How do currency fluctuations affect investments?

How do currency fluctuations affect investments?

Politicians have been promising to make America stronger long before Donald Trump was born. Sometimes these calls for strength are applied to our currency in the form of strong dollar policies. “Strong” sounds better than “weak.”  Yet, President Trump has been vocal about his distaste for the Chinese efforts to weaken Chinese currency. He prefers the Chinese currency be stronger and hence the U.S. dollar weaker.

We anticipate the media will be covering trade policy and the possibility of a so-called “currency war.”  In keeping with our desire to be a sanctuary from the noise, before it got too noisy, we wanted to explain in a non-political way the basics to help our clients maintain some perspective.

One key concept to remember is when it comes to currency, anytime something happens to one country’s currency, the opposite happens to another. The weaker a foreign currency – the stronger the dollar.

…when it comes to currency, anytime something happens to one country’s currency, the opposite happens to another. 

A stronger dollar makes foreign goods and services more affordable to Americans. This is great for Americans abroad, as any visitor to the UK since the Brexit vote can attest. With the Pound dropping, a pint of good British ale costs 16% less today to an American than it did last summer.

U.S. companies who get much of their supplies or raw materials from overseas will pay less for those goods which in turn can boost their profits.

However, generally a stronger dollar is not so good for U.S. based manufacturers and suppliers who sell products overseas. Their goods are more expensive to foreigners.

Now look at the flip side. For the Chinese, as their currency is weakened, anything they want from abroad is costlier. Meanwhile, the workers who make up their cheap labor force don’t want to be a cheap labor force. They want higher wages and good working conditions, all of which cost money. Money that is now worth less.

It was a common refrain a few years ago that the U.S. dollar was going to plummet in value due to excessive deficits and debt. Some talked about it causing hyperinflation. None of that happened. Rest assured, the Chinese don’t want to fall into that predicament either.

The Chinese cannot simply weaken their currency over and over without consequences in China itself. Remember that statement when the term “currency war” comes up.

Pros become cons

We are not taking a position on how much higher or lower the dollar should be. That topic can and will make for some interesting political and economic debates.

We just want our clients to have a basic understanding that both a strong and a weak dollar have consequences, but those consequences are usually not nearly as dramatic as they are predicted to be in the scheme of things.

There is no guarantee currency fluctuations won’t cause problems in economies or markets, but there are offsetting forces which can help keep things from getting too volatile. Nonetheless, currency changes have important effects.

As currency is exchanged, its value changes. At the time of this writing, the Euro was trading at $1.05. In the past year, it has been in as low as $1.03 and as high as $1.15. If you previously exchanged $1.15 for one Euro and today wanted to exchange that Euro for dollars, you would only get back $1.05. You lost 10 cents even though you didn’t buy anything with your Euro. That 10 cents is now in the pocket of the traders who facilitated your exchange.

And so it goes in the currency markets. One can speculate strictly on the changes between currency. No goods or services are exchanged at all. Every buy is offset by a sell and since there is no value added by this trading, the expected return is zero in the aggregate over the long term. For every 10 cents made, 10 cents is lost.

How does currency affect your investments?

Imagine the Euro was used to buy a share of stock or a bond. If the stock or bond does not change in price, the 10 cents is still lost because the Euro fell in value. A weaker Euro means a stronger dollar. When the dollar is strong, it hurts your foreign investments, all other things being equal. A weak dollar helps your foreign holdings.

Of course, in financial markets all other things are never equal. For instance, while a rising dollar can be a negative, it can be a positive to the profits of many of the foreign companies in which one invests because the products of those companies become less expensive to American buyers.

We ignored costs in our example but in the real world costs can add up. Thus, the zero-expected return from currency exchanges becomes a net negative. For all the costs involved, it is preferable that long-term investors avoid moving money back and forth across borders frequently (as some do) trying to outguess whether foreign markets will do better or currency rates will change favorably.

Think about that. Trying to move in and out of foreign holdings means you aren’t just making a short-term bet on which way and how far the prices of the stocks and bonds will move, you are also making a bet on the direction and amount of the currency effect. We believe it is much better to a maintain a permanent long-term position in overseas investments. You should get the favorable long-term odds of investing in financial assets without incurring added currency related costs. Invest, don’t speculate.

What about hedging currency risk?

Hedging reduces currency risk but it doesn’t reduce a portfolio’s overall risk.[i] By hedging the currency risk, the foreign holdings become more strongly correlated with U.S. holdings, thus undermining the smoothing effect of diversifying.

In addition, hedging isn’t free. Over the long term, hedging costs can significantly erode returns. Therefore, for long-term investors, we believe it is better to leave overseas holdings unhedged. One important exception to that general rule is investment in foreign bond markets.

…predicting those (currency) fluctuations with enough precision to profit is as foolhardy as trying to time stock or bond markets

We want bonds to be relatively stable to act as a shock absorber to the ups and downs of stocks. Accordingly, we prefer high quality short to intermediate term bonds. As long as there is no default, the return from these bonds is easily calculated.

For foreign bonds, currency changes can be large enough to wipe out the reliable return of good bonds. Hedging can remove that risk.

Hedging can also improve returns from a diversified bond portfolio. Say a foreign bond yields 4% while a similar U.S. bond yields 3%. As long as the cost of hedging is less than 1%, the hedged foreign bond will net more.

The bottom line is currency fluctuations affect our investments but predicting those fluctuations with enough precision to profit is as foolhardy as trying to time stock or bond markets in general. For true investors, taking a long-term view and making foreign holdings a permanent part of the portfolio remains a wise approach.

Don’t let headlines about currency get you down. Try enjoying a fine European wine or book a trip to Wimbledon this summer. Both are more affordable than last year.

[i] Le Graw, (GMO White Paper April 2015)