With U.S. stocks making up less than half of the roughly $80 trillion total global equity market capitalization1, you may be limiting your investment opportunities if you only look within the United States, says John De Clue, chief investment officer for U.S. Bank Private Wealth Management.
Yet, investing in international markets presents unique risks and uncertainties. One risk that’s often not well understood is how the fluctuating value of the U.S. dollar versus other currencies can impact the overall value of a foreign equity investment or asset.
When the value of the U.S. dollar weakens in the international currency market, other currencies gain value. And when the U.S. dollar strengthens, others drop. These changes not only affect the value of cash, but also of investments made in either currency.
A multitude of factors can create the risk of price swings in a country’s currency. These include both global political developments and national or local economic conditions. For example, if a country adjusts its central bank policies by raising or lowering short-term interest rates, it could affect the value of their currency relative to other currencies. Or if a government sparks political tensions of some sort, that country’s currency might weaken as investors move to a safer haven. The same goes for trade issues or fiscal policy.
“Although it’s sometimes unclear why currencies rise and fall in value relative to one another, differences in the economic health of one country versus the other, or interest rate differentials between two countries are often the root cause,” De Clue says.
De Clue offers an example of an interest rate differential and differing currency values: If the 10-year U.S. Treasury note yields 2.95 percent and the 10-year German Bund yields 0.5 percent, investors in the German Bund might be inclined to sell that holding and move to the U.S. Treasury market. “In performing this transaction, they would in effect be selling euros to purchase U.S. dollars, which could drive the dollar higher,” he says.
When a U.S. investor buys the stock of a non-U.S. company that trades on a foreign exchange in a currency other than the U.S. dollar, in addition to buying shares of that stock, a currency exchange occurs either directly or indirectly behind the scenes.
So it’s possible for the investor to make money if the foreign currency rises in value even if the underlying stock doesn’t appreciate. But the opposite could just as easily occur if the foreign currency weakens vs. the dollar. Thus, a single stock transaction can involve either a gain or loss on the security itself, and a gain or loss on the currency movement.
If you’re considering an international investment, De Clue suggests working with a portfolio manager to determine if it makes sense to hedge the currency risk. This process can protect to some degree against adverse swings in foreign currency, with the hope that the underlying asset will appreciate.
Currency hedging is essentially a separate investment designed to protect against a possible negative currency movement. For example, say you and your portfolio manager want to make an investment in a Japanese equity that appears to be attractive, but the outlook for the Japanese yen remains cloudy, with the prospect that the yen might weaken over the short term. In this case, your manager might recommend a strategy that includes some protection against this outcome via hedging exposure to Japanese yen.
In the long run, De Clue says the impact of currency price swings tends to wash out. But on a shorter-term basis, it’s important to be aware of how underlying currency movements may impact the return of a non-dollar investment.
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