Nicholas Lacy, CFA, Chief Portfolio Strategist discusses the influence of the declining dollar on markets as a whole and the future currency outlook.
Through September 26, the dollar has declined approximately 9% against the developed world while the euro has gained approximately 11% against the dollar. What impact has a declining dollar had on markets as a whole and what does this mean for our currency outlook?
So far this year, domestic investors are reaping the benefits of international equity holdings, with developed markets earning almost 20% and emerging market equities nearing 28% through the end of September. To put this into context, U.S. large-cap performance has been a bit more muted, coming in at 14%, while small caps returned roughly 11%.1 While a 14% return is nothing to shake a stick at, owning international equities has rewarded investors in recent months. To understand where this relative outperformance has been derived depends on where you were invested, literally.
U.S. investors are exposed to two main drivers of return and risk when owning international equities: local market return and exchange rates. Local market returns are the total returns earned if you reside in the country in which you are investing and use that country’s currency to purchase the investment. For example, a Japanese investor purchasing Japanese equities in Japanese yen, would not be impacted by exchange rates and would receive the ‘local’ total return.
Things work a bit differently in the U.S. Most domestic investors purchase international equities with U.S. dollars as opposed to the currencies of the countries in which they are investing. This is commonly referred to as an ‘unhedged’ strategy and introduces exchange-rate risk into the total return equation.
If an investor were to buy shares in a Japanese company with U.S. dollars, his returns would be eroded by a strong U.S. dollar since he would lose value when exchanging his profits (valued in Japanese yen) to U.S. dollars. In other words, he would need more Japanese yen to buy the same number of U.S. dollars. The opposite holds true if the dollar is weak; it would take fewer Japanese yen to by the same number of U.S. dollars, creating a currency ‘premium’ in addition to the local market return.
So, what do exchange rates have to do with international equity performance this year? Everything! If you were to strip out the impact of the U.S. dollar declining this year by approximately 9%, the local total return would be more like 9% for non-U.S. developed markets – less than that of the S&P 500. This is the perfect example of exchange rates benefiting U.S. investors. This is good news as it tells us that developed markets outside the U.S. are not yet experiencing the magnitude of returns seen here at home, leaving more room for local market improvements like the U.S. has been experiencing.
Aside from exchange rate premiums, earnings growth and profitability have been key drivers, especially in Europe where they are improving more rapidly than in the U.S. When you purchase an equity, you are investing in that company’s corporate earnings, earnings growth, and a dividend (if available). Investors should want to own stocks in companies whose earnings are growing faster and can be purchased at a fair, or discounted price.
Emerging market equity performance this year was less about the exchange rate benefit (which was only about 5% of the 30% total return) and more about improving valuations in these markets.
Non-U.S. developed markets still haven’t experienced the improvements in valuations seen here in the U.S. Excluding exchange rates, we believe there is still room for improvement through multiple expansions to support further price appreciation.
As long as earnings continue to grow at a faster pace relative to the U.S. and fundamentals continue to improve overseas, the prospect of continued price appreciation remains quite likely, absent a rally in the U.S. dollar. While the same holds true for emerging markets, it’s important to note that these markets are more expensive than their developed counterparts and selectivity is key.
1 Morningstar data using: the MSCI EAFE Index, MSCI EM Index, S&P 500 and the Russell 2000. Performance as of September 30, 2017.
International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. The returns mentioned do not include fees and charges which would reduce an investor’s returns. Past performance may not be indicative of future results. Investing involves risk including the possible loss of capital.