King Dollar No More?

After a period of significant strength, the recent pullback in the US dollar has left some investors wondering whether its impressive run may finally be reversing (Display). We wouldn’t count the dollar out just yet, especially given the fundamental factors that supported the currency in 2022—and the lingering uncertainty surrounding inflation and the Federal Reserve’s response. At the same time, we believe it’s time to consider and strategically position for potential further weakening in the greenback.

Last Year's Dollar Strength Has Reversed Course Recently

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Which companies are most likely to benefit from a turn in the dollar trend? There are many factors at play, most notably where a given company generates its sales. In today’s global economy, that may or may not align with the location of its corporate headquarters.

In 2022, the headwinds imposed by dollar strength on US-based multinationals provided a stark reminder of the potential for this mismatch. Put simply, domiciles and home stock exchanges often prove to be misleading guides. For instance, our analysis of corporate earnings call transcripts showed an uptick in mentions of dollar strength beginning in the second half of 2022. That’s when overseas sales suddenly declined in value in US dollar terms. 

What’s more, US-based exporters found themselves positioned less competitively against global peers with weaker currencies. A persistent break in the strong dollar trend would reduce the currency headwind faced by these companies. Conversely, foreign companies with significant dollar exposure would see the recent boost from earning-appreciating dollars start to fade.

Determining which corporates could be most impacted by currency fluctuations requires company-level research. In times of changing macroeconomic trends, active management can sharpen investors’ focus on what matters. An active approach allows managers to gain exposure to the most favorably situated companies—not just in terms of currencies, but equally important in terms of the relative growth rates of different markets.

Don’t Lose Your Balance

After a strong run of US equity performance, some US-based investors may be tempted to avoid currency risk by opting out of international equities. Yet limiting the universe to only US-based stocks is likely to detract from risk-adjusted returns in the long run.

Plus, there’s a lengthy list of reasons to “go global.” Exposure to different geographies allows investors to take advantage of the full set of global investment opportunities while capturing diversification potential. Broad market trends also change swiftly, with leadership abruptly shifting from one region, sector, or style to another. Despite global stocks outperforming US stocks by a considerable margin in local currency terms in 2022, the strong dollar offset almost all that outperformance for US investors. But if the dollar trend reverses, a relatively weaker dollar would create a tailwind for US investors’ overseas investments as we saw in the fourth quarter of last year (Display). 

Non-US Stock Benefit When US Dollar Declines (e.g., 4Q:2022)

The bottom line? Maintaining global exposure prevents investors from being caught on just one side of the currency trend. Instead, they’ll have already reserved a spot for when the tide changes. So, hang on to those international stocks. And if you need further enticement, consider that several international markets appear to have more economic pessimism baked in than the consensus in the US.

To Hedge or Not to Hedge

What about international investors? When assessing currency risks and returns, consider this familiar refrain: location, location, location. For instance, US-based investors with global equity portfolios will often have most of their exposure denominated in dollars due to the outsized weight of the US markets. But international investors with a similarly diversified portfolio will typically face a larger mismatch between their home currency and that of their investment portfolios.

This means that non-US investors generally face more currency risk. Depending on the situation, hedging out a portion of the currency exposure in a non-US investor’s equity portfolio could enhance risk-adjusted returns. For global bond investors, regardless of your domicile, hedging may enable bonds to better fulfill their intended defensive, stabilizing role.

Emerging Opportunities?

The spillover effects of a strong dollar have been particularly challenging for some emerging market economies this year. A cheaper dollar would bring some relief to emerging market countries in the form of less expensive commodity imports and less pressure on central banks to continue raising interest rates to prevent capital flight. A weaker dollar also makes dollar-denominated debt in emerging market countries more manageable.

While it may be tempting to jump in, balance—as usual—remains wise. Think of an allocation to emerging markets as a core part of your portfolio, complementing international developed market exposure. That way, you can capture upside potential while avoiding the pitfalls of trying to time the turn.

New Year, Same Uncertainty

With signs of a gathering global slowdown, we’re not quite ready to call a definitive end to the dollar’s winning streak. A limping global economy could spark flows back to the US. Instead of going all-in on a break in the buck, consider active management, maintaining geographic balance, and selectively employing hedges. This should help you capture potential benefits while maintaining an eye on risk.

Maura Pape
Senior Investment Strategist—Investment Strategy Team
Roosevelt Bowman
Senior Investment Strategist—Investment Strategy Team

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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