24 August 2022
The US Dollar has been on a winning streak this year: it’s strengthened by more than 10% year-to-date, reaching a 2-decade high against other major global currencies. Notably, the USD reached parity against the Euro for the first time in 20 years in July.
The global economy today runs on dollars: with the USD involved in almost 90% of foreign currency transactions, the surging dollar affects not just the US economy, but also the rest of the world.
What’s behind the recent USD strength, and what does it mean for your investments? Read on to find out.
The USD’s strength this year has been driven by the Fed raising rates at a faster pace than other major central banks, and its status as a safe haven currency.
A strong USD could help to ease inflation in the US. But, it could weigh on the earnings of US companies that have a large presence in overseas markets. And emerging economies could also find it harder to pay off their USD debts.
When you invest in a portfolio of global stocks and bonds, your investments are exposed to currency fluctuations through the currency in which you invest, and the geographic exposure of your investments.
Our investment framework, ERAA®, takes into account each ETF’s underlying currency exposure, and optimises portfolios for long-term returns through shifting economic and currency regimes.
The Fed has raised interest rates at a faster pace than other major central banks in its bid to cool inflation. Higher interest rates make the USD more attractive to global investors because they can get higher returns from holding USD assets. And when demand for the USD increases, its value relative to other currencies also increases.
First of all, what is a “safe haven” currency? Safe haven currencies are those that are expected to retain their value even in times of economic or geopolitical uncertainty. The USD has safe haven status because it’s so widely used: global central banks hold nearly 60% of foreign exchange reserves in USD, and it’s the predominant currency for international trade and financial market transactions.
When markets are as volatile as they’ve been this year, investors tend to prefer safe haven assets (such as the USD or Gold) over riskier assets (such as emerging market equities or high-yield bonds).
The US imports more than half of what it consumes from abroad. A strong USD makes imports cheaper for US consumers, and could eventually help ease inflation. Some analysts say cheaper imports could lower pressure on the Fed to continue aggressively hiking interest rates.
In the rest of the world, however, dollar appreciation has the opposite effect – importing goods in USD becomes more expensive, pushing up inflation outside of the US.
A strong USD lowers the relative value of other currencies. So when US companies have large exposure to international markets, their overseas revenues will take a hit when converted back to USD. We’ve already seen companies such as Microsoft, IBM, and Netflix cut their earnings forecasts for 2022 because of unfavourable exchange rates.
Many emerging economies have a share of their debt held in USD. A stronger dollar makes it more expensive for these countries to pay off their debts. And, given that most global trade is conducted in USD, dollar appreciation also reduces the purchasing power of these developing nations. Some economies, like Sri Lanka, have already stopped paying foreign bond holders, and economists are predicting more emerging market defaults could follow.
We’ve covered the impact of a strong USD on the global economy. But how does it affect you? Apart from making a trip to the US more expensive for those of us living elsewhere, a stronger USD could also affect your investment returns.
When you invest in a global portfolio of stocks and bonds, you’re exposed to currency fluctuations through:
The currency your investments are denominated in (eg. if you’re based in Singapore and investing with SGD into a USD-denominated ETF); and
The geographic exposure of your underlying securities (eg. if you invest in an Australian company through a USD-denominated ETF)
When you invest with SGD into a USD-denominated ETF, your investments will gain value when the USD rises against the SGD, so long as all other factors remain constant. The change in value of the USD against the SGD is called the “currency impact”.
That said, determining your overall currency exposure isn’t as straightforward as just looking at what currencies your ETFs are denominated in. Because our portfolios are globally diversified, they’re exposed to multiple currencies apart from the USD. Using the example above, if you’re invested in an Australian company through a USD-denominated ETF, and this company gets its earnings in AUD, you then have indirect exposure to the AUD.
Our investment framework, ERAA®, considers the underlying currency exposure of each ETF when it optimises each portfolio.
In uncertain markets, investors tend to favour safer assets such as the USD. So, USD exposure can benefit your returns. In these conditions, ERAA®’s algorithm will therefore increase its portfolios’ exposure to the USD.
And in good times, when riskier assets, like stocks, tend to perform well, ERAA® reduces its allocation to the USD. A neutral weighting means that 30-40% of a portfolio’s assets would be USD-denominated.
The USD has strengthened significantly this year, and here are the scenarios that could play out over the coming months:
Slowing global growth data and greater recession concerns could further benefit safe haven currencies such as the USD and JPY.
However, if the US enters a recession, the Fed would likely pivot and become less aggressive in its interest rate hikes, reducing the USD’s value versus other currencies.
But given the US economy is still one of the strongest globally, its currency is still relatively more attractive than those of other economies such as the Eurozone.
Overall, we don’t see the USD turning significantly weaker in the near term. But if the Fed raises interest rates less aggressively later this year, the pace of the USD’s appreciation against other currencies might slow or pause. Instead of broad-based USD strength, we might see more divergent currency performance depending on each country’s central bank decisions and pace of economic growth.
By investing in a diversified portfolio of asset classes with broad geographic exposure, you minimise the impact of country-specific events on your investments. As always, ERAA® continues to optimise your portfolios for long-term returns through the shifting economic and currency regimes.