International Stocks & a Weaker Dollar

What follows is an excerpt from our quarterly client newsletter...

International stocks have had a stellar start to 2017. Emerging market stocks (EM) have doubled the S&P 500’s year-to-date returns and are up 50% from early 2016 lows. Developed international, led by Europe, has also earned U.S. investors a healthy premium over U.S. stocks.

The trend is still early, but adding to international stocks has benefited our clients this year. Foreign stocks have been aided by stronger global growth, European election results that cheered markets, and the topping of low expectations after years of underperformance.

There is another underappreciated cause: a weakening U.S. dollar. Since the GFC, the dollar has appreciated versus most currencies, reflecting a strengthening U.S. economy. So far this year, the dollar has lost value.

Foreign stock prices and dividends are expressed in local currency on their native stock exchanges. For U.S. investors, a weaker dollar boosts returns because foreign stock prices and dividends turn into more U.S. dollars.

In 2016 and especially in 2015, a strengthening dollar detracted from U.S. investors’ international stock returns. This year, the opposite has happened. Historically, during periods when international stocks outperform U.S. stocks, a weakening dollar has been a major driver of returns.

Currency fluctuations can leave investors feeling helpless: the price of your international stocks may increase, but if the exchange rate works against you, then your investment declines in value.

The impulse is to find a way around the fluctuations. Yet, exchange rates are notoriously impossible to forecast, let alone for investors to time. Removing the risk (through contracts that “hedge out” currency moves) can have high costs. And most importantly, while currencies fluctuate in the short-to-medium term, the differences tend to cancel out over the long-term.

Instead of seeing exchange rates as a hazard, investors should embrace the benefits. Through foreign stocks, U.S. investors diversify against both domestic economic and currency risks.

A growing U.S. stock market, stagnant European economic growth, and strengthening dollar have combined to make international investing relatively unproductive the past few years. If valuations matter, and history tells us they do, then U.S. investors will continue to benefit from overseas exposure.