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Question of the Week - October 20, 2014

Question of the Week - October 20, 2014

Guest Post - Monday, October 20, 2014

How does a stronger dollar affect us?

A stronger US dollar has been in the news lately, particularly as it relates to the financial markets and the global economy. How does a strong US dollar affect US businesses? What gives a currency value? Why are some weak and why are others strong? What causes them to fluctuate? Here is our perspective.

What is a currency?

Currencies represent a store of value. However, they only have value in relation to what goods they can buy or in relation to one another.

What is a safe-haven currency?

For perspective, it's helpful to start with the safe haven currencies, which include the U.S. dollar, Japanese yen, British pound, Swiss franc and, possibly, the euro. (Some might refer to gold as more a currency than a commodity, but we'll leave that topic for another time.) Safe haven currencies have traditionally held their value over other alternatives because they tend to embody the strengths of these nations. This strength comes from stable political systems, rule of law, consistent fiscal/central bank policies, lower debt/GDP levels, stable/low inflation and interest rates, large and relatively affluent populations, and military power (directly, in the case of the U.S. and Britain, but implied via coalition in the case of some of the others). When uncertainty flares up in the world, stability and consistency are sought out, and these currencies tend to directly benefit by rising in value.

What is a weak currency?

The countries with weak currencies tend to have the opposite traits—unstable political regimes, weak personal/property rights (absence of rule of law), fiscal and central bank policies that are either politically-motivated or ineffective, corruption, higher and volatile inflation, low per capita incomes, higher debt levels and geopolitical conflict/instability. Emerging market countries have historically had weak currencies, but this is dramatically changing, most notably in the area of debt/GDP, where some of the big developed nations are now less attractive. As nations grow and enrich themselves, the status of their currencies may also improve, especially if they make progress in legal and economic development.

What else can affect a currency's value?

Many other forces can affect a currency's value, such as commodity prices. The so-called-commodity currencies (Australia, Canada, and Russia, to name a few) are those of heavy exporters of natural resources. Their trade balances, GDP and fiscal deficits/surpluses are greatly influenced by commodity prices, so can react in line with such markets and speculators treat them accordingly.

A country's inflation and interest rates also drive the price of a currency. If currency traders can get a higher after-inflation (real) return in dollars they will move from, say, euros. This demand drives the price of the euro down and the dollar up.

The US dollar

The dollar's recent strength may be due to a strong reputation as a safe/reserve currency, higher interest rates, and a stronger economy, than other countries or regions such as Japan or the Eurozone.

Politicians tend to like a strong dollar, mostly because it gives the impression of economic strength and it improves our purchasing power when buying foreign goods like oil and other consumer goods. However, it also makes manufactured/exported goods more expensive to sell abroad. This is why we hear our political leaders complain about currency manipulation by export-driven economies like China that try to keep their currency prices artificially low, making the cost of their exports cheap.

Currency prices and your portfolio

Since portfolio holdings are priced in U.S. dollars, a stronger U.S. dollar automatically results in foreign holdings lagging when they're translated over to dollar terms. However, it cuts both ways so that a stronger foreign currency can essentially provide a ‘free' return on top of whatever is earned in local currency terms.

Most experienced economists and equity portfolio managers don't try to time currency movements on a short-term basis. These fluctuations can be fickle, and active hedging against them on an ongoing basis can add significant costs to a portfolio. However, a small addition of the foreign bond asset class can often serve as a good hedge and diversifier against the currency risk of multinational corporations in a portfolio. So, while we believe that it is important to have at least some foreign exposure in a portfolio, we don't let the currency tail wag the investment dog.

How long do currency cycles last?

History tells us that broader US dollar cycles have been 5-10 years in duration, but it varies. These cycles have had their inflection points, often during periods of peak greed or fear.

Historical Dollar Cycles

Chart - Historical Dollar Cycles
Source: Deutsche Bank

Additional Reading

Read our Weekly Review for October 20, 2014.

Read the previous Question of the Week, September 22, 2014.

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