Three Ways The Strong Dollar Is Impacting Your Investment Portfolio In 2018
It’s tempting to think that because you invest in dollars, and perhaps only hold U.S. assets, that you can ignore the impact of the dollar on your portfolio. That’s not true. Currencies are among some of the harder themes to understand in investing, but here’s how the strengthening dollar has impacted the markets in recent years.
A strong dollar weakens commodity prices
All else equal, a strong dollar should lead to lower commodities prices in dollars. A stronger dollar has the ability to buy more foreign goods. Commodities follow that pattern. So when the price of the dollar rises, then commodity prices should decline, all else equal. For example, a barrel of oil costs less when paid for in dollars, if the dollar rises in value.
Yes, some commodities are produced in the U.S. but commodities markets are generally global in nature and typically only priced in U.S. dollars for convenience. As the value of the dollar rises, so commodity prices should decline when priced in dollars. Of course, in recent years this hasn’t happened. We’ve generally seen commodity prices rise at the same time as the U.S. dollar has strengthened or appreciated. This makes the recent strength that we’ve seen in various commodity markets even stronger, because the dollar is rising too. For example, if you look at the price of a major oil index priced in Euros, you’ll see it’s run up a little more over the past year, than the same index priced in dollars. The currency that you’re using for the analysis makes a difference.
So despite their generally good run in recent years, commodities have actually done better than they first appear when looked at in dollars. The strong dollar has helped to hold down commodity prices, which would have moved up even more, when priced in dollars, had the dollar not strengthened. If you looked at those commodities price in other major currencies such as the Euro or British Pound, you’d typically see an even steeper price increase for commodities such as oil. So, when it appears a commodity price is changing, you should question how much of that move is due to the value of the commodity and how much is due to a change in the value of the currency that it’s priced in.
It’s easy to look at prices of commodities in dollars and see them move up or down, but forget that the dollar is a relative price as well. The dollar too, can be gaining or losing value over time. This is like when you’re sitting on a train and look out the window to see what appears to be another train moving on the next platform, but then you realize that it’s actually your train that is moving and the other train is stationary. The thing to remember with currencies is that it doesn’t matter whether you’re pricing things in U.S. dollars, Euros or Japanese Yen, your currency train is always moving forward or backwards and it pays to understand your direction of travel. Otherwise, when you look out the window, you’ll miss what’s actually going on.
S&P 500 firms are typically hurt by the stronger currency
Generally, many members of the S&P 500 should be thought of as global companies that happen to be headquartered in America. As a rule of thumb about half of S&P 500 sales are generated overseas, though the exact figure changes with currency moves and index composition. Of course, there are certain companies such as utilities, that as very U.S. focused and only producing power within the U.S with little activity overseas. However, industries such as utilities are the exception. Other companies, such as Apple, are selling products all over the world. For these sorts of companies, which include most members of the S&P 500, the strong dollar is a headwind to profitability.
Those earnings coming in from overseas are worth less when stated in dollar terms in the accounts as the dollar rises in value. Furthermore, if the company has major costs in America, such as factories, then those costs are unchanged as the dollar goes up, so margins can shrink as overseas revenues fall but the domestic costs of production stays the same. Therefore the recent run up in the S&P 500 appears more impressive when set against the backdrop of the stronger dollar for large firms. A strong dollar is generally considered a headwind to the S&P 500 growing earnings.
So remember, even if you are a U.S. investors holding large U.S. companies in your portfolio, then currency changes can still impact your investment returns. This is because the companies you own are global, and so a strong dollar can hurt their overseas operations. Conversely, a weaker dollar can boost earnings of larger firms. Again, this doesn’t apply to all firms, only those with significant overseas sales. Yet, when we’re talking about S&P 500 companies, most are global and overseas sales are a significant part of their sales and profits.
Smaller U.S. companies can be boosted by a strong dollar
The reverse can be true for smaller U.S. firms. These smaller companies typically sell mostly into the U.S. market, since they haven’t yet expanded significantly overseas as many large firms have. Here a strong dollar can boost margins. They sell products in dollars, so those revenues don’t change, but if they import materials to make their products from abroad, then those materials are likely cheaper when the dollar gets stronger. Therefore, for smaller companies a strong dollar can boost margins. As result, it’s generally true to think of a strong dollar as helping smaller more US-focused stocks, and hurting larger, more global ones.
Where is the dollar today?
Compared to other currencies, the dollar has had a good run over recent years. It’s up almost 30% from the lows the dollar hit in 2011 against major currencies. 2018 has seen a good run for the dollar too, with the currency up around 6% since the start of this year. Nonetheless, we’re still some way below recent historical peaks in the dollar’s value such as 1985 and 2002.
Looking at it another way, on a fundamental basis in terms of how much the U.S. dollar can buy, the Big Mac Index suggests that the dollar is 45% more expense than the average of 4 major currencies based on comparing how much McDonald’s Big Mac costs in different countries. In theory, if currencies were all fairly valued, a Big Mac would cost the same everywhere regardless of the country you were in. A more sophisticated analysis using a full basket of goods rather than just a single burger, still has the U.S. as generally expensive against most other major currencies, but with the exception of most Scandinavian currencies.
As a result, the dollar appears on the expensive side today whether looking at its recent run-up in value or more fundamental measures. However, we’ve seen moves up of 40% to 50% in the dollar off the lows in recent history, so today’s dollar may be expensive, and we are likely closer to the end of its the strengthening cycle than the beginning. Nonetheless, the dollar could have further to run. Currently, the dollar is supported by high U.S. interest rates on government debt relative to other countries. Tariffs too may be boosting the dollar, as money is spent domestically rather than overseas. Finally, the dollar is often used as a safe haven during times of market panic, so even if the dollar appears expensive and may weaken based on fundamentals in the coming years, any market panic could see the dollar temporarily strengthen once again. As a result, the dollar appears expensive relative to history and most indicators, but could have further to run. When it does eventually turn and start to weaken, that will likely be a positive for many S&P 500 firms, that are global, and for commodity investments, but be a drag on certain smaller U.S. firms.