What Dollar Strength or Weakness Means for Your Portfolio
How to Protect Your Portfolio From Currency Risks
There has been an unspoken rule among heads of state, finance ministers, and central banks saying that they don’t target and specifically mention currency valuations. That’s why it came as quite a surprise in January 2017 when President Donald Trump said that the dollar was ‘too strong’ and blamed it for the lack of competitiveness with China. Equally surprising was Trump’s pick for Treasury Secretary — Steven Mnuchin — who appears to hold the opposite view.
In this article, we will look at where the dollar may be headed, what a strong dollar means, how it affects investors, and what investors can do to mitigate risk in any scenario.
Strong vs. Weak Dollar
Global currencies trade relative to each other rather than at an absolute value. For example, you can’t ‘buy’ euros without ‘selling’ dollars. The price of a euro in dollars is known as the exchange rate and it varies depending on each economy’s performance and other factors. A ‘strong’ dollar means that each dollar purchases more units of foreign currency, while a ‘weak’ dollar means that each dollar purchases fewer units of foreign currency.
The United States has maintained a ‘strong dollar policy’ since 1995, which means that it does not intentionally act to devalue the dollar versus foreign currencies. By doing so, the United States has encouraged foreign bondholders to buy Treasury securities, inflation has been kept in check, and the currency has become a staple of the global financial system since it’s backed by the world’s largest and most resilient economy.
The benefit of a strong dollar is that each dollar purchases a greater number of goods priced in foreign currencies, but the tradeoff is that domestic goods are more expensive to foreign consumers. In the case of China, this meant that the U.S. imported $483.9 billion while exporting just $116.2 billion from China in 2015.
This created a record $367 billion trade deficit that has become a popular political target among populist politicians.
Impact on Investments
The dollar’s valuation has a significant impact on both the United States’ domestic investments and foreign investments.
The strong dollar has helped contain inflation during the 1990s, but since the 2008 Great Recession, the rising dollar has made the Federal Reserve’s job harder. The central bank would like to see greater inflation to promote borrowing and economic growth, but a strong dollar makes that impossible. The strong dollar may also be depressing domestic demand and pulling down net exports, according to Federal Reserve Chairwoman Janet Yellen.
The dollar’s status as a global reserve currency means that other countries also rely on its stability. Since the dollar has been relatively cheap, emerging market non-bank borrowers have accumulated more than $3 trillion in dollar-denominated debt, according to the Bank for International Settlements. A strengthening dollar — and weakening emerging market currencies — could create problems by making dollar debts expensive to repay in local currency revenue.
Hedging a Portfolio
There are many ways for investors to hedge a portfolio against currency movements, but currency-hedged exchange-traded funds (“ETFs”) are the most popular.
These funds replicate an underlying index — just like a typical fund, but add short-term forward contracts that enable them to convert foreign currency into dollars at a pre-agreed exchange rate. The goal is to minimize the impact of currency movements on dollar-denominated portfolio returns.
Charles Schwab’s Michelle Gibley points out several important factors to consider:
- Reduced Volatility: Currency-hedged funds tend to exhibit less volatility than unhedged portfolios, according to data comparing MSCI EAFE Index between 1969 and 2016.
- Long vs. Short-Term: Currency-hedged funds have outperformed over the short-term as the dollar has risen versus other currencies, but there is little long-term benefit.
- Costs: Currency-hedged funds have higher expense ratios than unhedged funds, while investors must also pay the carrying cost and bid/ask spread.
- Diversification: International ETFs are designed to diversify an investment portfolio, but stripping out the effect of currency valuations can reduce that diversification.
In general, most long-term investors should stick to unhedged funds since they tend to generate higher returns with lower costs and greater diversification. Short-term and active investors looking to profit from specific situations, however, may want to consider currency-hedged funds to reduce risk or capitalize on certain scenarios.
The Bottom Line
The United States has historically maintained a strong dollar policy, but these dynamics could change with President Trump’s focus on domestic manufacturing and export. While the policy may remain unclear at the moment, investors should keep in mind how a strong versus weak dollar impacts investments. At the same time, it’s important to note that long-term investors may want to ignore these risks and stick with unhedged funds for the best risk-adjusted returns.