Monte Carlo Simulations cannot predict the future or eliminate investment risk. The output of the Monte Carlo Simulation is based on ACG’s capital market assumptions that are derived from proprietary models based upon well-recognized financial principles and reasonable estimates about relevant future market conditions. Capital market assumptions based on other models or different estimates may yield different results. ACG expressly disclaims any responsibility for (i) the accuracy of the simulated probability distributions or the assumptions used in deriving the probability distributions, (ii) any errors or omissions in computing or disseminating the probability distributions and (iii) and any reliance on or uses to which the probability distributions are put.
The projections or other information generated by ACG regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Judgments and approximations are a necessary and integral part of constructing projected returns. Any estimate of what could have been an investment strategy’s performance is likely to differ from what the strategy would actually have yielded had it been in existence during the relevant period. The source and use of data and the arithmetic operations used for calculating projected returns may be incorrect, inappropriate, flawed or otherwise deficient.
Past performance is not indicative of future results. Given the inherent volatility of the securities markets, you should not assume that your investments will experience returns comparable to those shown in the analysis contained in this report. For example, market and economic conditions may change in the future producing materially different results than those shown included in the analysis contained in this report. Any comparison to an index is for comparative purposes only. An investment cannot be made directly into an index. Indices are unmanaged and do not reflect the deduction of advisory fees.
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