Tim Richardson CFA, Investment Specialist
“A US dollar is an IOU from the Federal Reserve Bank. It’s a promissory note that doesn’t actually promise anything.”
– PJ O’Rourke, US humourist
The strong US dollar may weaken when the global economy begins to recover, and investors regain their risk appetite. This will support the earnings of many US-based international companies, and potentially boost Australian investors’ returns from global equity funds.
Does a strong US dollar matter?
- The US dollar sits at a 35-year high.
- The earnings of globally orientated US companies have been weakening.
These two factors are connected.
A strong US dollar (USD) raises the price of US exports in a foreign currency, e.g. euros, reducing overseas demand. It also diminishes the value of overseas earnings from offshore subsidiaries when converted back into US dollars.
Morgan Stanley recently published a note to clients that estimated each 1% gain in the US dollar DXY index brings a 0.5% fall in US company earnings.
Why do investors expect the dollar to fall?
US interest rates are currently at 4.0% and are expected to rise further. This will eventually reduce inflation and allow a reversal of the rate rises to begin. This, in turn, will stabilise global economic growth and investors will increase offshore exposure, weakening the USD.
How will this affect the earnings of US-based global companies?
A weaker USD will boost the overseas earnings (in USD terms) of US-based global companies. Imagine a US-based company with a European subsidiary, whose costs and revenues are entirely in euros. Its earnings (in euros) would be unchanged by the USD depreciation, but the USD value of those earnings would rise.
So is this good news for Australian investors?
While a lower US dollar will boost the bottom line of this US-based company, the impact of the currency adjustment won’t be quite the same for Australian dollar (AUD) investors.
In the above example, returns will depend on the change in the euro relative to the Australian dollar (AUD). If the US depreciates equally against the AUD and euro, then the increased USD earnings would be offset by the stronger AUD, leaving Australian investors no better off.
But in the real world won’t Australian investors gain something when the US dollar falls?
There are two common scenarios under which Australian investors in global shares will benefit when the US dollar depreciates.
Firstly, imagine a company has a currency mismatch; its costs are all or mainly in USD, but its sales are all or mainly in euros. If USD costs and euro selling prices remain unchanged after the USD falls, then its margins will increase (in both USD and euro terms). Hence the value of the profits will rise in either currency, (assuming no change in sales volumes), which also increases the AUD value of the earnings. (Although the revenue benefit could be offset in the short-term if the company hedged its currency exposure.)
Secondly, the same US exporter could further benefit from the lower USD, by cutting its price in euros to keep its price (and margins) unchanged in USD terms. If the demand for the product is elastic, (demand rises by a larger proportion than the price falls), then revenue and earnings in USD and euros will increase, boosting AUD returns.
That sounds interesting – so is now the time to hedge currency risk?
That is a different question and depends upon an investor’s individual circumstances, risk appetite, and view of currency markets; professional advice is probably a good idea.
It may be worth considering investing in a global equity fund that offers currency flexibility through the choice of hedged and unhedged portfolios (such as the Pengana Axiom International Ethical Fund, which offers such flexibility to investors). The hedged portfolio generally outperforms the unhedged portfolio when the USD falls against the AUD and underperforms when the USD strengthens.
There are some great companies in Australia, but in aggregate, Australian companies represent just 2% of the global share market, concentrated in a few sectors such as mining, banking, and property. A diversified portfolio of high-quality global shares reduces sector risk, helping investors build long-term wealth.
Sustainable quality companies delivering positive change can grow earnings through the economic downturn and beyond. Many are now much more attractively priced relative to their earnings than at the start of this year. A weaker USD as the global economy recovers should boost returns for Australian investors in global shares.