Three ways to take on the falling US dollar
A downtrend in the US currency is underway, having started after the COVID-19 market sell-off and triggered by the huge amount of quantitative easing (QE) in the US. From its 20 March high this year, the US Dollar Index (DXY) has fallen around 10% to 1 December, while the US dollar has dropped even more against the Australian dollar, by around 30%. Not even record highs in the US share market have stopped the dollar’s fall.
The US central bank’s quantitative easing (QE) program is huge, having pumped around US$6 trillion into the economy this year. QE increases the supply of a currency and therefore decreases its value. Real yields on 10-year treasuries have collapsed below zero making US bonds less attractive to investors, so money has been flowing out of the US, weakening the currency’s value, as measured by the US Dollar Index. In addition, as the coronavirus has spread throughout the world’s largest economy, output has shrunk, with a forecast fall in real GDP of 4.3% in 2020, well below the 1.9% growth expected in China. All this has weighed on confidence in the US economy.
1. Currency hedging
Movements in currency exchange rates can have a big impact on your returns from international share investments. Hedging can reduce your exposure to currency volatility. For investors with short-term horizons that invest in US assets, the decision whether to hedge your currency exposure is an important one. If, for example, the Australian dollar rises 10 per cent against the greenback, all other things being equal, the value of your offshore US investments would fall by 10 per cent when the assets are converted back into local currency.
However, there could be less reason to hedge currency movements over the long term as compared to a short-term investment. What goes up eventually comes down – and currency volatility can be smoothed out. As a result, you could be cutting yourself off longer term from the benefits if the Australian dollar falls. A common route being taken by investors is to take a bet each way on the currency and buy into both hedged and unhedged managed international share funds. The more conservative you are, or the shorter your investment horizon, the higher the ratio of hedged investments versus unhedged investments should be, to minimise currency exposure.
2. Emerging markets
A falling US dollar is often seen as good news for emerging markets, because it makes the cost of US goods and services, which they may import, cheaper in their own currencies. Also, emerging nations often have US dollar debt. If an EM country has a lot of US dollar debt, the weakening dollar deflates the value of that debt in local currency terms and servicing that debt will cost less.
When the US dollar falls, investors also turn to higher-yielding debt from emerging markets and money flows into their bond markets, supporting asset values. This is exactly what we’ve seen during the coronavirus pandemic; emerging market debt has rallied. With interest rates having fallen sharply in developed nations in response to COVID-19, we believe many emerging market bonds remain very attractive for income and growth opportunities.
Within equities, the weaker greenback is also good for countries which export commodities. The weaker US dollar is usually accompanied by stronger commodity prices, such iron ore, which in turn boosts growth and promotes trade surpluses for commodities exporters such as one of the world’s biggest emerging markets, Brazil. So both emerging markets bonds and emerging markets equities can benefit from a falling US dollar.
3. Resources companies
The pricing mechanism for most commodities around the world is the US dollar. So during periods of US dollar weakness, the price of commodities tends to fall too. This is why the US dollar has such an important role in influencing the price of commodities; A lower dollar is good for demand for commodities.
Coming out of a global recession too, commodities demand could rise as economies recover from the COVID-19 pandemic: we, and the IMF, believe this could be as early as next year. With COVID-19 vaccines likely being deployed, on top of huge levels of government spending in infrastructure projects around the globe, economic growth is likely to return towards more normal level in 2021. An IMF report published in November 2020 argues that a global synchronised infrastructure investment push could invigorate growth and limit scarring from the COVID-19 pandemic. While the IMF has forecast a historic global GDP contraction of 4.4% in 2020, it expects a partial recovery next year, with growth forecast at 5.2%. The IMF says the global recovery has already started. For many economies—including the United States, Japan, and the Euro Area—economic activity in the third quarter turned out stronger than expected.
As the global recovery gathers pace next year, resource companies – including those that mine iron ore and copper – will directly benefit, with any price falls for commodities adding to demand. The big Australian iron ore miners BHP Billiton, Rio Tinto and Fortescue Metals Group are currently hitting fresh highs this month, and this run could continue in 2021.
Positioned for currency volatility
These three investment ideas: hedging your international equity exposure; investing in emerging markets, and investing in resource companies, are strategies to consider when investing in an environment in which there is pressure on the US dollar. Always speak to a financial adviser to consider your individual financial circumstances, needs and objectives and read the relevant PDS before making a decision to invest. Currency movements are unpredictable and volatile and are just one of the many risks investors have to navigate.
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