Everyone has finally seemed to get it. Investing abroad pays. The only problem: By the time everyone finally gets it, things get more risky. And this may be especially true for newcomers finally taking the plunge overseas, attracted by long-term outperformance of foreign bourses. Only now they may find, however, that foreign alpha has dried up.
Why?
There are two basic components to foreign investing: the underlying securities and foreign exchange. We can expect that many exchanges abroad should continue to do well, fueled by solid growth and profitability that may well exceed our own. But the tailwind from rising currencies generated by five years of a declining dollar may be coming to an end. If that happens-and many foreign-exchange analysts expect that it will by the middle of next year-net foreign returns may end up trailing the U.S. market.
Understanding Foreign Returns
The impact that foreign exchange has had on total returns is evident when studying the performance of the MSCI's international benchmark, EAFE, against its U.S. index. Over the past five years through the beginning of October, a period that roughly coincides with the dollar's decline, annualized total returns for MSCI's U.S. index averaged 15.77%. EAFE appreciated 24.12%-in dollar terms. Looks great.
However, more than 6% of this annual outperformance has been directly attributable to the falling dollar. In other words, three-quarters of excess returns investors garnered overseas over the past five years was due solely to the rising value of foreign currencies.
The calculus has changed over the past year, suggesting something different may be going on. EAFE total returns in dollars were an impressive 26.21%, topping the U.S. by 8.12%. But this difference (and more) was due to the falling dollar, which generated 9.54% of additional return for U.S. investors. When compared in local currency terms, EAFE actually underperformed the U.S. by 139 basis points over the past year.
Statistically, this could be just a one-off change in fortunes. Nonetheless, the one- and five-year figures demonstrate the very large role currency has played in boosting dollar-based investor returns overseas. The key question investors then must ask is: Will this tailwind last?
To help figure that out, let's look at a longer time frame that captures a more complete exchange-rate cycle. EAFE's 10-year annualized returns in dollars were 8.37%. U.S. returns averaged 6.41%. So during a decade that saw the introduction of the world's second most important currency, the euro, and then its out-of-the-box collapse for several years followed by a rally that sent it soaring, foreign exchange accounted for less than 2% annually of net performance. And in local currency terms, EAFE actually underperformed domestic equitiesby a slight bit over this time.
All this suggests that over the long term, the impact of foreign exchange tends to net out. If this is so, we may see U.S. investor gains from foreign currency appreciation slow, if not reverse, suggesting a risk for Americans venturing abroad unhedged-a dollar trap.
Dollar Bears And Bulls
This is not to say that the dollar is ready to reverse course at this moment. Over the near term, J.P. Morgan's currency strategist, John Normand, believes the dollar will continue to weaken, topping out at around $1.48 during the next quarter.
Adnan Akant, head of foreign-exchange strategy at the global fixed-income and currency manager Fischer Francis Trees & Watts, a firm with $32 billion in assets, remains (long) the euro, in commodity currencies (like the Australian, New Zealand and Canadian dollars) and in high-yield emerging market currencies (like the Turkish lire and Brazilian real).
Dollar bears and bulls alike agree the reasons that continue to drag down the dollar are still extant. Scott Hixon, INVESCO's currency specialist who oversees $1.5 billion in foreign-exchange investments, points to pressure from the U.S. housing slowdown and the subsequent subprime blowup, which are drags on domestic growth. This has led to a substantial cut in U.S. interest rates and the prospects of additional monetary easing to come. At the same time, rates in most other developed markets have been rising. "These negative turns," explains Hixon, "have generated greater near-term uncertainty about the American economy and increasing negative sentiment against the greenback while other major economies are motoring along."
However, Hixon sees a major disconnect between currency valuations and purchasing power parity-a key factor that analysts use in assessing the worth of currencies. "One needs to go back to the early 1980s to see an equivalent misvaluation of the dollar versus the world's developed market currencies," says Hixon. As of the beginning of September, he saw the dollar undervalued 23% versus the Canadian dollar, 24% versus British sterling and 28% versus the euro. "This is not to say that the dollar can't move lower over the next few months," qualifies Hixon, "just that such an event would be unprecedented since fixed exchange rates were broken in 1972."
Such undervaluation, he argues, will spur "a significant expansion in net flows into the states as foreign-based investors realize the discount that the weak dollar has availed them." At the same time, he feels a prolonged slowdown in U.S. growth would eventually affect global prosperity. If this happens, Hixon thinks the U.S. safe haven status (which the euro has yet to achieve) will also enhance the flow of capital into the states, further boosting the dollar.
