Over the last five years, the U.S. dollar has moved higher as a result of various monetary policies and positive U.S. economic growth.1 The U.S. Dollar Index has risen 10 percent since the trade war began in January 2018 and about 25 percent since mid-2014.2
This appreciation came as a surprise to many following the addition of the Chinese yuan to the International Monetary Fund’s (IMF) basket of reserve currencies in 2016.3 This action sparked initial concern among U.S. investors as it recognized China as a global economic power and represented the potential end of the dollar’s position as the dominant transaction and reserve currency.
However, the U.S. dollar has remained the reliable currency in the face of a slowing global economy and geopolitical upheaval.4 This strength has impacted several areas of the market worth looking at.
One clear impact of a strong U.S. dollar, and the most positive one for most of us, is the increase in purchasing power for the American consumer.5 As the dollar has appreciated, it has become easier for Americans to buy goods and services. Inflation has been very low by historical standards at only 1.5 percent over the last five years.6 This has been a primary driver of higher U.S. consumer confidence in recent years.7
A less obvious consequence of a strong dollar is weakened performance of non-dollar assets. These are assets in a portfolio that are used to hedge potential dollar weakness that would drive our living expenses and inflation higher.
International equities have lagged the U.S. stock market over the last five years. The MSCI EAFE Index8 has generated about a 3 percent annual return over the last five years9, while the S&P 500 has delivered close to 10 percent.10 About half of this discrepancy though can be attributed to currency.
If a local investor in the MSCI EAFE Index were to look at their returns, they would see about a 6.5 percent annual return.11 Foreign companies are still profitable, growing and providing returns for investors – their performance though has been muted for U.S. investors due to a robust dollar.
While the recent solid performance of the dollar may urge U.S. investors to stay exclusively within the U.S. stock market, it’s important to remember the value of hedges.12 Getting paid in, spending in and investing in nothing but U.S. dollars means putting all of our eggs in the dollar basket. Having some non-dollar denominated assets in a portfolio helps diversify and hedge future challenges the U.S. dollar may face.
The U.S. is in a healthy position today and many international economies that would benefit from reforms are envious of U.S. stability. However, markets have a way of not continuing in a straight line. The recent dollar strength is case in point – even including the recent run, the U.S. Dollar Index has declined against other currencies by about 0.1 percent a year since 1973, while inflation has averaged nearly 4 percent a year.13 Part of an investment strategy should be hedge risks that seem to unpredictably sprout when things do change.
Sources:
1. The Balance – Dollar strength and why it’s so strong right now
2. MarketWatch – U.S. Dollar Index
3. Reuters – China’s yuan joins elite club of IMF reserve currencies
4. Forbes – Stocks plunge as investors see signs of a slowing global economy
5. Investopedia – Strong dollar: Advantages and disadvantages
6. CPI DFA Returns 2.0
7. MarketWatch – Consumer confidence surges near 18-year high even as Fed gets ready to cut rates
8. MSCI – MSCI EAFE Index
9. Morningstar – iShares MSCI EAFE ETF (EFA)
10. Yahoo! Finance – S&P 500
11. MSCI – End of day index data search
12. Investopedia – Hedge
13. Macrotrends – U.S. Dollar Index – 43 year historical chart
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