U.S. Dollar Strength Affecting International Equity Investments11-18-2014 |
Sources: Rates Data and Economic Calendar—Bloomberg Markets as of 11/17/14; Equity Market Returns and Fixed Income and Alternatives Data—Wells Fargo Advisers as of 11/14/14
U.S. Dollar Strength Affecting International Equity Investments
The dollar has appreciated 12.1% relative to the Euro since hitting a 2014 low in May when it traded for $1.39/EUR. It should be noted that there are a variety of factors that influence global exchange rates, however, and Central Banks appear to be at the heart of the movement witnessed since May. On one side is the European Central Bank (ECB) which is embarking upon a mission to increase the size of their balance sheet to €3 Trillion through the purchase of asset backed securities. The head of the ECB, Mario Draghi, has also discussed the flexibility of the type of assets that will be purchased suggesting that sovereign debt could be considered in order to ensure their balance sheet goals are met. On the other side is the U.S. Federal Reserve, which is beginning the slow process of reversing course and becoming less accommodative. As has been well publicized, the Fed concluded its tapering process in October and many believe (including us) that they will likely begin to raise interest rates sometime during the first half of 2015.
Monetary easing and tightening by design has a direct effect on interest rates. When set in a global context, these actions can have a direct effect on exchange rates. All things being equal, when a country or economy is offering a higher interest rate, some investors may choose borrow in their local market, buy bonds in the foreign market and earn the difference in interest rates. This is known as a type of carry trade and so long as exchange rates stay stable the strategy enables an investor to earn a positive rate of return. The shift in supply and demand, however, caused by investors buying higher yielding currencies and selling lower yielding currencies, forces the exchange rate to change. As a result, higher yielding currencies often appreciate while lower yielding currencies depreciate (relative to each other.)
The current divergence of global Central Bank policies suggests higher interest rates in the U.S. and lower rates in the Eurozone for the foreseeable future. This is one of the reasons that the U.S. Dollar has appreciated relative to the Euro and has lowered the returns of unhedged U.S. investors who own foreign stocks. To illustrate this point further, consider a U.S. investor that sells foreign stock, receives Euros in return, and has to convert those Euros back to U.S. Dollars. If the Dollar is more expensive than it was when the trade was initiated, the investor will receive less and will have a lower total return. So, the total return for a U.S. investor that owns foreign stock is not just the foreign market return but the foreign market return plus the return on the foreign currency. Many investors in the U.S. have come to now expect this scenario since the Euro has fallen 10.1% in 2014.
* As of 11/18, the U.S. Dollar has appreciated 11.2% in 2014
According to Morningstar as of 11/17/2014, the MSCI EAFE index in USD has experienced a loss of 3.38% thus far in 2014, while the MSCI EAFE in local currencies has returned a positive 2.22%, a difference of over 5.5%. This is even more dramatically exhibited when looking at the MSCI index that focusses on Europe alone. While we at Hennion & Walsh do not suggest individual investors hedge currency returns by purchasing a derivative, we strongly recommend that anyone diversified internationally understand the potential effects that exchange rates may have on their total returns. If you have any questions about how your portfolio can be affected by changes in exchange rates or would like us to review your current holdings, please do not hesitate to contact your Hennion & Walsh Financial Advisor or a member of the Hennion & Walsh’s Asset Management Team.
Exchange Rate Data- https://www.ecb.europa.eu/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html
Local and U.S. Index Returns- http://news.morningstar.com/index/indexReturn.html
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