The US Dollar has been on a bull run since the aftermath of the great financial crisis, gaining about 45% from 2008 through March of this year when measured against a basket of other countries’ currencies. But that winning streak appears to be at an end, given the ding to the US economy from the Coronavirus and government actions taken in response. Since the March high, the Greenback has lost 10%, and according to many observers is headed lower still.
This relative decline in the value of the Dollar has negative implications for American families in terms of purchasing power. But for US investors heavily weighted toward domestic stocks, now may finally be the time to increase exposure to foreign equities.
The relative value of a county’s currency acts as an adjustment mechanism in conducting global trade and fluctuates based upon internal fundamentals as well as perceptions of strength or weakness held by other nations. Stephen Roach, former Chief Economist for Morgan Stanley, predicted in June that the US Dollar could decline by as much as 35% due to a weakening in the US economic recovery and the perception of diminished American leadership.
The US has historically depended on the safe-haven role of the Dollar and its dominance in global transactions to afford financing our massive (and exploding) national debt. But that privileged role may be losing momentum. In 2000, 70% of foreign exchange assets held by the world’s central banks were in US Dollars; today it has declined to 60%. Partially owing to the virus response, the national debt has vaulted from 80% of GDP last year to well over 100%, the highest since WWII. Meanwhile, the US response to the pandemic has lagged the rest of the developed world and is adding addition tonnage to the economic engine struggling to pull us out of the valley. Add in the drag from the ongoing trade war and heightened tensions between the US and China, and it is understandable that foreign confidence in Uncle Sam has taken a beating.
Where to turn as an investor? While a balanced portfolio should contain a healthy dose of foreign exposure, many US investors have favored domestic equities over the past several years. To be sure, the results have been lopsided. Over 10 years through July 31, the S&P 500 has returned an annualized average of 13.8%, compared with a paltry 5.3% per year for developed economy foreign stocks and just 3.7% for Emerging Markets. But if one believes that trees do not grow to the sky, a rotation into more attractive asset classes might be expected.
A weakening Dollar is favorable to US investors who buy stocks outside the US, as any appreciation in foreign markets is magnified through the exchange back into Dollars. In addition, the economic recovery is gaining momentum in Europe and Asia just as the US expansion begins to level off.
In terms of valuation, US stocks seem pricey compared with the rest of the world. According to Yardeni Research, the S&P 500 index is trading at roughly 23 times forward earnings. By comparison, foreign stocks look more attractive at about 18 times earnings for the developed economy EAFE index, and just 15 times for Emerging Markets (including China). These relative bargains may offer a compelling motivation to rebalance portfolios in favor of more international exposure.
In addition, many Emerging Market countries borrowed heavily in US Dollars and have felt the pain of higher interest costs as the Dollar gained; now they are on the downhill slope as debt service is getting cheaper. And since many emerging economies depend heavily on commodity production, a cheaper Dollar should boost exports to non-US buyers, since many commodities trade in Dollars and will now be cheaper in the buyer’s home currency.
Not everyone agrees with Stephen Roach about the magnitude of the Dollar’s likely decline, but a broad consensus expects a further erosion. This may be a good time look abroad.
Christopher A. Hopkins, CFA