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Written by Steve Meizinger
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Tuesday, 20 October 2009 00:00 |
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Page 1 of 8
 Currency exposure—by which we mean the value of the U.S. dollar relative to other major currencies around the world—is one of the most often overlooked contributors to investor returns.
That’s especially true today, as investors of all types are pouring an increasing amount of assets into international and emerging market equities, embracing a range of academic studies showing that international diversification can lower risk in a portfolio. As international allocations increase, however, the strength or weakness of the U.S. dollar relative to the local currency is having an increasingly large impact on total portfolio returns.
Today’s investors need to consider their currency exposure when investing in foreign assets. Several tools exist in today’s marketplace to accomplish this objective.
What Drives The Value Of The Dollar?
The forces that drive the relative value of currencies are incredibly complex. Factors such as economic growth as measured by GDP, retail sales, industrial production, unemployment, capacity utilization and a country’s producer and consumer prices have a substantial impact on the value of an individual country’s currency.
At the same time, the U.S. dollar—the currency that U.S. investors are most concerned with—is even more complicated than most.
The U.S. dollar is often referred to as the world’s reserve currency, meaning that many governments and institutions hold significant quantities of the dollar as part of their foreign exchange reserves. This reserve status makes the dollar the de facto international pricing currency for products traded on a global market, including oil and gold.
It also makes the dollar the de facto “safe haven” asset for investors worried about the economy. In 2008, investors were forced to flock to the few safe haven currencies, and the U.S. dollar was pushed to new heights amid the global recession … despite the poor performance of the U.S. economy.
More recently, there have been calls from China to replace the greenback with a new global currency, reflecting developing nations’ growing unhappiness with the U.S. role in the world economy and their financial dependence on the U.S. This has put into question whether the USD will be able to retain its reserve currency status over the long term. Any break from the dollar’s tradition as reserve currency for the world would put pressure on the greenback.
What else impacts the value of various currencies? Obviously, political stability plays a role, but to what extent? An investor can only speculate. Government debt levels are also important, but currency valuations are a product of many factors, not just a single input. How are governments reinvesting those funds? Are they spending the capital in a productive manner? A symbiotic relationship exists between these critical fundamental factors and the currency markets.
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