The U.S. dollar has been growing in strength over the past few years. When we talk about the dollar’s strength or weakness, we are referring to its value versus other currencies. The benchmark commonly used to track the value of the U.S. dollar is the U.S. Dollar Index (symbols: USDX, DXY, DX.F). The index was around 95 at the end of June 2018. That is far above the record low of 71.6 set in April 2008. It’s also well below the record high of 163.8 set in March 1985. Depending on the length of your perspective, the dollar is either high or still has a long way to go.
Fed’s QE Policy
There are several good reasons for the dollar’s improvement. First, the Federal Reserve has ended the policy of quantitative easing (QE). The Fed’s QE policy was initiated following the 2008-2009 economic downturn. QE increased the money supply with the objective of stimulating the economy. In other words, the Fed put more dollars into the system. The law of supply and demand was in effect with more dollars pushing the dollar index lower. QE has ended and some expect the Fed will have to eventually take some of those dollars back out of the system which will make the dollar stronger.
Higher Interest Rates
Secondly, the Fed has started to raise interest rates and has made public their intention to allow rates to continue to rise. The interest rates on U.S. Treasury notes has moved higher making the notes more attractive to foreign investors. The increased demand has also helped push the index higher.
Instability of EU
The third factor has been driven by political instability in the European Union. The Euro makes up 57.6% of the dollar index. The conversion rate was $1.20 to €1.00 at the beginning of 2018. That’s down from the 2010 high when the exchange rate was $1.44 to €1.00. The Euro’s value is driven in part by the European Central Bank’s interest rate policy. The debt levels of individual countries and the strength of the European economy also impact its value.
The outlook for the dollar is always uncertain. While the current Fed policy of higher interest rates are a positive influence, concerns about a trade war over increased tariffs has weakened the dollar from its level a year ago. A weaker dollar increases the price of imported goods. U.S. consumers would be likely to buy more U.S. goods than foreign goods because the prices are lower. At the same time, overseas consumers will find the price of U.S. goods cheaper which could lead to an increase in exports for the U.S.
What this Means for Investors
Why does this matter to us as investors? The impact of the exchange rate has an effect on stock prices of international companies. A 10% increase in the value of the dollar would mean a similar decrease in the value of foreign securities even if their share price did not change. When you buy a foreign security, you pay for it with your U.S. dollars at the current rate of exchange. Selling that security in the future will require an exchange back to U.S. dollars. If the dollar has risen in value, you won’t be able to buy as many dollars. The security will need to increase in value by at least the same rate as the dollar to break even. The reverse is true if the dollar weakens. Your foreign security may not move up in value. However, you still can make money when the U.S. dollar weakens against the currency your security trades in.
Diversify with International Investments
Adding international investments to a portfolio offers an additional layer of diversity. Investors have an opportunity to capture higher returns from foreign markets, which may thrive when U.S. stocks are weak. Many advisers agree that having some exposure to international markets provides investors the ability to diversify against any domestic downturn.
The question then becomes how much to allocate overseas. Financial advisers often recommend allocating a range of 15% to 25% to international securities. The precise allocation to foreign investments will differ among investors; however, it’s important to settle on an allocation and stay with it. Allow the markets to tell you when to add or cut back by monitoring the allocation. This tends to force you to add when international is out of favor and cut back when international markets are near their high.
When investing internationally, it’s important to diversify not only among securities, but also among countries. Mutual funds and exchange traded funds provide an efficient and effective way to achieve broad diversification. Many funds also perform some currency hedging to minimize volatility caused by fluctuations of the U.S. dollar.
Finally, an international allocation should also diversify among developed countries and countries that make up the emerging markets. Developed markets are usually the most advanced economically. They have highly developed capital markets with high levels of liquidity, meaningful regulatory bodies, large market capitalization, and high levels of per capita income. An emerging market is a country in the process of rapid growth and development with lower per capita incomes and less mature capital markets than developed countries.
More than half of the world’s market capitalization lies outside the U.S. Over the years, there have been long periods when international stocks outperform U.S. stocks. Diversifying a portfolio internationally provides access to opportunities outside the U.S. and a hedge against a weak dollar.
- Rising U.S. interest rates increase the dollar’s value by making it more attractive to foreign investors.
- The Euro’s value is driven by interest rates, debt levels of the member countries and Europe’s economic outlook.
- The international portion of an investment portfolio should be diversified among companies and among countries.