A solid grasp of exchange rates and how they impact various asset classes can help international investors make better-informed decisions.
The asset class most likely to be impacted negatively by a strengthening dollar is non-dollar fixed-rate bonds.
Weakness in foreign currencies and corresponding strength in the US dollar has caused the dollar to rally toward multiyear highs relative to a basket of other currencies. Still, the dollar remains at low levels compared with previous decades. In this context we thought it would be useful to review exchange rate conventions and the impact of exchange rate changes on various asset classes. Next, we take a look at the factors that have helped the dollar to strengthen and how they might evolve in the coming years.
The Unconventional Conventions of Exchange Rate Quotes
The conventions of quoting exchange rates can be confusing and counterintuitive. First, there is the legacy of base currency hierarchy. That hierarchy goes as follows: euro > British pound > Australian dollar > New Zealand dollar > US dollar > every other currency. Thus, the convention for quoting the euro and US dollar exchange rate is always "EUR/USD." A British pound to Australian dollar cross rate would be "GBP/AUD." And a US dollar to Japanese yen cross rate is "USD/JPY." Sometimes the notation is slightly different: EUR-USD or USD-JPY for example. Also, for the "every other currency" part of the above hierarchy, there is no standard convention for which part of the cross rate comes first or second.
Next, there is the strange convention for what exchange rates like EUR/USD or GBP/AUD mean exactly. When we think of rates in the scientific sense, such as meters per second (m/s) for speed or pounds per square inch (psi) for pressure, we state them in terms of quantity of the numerator per one unit of the denominator: number of meters traveled per each second, number of pounds per each square inch, etc. Not so with exchange rates. For reasons we cannot divine, the progenitors of exchange rate convention decided to do the opposite. An exchange rate like EUR/USD means one euro per number of US dollars. EUR/USD quoted at 1.30 thus means ‘for each euro, 1.30 US dollars’ and the base currency (the one we fix) is always in the numerator, not the denominator.
How Foreign Exchange Movements Can Impact Your Investment
Investors’ home country currencies constitute their present and future purchasing power. For US investors, a strengthening dollar is the converse of weakening foreign currencies, and it means that investors’ assets outside the US could be negatively impacted by the dollar’s strength. All else equal, those assets would buy fewer US dollar goods.
But all else is not equal when investing outside the US. Non-US equities, in particular, may be impacted in myriad ways by fluctuating exchange rates and their impact on company costs, revenues, assets, and liabilities. However, the asset class most likely to be impacted negatively by a strengthening dollar is non-dollar fixed-rate bonds. The purchase of a non-dollar fixed-rate bond locks in a yield to maturity. Assuming the bond is held to maturity, its return would be roughly its yield plus or minus the change in the exchange rate between the time the bond was purchased and its maturity. In the context of a weakening foreign currency, the currency impact subtracts from the yield in US dollar terms. The calculation for deciding whether and how much to invest in non-dollar bonds going forward is to take the starting yield, make an adjustment for the currency forecast over the investment horizon, and then determine whether the expected yield in dollar terms is sufficient to compensate for whatever additional risks are involved compared to US government bonds and their yields.
With stocks, exposure to a strengthening dollar can be positive or negative depending on the circumstances. For example, an export-oriented company based in Europe may make significant sales to US dollar-based customers while euro-denominated manufacturing labor constitutes a large portion of its costs. Such a company could benefit from a stronger dollar as its costs would decrease faster than its revenues (when translated to US dollars), and the company’s profit margins and earnings could increase enough to offset the decline in the exchange rate. This is a positive result from weakness in a company’s operating and reporting currency.
On the other hand, a retailer that sells products manufactured from raw materials using foreign labor could be negatively impacted by weakness in its domestic currency. In this scenario, the company’s costs rise relative to what it can charge in its domestic market, and competitors that offer domestically sourced products gain a pricing advantage.
Exchange Rate Forecasting: Mind Your Ps
Over long periods of time we believe exchange rates are ultimately tethered to purchasing power parity (PPP). Purchasing power parity is a theory that explains how exchange rates adjust over time to equalize the value of identical goods priced in different currencies. Over shorter periods, a variety of factors can influence currency exchange rates, sometimes pulling the exchange rate between two countries far away from what might be considered a fair value based on their citizens’ purchasing power. Such factors include differences in the countries’ interest rates, trade flows, current account balances, savings rates, government budget deficits, raw materials prices, import/export intensity, and political actions, among others.
Attempting to navigate the intersection of these various factors may be a fool’s errand: there are a relatively small number of actively traded currencies in comparison with thousands of individual stocks, and the foreign exchange markets are incredibly deep and liquid. The competition to gain in the short run from a bit of news regarding any factor expected to influence an exchange rate is extremely intense and rapid. But, with a long enough time horizon, a bit of forethought, and significant enough deviation of exchange rate from the path of relative purchasing power, investors have a chance to benefit from the forces of purchasing power parity, or at least avoid getting hurt by them.
Will the dollar’s strength last?
The US dollar’s relative strength today is a fairly recent phenomenon. The dollar has been a generally weak currency against many developed and emerging markets currencies for much of the past decade. Once the "strong dollar policy" of Robert Rubin, Secretary of the Treasury under Clinton, was in the rearview mirror, it was apparent that the policy had worked too well — to the point that the dollar had strengthened substantially beyond the level implied by its purchasing power against many other currencies. The political will to continue supporting the dollar’s strength (by running large government surpluses, for example) began to evaporate. As a result, the dollar weakened by more than 37% against a trade-weighted basket of other major currencies between 2001 and 2011.
The dollar weakness between 2001 and 2011 is likely to have "overcorrected" the excess strength it had built in the prior years, especially relative to commodity-oriented currencies. The currencies of Canada, Australia, and commodity-oriented emerging markets such as Brazil (iron ore, agriculture) and Chile (copper) benefited from US dollar weakness, commodity strength, and strong demand from China, whose appetite for raw materials greatly increased throughout the 2000s. Strong economic growth in these economies had allowed their central banks to keep interest rates higher than in the US, so investors attempted to profit from the extra "carry" they could earn by investing in foreign currency bonds, knowing that the currencies were likely to be supported by continued trade flows.
Today, the phenomenal growth in the volume of China’s raw materials imports has slowed as its leaders attempt to shift focus from commodity-intensive investment projects to an increase in domestic consumption. Elsewhere, such as Europe and Japan, growth has stalled, and central banks have brought interest rates to zero with promises of further stimulus. Commodities and energy prices have fallen with the slowdown in China’s demand, impacting the trade flows of commodities exporters.
All of this leaves the US as a bright spot: the one major economy closest to operating at a "normal" level after several years of lackluster growth. The Federal Reserve is likely to begin raising interest rates next year, but inflation expectations remain subdued. The US dollar is close to fairly valued against major currencies such as the euro, pound, and yen, and is still undervalued against the Canadian and Australian dollars and several emerging markets currencies — all on the basis of purchasing power parity. This should mean that an improving interest rate spread with other currencies is less likely to be undermined by purchasing power’s stubborn tow in the wrong direction.
As a result of these influences, we remain optimistic about the dollar’s continued strength and favor domestic over foreign denominated bonds of otherwise equivalent risk. We also favor foreign companies with strong and improving export positions. We are wary of companies positioned to suffer as a consequence of weakening exchange rates in their home countries.
Copyright 2014 Saturna Capital Corporation and/or its affiliates. All rights reserved. Vol. 8 · No. 9
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