Falling US dollar means investors should look abroad

New York

SINCE the start of last year, the dollar has lost more than 12 per cent of its value against a basket of foreign currencies. During that same stretch, stock funds that invest abroad have gone from being laggards to leaders.

"Foreign investments tend to do better when the dollar is weak," said Jack A Ablin, chief investment officer for Cresset Wealth Advisors. That's because "when you invest in foreign stocks, you're actually buying two things - the foreign equities, but also the foreign currencies needed to buy them," he said.

And as those foreign currencies strengthen against a weak dollar, the returns on foreign investments held by Americans get a lift.

Over the last year, European equities have largely been flat when measured in their local currencies. But when translated into dollars, European equities have returned nearly 18 per cent over the last 12 months for Americans.

Many market observers think the dollar could weaken further, especially as inflationary fears build in the United States. "The dollar is still fundamentally overvalued against a number of currencies, particularly in the emerging markets," said Thomas Clarke, a portfolio manager of the William Blair Macro Allocation Fund.

Does that mean investors should continue to look overseas? The short answer is yes, market strategists say. But it's complicated.

The falling dollar is a double-edged sword for Americans investing abroad, said Harry W Hartford, president of Causeway Capital Management.

"On the one hand, if the dollar is weakening versus the euro or the yen or the Swiss franc, the value of your foreign investments is going to go up just on the currency alone," he said.

"But there's another impact you cannot ignore." While the foreign funds held by American investors benefit from a currency tail wind, the international companies held within those funds face headwinds as they try to compete against US businesses whose goods are cheaper because they're priced in dollars.

Mr Hartford notes that companies in the Morgan Stanley Capital International Europe, Australasia and Far East Index (known as the MSCI EAFE) generate roughly 15 per cent of their revenue in the United States and an additional 10 per cent in emerging markets, where many currencies are at least partially linked to the dollar.

"The benefits investors will have seen from the decline in the US dollar could be offset by the translation effect on company revenues," he said.

This doesn't imply that American stock investors should avoid foreign exposure, however.

Regardless of how the dollar trades from here, shares of foreign companies are more attractively priced, on average, than domestic stocks.

Domestic blue-chip equities, for example, are trading at a price-to-earnings ratio of 32, based on 10 years of averaged profits. That's twice as expensive as they've historically been, according to Research Affiliates.

By contrast, shares of foreign stocks based in developed economies such as Europe and Japan have a P/E of 17.5, which is a 30 per cent discount from their historic median. Emerging market stocks are trading at a P/E of 15.

"I look on Europe as a bargain and the emerging markets as a bargain," said Robert D Arnott, chairman and chief executive of Research Affiliates. "I'm perfectly happy about nondollar investments because they are cheap and the US stock and bond markets are not."

Still, to benefit from the gains a weak dollar produces while avoiding potential problems, investors may want to focus on specific types of companies - those domiciled abroad but whose profits are not going to be affected by any further decline in the currency.

"One place to look is international small caps," said Mr Ablin said, referring to shares of small companies domiciled abroad with a market value of around US$3 billion or less. "These companies are denominated in foreign currencies. But because they are smaller, they tend to transact most of their business in their home markets." The MSCI EAFE small-cap index tracks such stocks, and an investor can buy an exchange-traded fund that mirrors the index, like the iShares MSCI EAFE Small-Cap ETF.

Beyond smaller names, investors can also turn to foreign companies with commodity-based businesses.

One important factor is inflation, which has bolstered commodity prices and is a big part of the explanation for the dollar's fall in the first place, said James Paulsen, chief investment strategist at the Leuthold Group.

Mr Paulsen points out that the dollar fell last year even though the Federal Reserve had been raising rates. Higher rates typically tend to attract more cash flows and lift a currency's value, but rising "inflation destroys the value of the US dollar," he said.

Commodities, as well as other "real assets" like real estate, are viewed as an inflation hedge and tend to outperform in periods of dollar weakness. "They're joined at the hip," Mr Paulsen said.

If the dollar is falling because inflation is picking up in the United States earlier than in other parts of the world, then emerging market stocks ought to benefit. Many parts of the emerging world - such as Latin America - are dependent on commodities. Moreover, emerging economies are more tied to manufacturing than consumption compared with the developed world, and rising inflation often squeezes consumer companies first.

Since the dollar began to sink in January 2017, emerging market equity funds are up 37 per cent, nearly twice the gains of the S&P 500 index during that time. And in an earlier stretch in which the dollar was weak - from 2002 to 2008 - emerging market funds trounced those focused on the United States by nearly 20 percentage points a year for six years.

"A weaker dollar is beneficial to international investments relative to the US," Mr Paulsen said. "And that's more true for the emerging markets." NYTIMES