Global-minded investors face a slew of potential risks and uncertainties compared to those of us who are more domestically focused. Without getting into the laundry list of variables one must evaluate, we wanted to talk a bit about one recent factor that is creating a fair amount of volatility for international investors. This factor is the recent surge in the US dollar. The PowerShares Deutsche Bank US Dollar Index (ticker: UUP), which is an exchange-traded fund designed to replicate the performance of the dollar against six major foreign currencies, has risen 7% since its low on May 6th of this year. The dollar’s performance versus the Japanese Yen (+7.1%) and Euro (+8.2%) over that time frame has been especially noteworthy given the size of those economies. What is creating this sudden surge in demand for US dollars, and what does this tell us about the global investment landscape?
The recent spike in the US dollar is, by all accounts, a vote of confidence in the relative strength of the US economy. All else equal, money will flow into economies with superior growth prospects, thereby raising the value of currencies in those countries relative to the currencies of slower-growth alternatives. There is little doubt that the US looks better than Japan and Europe at the moment. Both Europe and Japan are trying desperately to stave off deflationary pressures – a perennial nuisance for Japan but a more recent threat in Europe – through massive bond purchases by their respective central banks. The US central bank, on the other hand, is on the verge of concluding its program of “Quantitative Easing”, or “QE” for short. This means that the Fed will no longer be artificially suppressing long-term interest rates in the US. It also means that the central bank is one step closer to raising short-term interest rates through a hike in its Fed Funds target rate.
Reflecting the more positive growth outlook in the US (and the potential for higher inflation), Treasury bonds offer much higher yields than those available on German and Japanese bonds. The yield on the 10-year US Treasury bond is 2.54% compared to 1.00% on the 10-year German bond and 0.53% on the 10-year Japanese bond. At the same time, US companies have been putting up far superior earnings growth recently compared to their German and Japanese counterparts. Therefore, some of the dollar strength simply represents the fact that investors are predictably and rationally buying investments with comparatively higher yields (Treasuries) and/or better growth prospects (US stocks). All this is great for the US, right?
Yes and no. It is undoubtedly a positive that short- to intermediate-term growth prospects in the US are far superior to Europe or Japan. It is also undoubtedly a positive that investors are seeking a home for their investment capital in the US. However, while a strong currency has historically been a symbol of economic strength and vitality, a rapid rise in the value of the dollar does have some downsides for the US as well. As the value of the dollar surges, companies with overseas operations are forced to recognize the effect on sales and assets outside the US when they are converted back to US dollars. Perhaps more troublesome, those US companies that export to overseas markets are put at a competitive disadvantage due to the dollar’s strength. Given that exports generally comprise about 13%-14% of GDP, the dollar’s strength stands to be a significant drag on US economic growth.
The take-away for US-centric investors is that earnings at US multinationals could be incrementally more volatile in a rising-dollar environment. This is one reason why the Industrials and Energy sectors have underperformed over the past few months. Companies in these sectors do a lot of business outside the US, and therefore investors increasingly believe that revenue and earnings estimates could be at risk. We agree to an extent, but we also believe that high-quality US multinationals with strong balance sheets remain attractive on a relative basis. While the rising dollar may present a challenge over the near term, we think investors should take a longer-term perspective while also taking valuations into consideration. The US seems to be the best house in a bad neighborhood at present, but we still have our challenges of our own. Rather than put all our proverbial eggs in one US basket, we think it makes most sense to remain somewhat geographically diversified.