How to Capitalize on a Stronger U.S. Dollar
The U.S. dollar has been a strong performer during the first half of 2015, as European and Asian countries have implemented or continued quantitative easing campaigns. In fact, the U.S. dollar has risen an average of 10% against most foreign currencies during the first quarter of 2015 alone, which has greatly impacted many international investment portfolios. These dynamics have been driven by the relatively strong performance of the U.S. economy.
In this article, we’ll take a look at how international investors can position their portfolios to benefit from a strong U.S. dollar.
Impact of a Strong Dollar
The strong U.S. dollar has a negative impact on U.S. investors holdings foreign assets since investors receive fewer U.S. dollars in exchange for the value of euros or other currencies. In fact, many large U.S. corporations that have significant sales abroad experience declines in their net income due to the high valuation of the U.S. dollar. Lower revenue growth and net income can lead to lower equity valuations, particularly in growth stocks.
In addition to the microeconomic impacts, a strong U.S. dollar usually means that interest rates will remain higher in the U.S. compared to many other countries. Higher interest rates are usually associated with lower stock market performance since they increase the cost of capital for investors and corporations. High-interest rates are also bad for bonds, because price and yield are inversely correlated, which tends to hurt bond portfolios.
Hedging Against Losses
The strong U.S. dollar is considered a type of currency risk for international investors – that is, a risk that stems from relative currency valuations. These currency risks affect all different kinds of foreign investments, including equities, bonds, American Depositary Receipts (“ADRs”), and international exchange-traded funds (“ETFs”) and mutual funds. Fortunately, international investors aren’t without options when hedging against these risks.
There are several ways to hedge against currency risk:
- International Hedged ETFs – Some international ETFs have baked-in hedges against foreign currency movements using swaps and other derivatives. In these cases, investors will participate in any foreign upside without the risks associated with the conversion of foreign currency into U.S. dollars.
- Forex ETFs and Swaps – International investors can take a more hands-on approach by investing in forex ETFs (those that hold baskets of currencies) or by purchasing foreign currencies directly in the forex market through swaps or other trades. It’s worth noting, however, that these strategies are generally much riskier.
Currencies are volatile and difficult to predict in the short- and medium-term, while even the long-term can be uncertain in some cases. Often times, economic growth will justify a rise or fall in interest rates, but monetary policy interventions can move currencies in ways that are difficult to reliably predict. As a result, long-term investors may want to reconsider hedging their portfolios against specific currency risks in some cases.
A second issue with hedging currency risks is that they provide an element of diversification to a portfolio. After all, a strong dollar may help currency-hedged ETFs, but a weak dollar will hurt them, compared to their unhedged peers. International investors that can’t time the market risk missing out on these diversification opportunities in the event that the U.S. dollar weakens against one or a basket of foreign currencies over time.
International investors may want to consider hedged ETFs or forex tools when the U.S. dollar is strong in order to help improve international returns. Of course, the risk is that they will time the market incorrectly and end up taking on further losses. Long-term investors may want to stick to unhedged ETFs to preserve diversification and leave the hedging opportunities to experienced active traders and investors that are closely watching the market.