Hixon surmises that sometime next year the U.S. economy will regain momentum from its current slowdown, which should translate into more positive global sentiment toward the dollar. Stephen Jen, the global head of Morgan Stanley's currency research, also believes the dollar is significantly undervalued against major currencies and believes the worst of the dollar's fall is nearly over. He sees the euro trading range-bound for the rest of the year between $1.40 and $1.45 before the currency starts to decline in 2008.
Jen also cites two underreported events that appear to favor the dollar. Dollar bears have always been keen on focusing on the United States' bloated current account deficit as a reason for further dollar deterioration. No more. The numbers have actually been improving. Peaking in the fourth quarter of 2005 at 6.7% of GDP, the U.S. current account deficit fell to 5.5% in the second quarter of 2007. And Morgan Stanley's economists expect the number to average 4.5% in 2008 and 4.1% in 2009. Moreover, in the third quarter of 2007, a surge in exports offset the fall in domestic housing, enabling American gross domestic product growth to surprise economists and advance by 3.9%.
The strong foreign currency rally that followed the Fed's 50 basis point rate cut in September hid the fact that Eurozone growth prospects are slowing. "Once the market refocuses on the diminishing growth differential between the U.S. and the Eurozone, and the likelihood that it may lead to ECB rate cuts," says Jen, "the dollar should rally to $1.30 by the end of 2008 with a longer-term target of $1.17." If Jen's call is right, unhedged Eurozone investors may have to outperform the U.S. market by 18% just to break even.
Even J.P. Morgan's dollar bear, John Normand, is more sanguine about the greenback's prospects in the longer term as the U.S. economy cycles through a trough. "The dollar typically starts to recover six months after a recession hits," Normand says, "since investors anticipate eventual improvement in growth and investment prospects."
Strategies
All this is not to say that long-term investors are better off staying home, realizing approximately the same net gains of a global portfolio, while avoiding the volatility generated from foreign currency exposure. There are great companies abroad and many industry leaders that aren't found in the states. (And advisors may devise currency and country weighting that differs from EAFE.
"Despite whatever country and currency allocation you devise," says Harold Sharon, director of international equity at New Jersey-based Lord Abbett (which oversees $2.5 billion in assets), "investors shouldn't expect anywhere near the same boost from foreign exchange going forward." He thinks the dollar will begin to rally during the first half of 2008. This means that if major equity markets perform comparably in local currency terms, U.S. investors' foreign positions may underperform our home market.
Because Sharon is a long-term investor who believes foreign-exchange exposure is part of the benefits of investing overseas, he generally doesn't believe in currency hedging. He thinks it's extremely difficult to anticipate shifts in foreign exchange. However, because of the dollar's significant undervaluation, Sharon says he could end up hedging up to 50% of his currency exposure if the greenback shows signs of rebounding and making up some of what it lost over the past five years.
Sharon prefers to naturally hedge against substantial foreign-exchange shifts by investing in companies that should benefit from such moves. Take the Japanese yen, for example, which has remained fairly stable against the dollar while the euro has soared. Sharon believes this has given Toyota and Honda a competitive advantage over European companies like BMW and Volkswagen in the American market. And this benefit is especially pronounced when profits from foreign operations are translated back into local financial statements.
INVESCO's currency strategist Hixon has already shifted into a pro-dollar stance. During the first half of 2007, 10% to 15% of his $1.5 billion in foreign-exchange investments were short the dollar. But when August's credit crisis hit, he established a currency position that was 20% long on the dollar. "Because we saw rising credit spreads and diminishing liquidity collectively seizing up markets," says Hixon, "we believe there would be a potent return to safe-haven securities and currencies." And he thinks the severity of the shock will reverberate in the dollar's favor over the next 12 to 18 months.
"Right now, the mantra of most FX pundits is 'the dollar must go down,' said with such confidence and no doubts," observes Jack Crooks, president of the Florida-based currency advisory Black Swan Capital. He agrees there are real forces driving the dollar lower. "But if I've learned one thing for sure after getting pummeled many times over the last 25 years playing in financial markets," Crooks concludes, "it's that when the entire market has supreme confidence about a particular matter, it's time to cover your wallet and head for the door!"
