Although central banks are using the available tools to fight deflation, we don't see this as a "currency war."
A weaker currency can help an economy by potentially boosting exports, jobs and inflation, as well as increasing corporate earnings.
A strong currency, such as the U.S. dollar, can cut international stock returns, so investors may want to use exchange-traded funds (ETFs) or mutual funds that hedge currency exposure.
With economies from Europe to Japan recently making moves that have weakened their currencies, talk of another round of "currency wars" is likely to heat up.
This refers, at least in part, to the fact that foreign central banks are making aggressive moves to ease monetary policy—either by lowering interest rates or increasing the supply of money by purchasing government bonds, an approach known as quantitative easing (QE). Increasing the supply of money can suppress the value of an economy's currency.
Why would policymakers want a weaker currency? In a world where interest rates are already very low, a weaker currency has become a desired way to stimulate growth. But there are also downsides—and not just for the countries with strengthening currencies, such as the United States.
Why would you want a weaker currency?
Global economic growth and interest rates remain low, resulting in central banks using unconventional means to try to boost growth. While most central banks are not explicitly targeting weaker currencies, it has become an unspoken goal. For example, the eurozone and Japan have loosened monetary policy and seen their currencies fall against the U.S. dollar.
Potential implications of a lower currency include:
- Export growth. A country's exports can gain market share as its goods get cheaper relative to goods priced in stronger currencies. The resulting increases in sales can boost economic growth and jobs, as well as increase corporate profits for companies that do business in foreign markets.
- Rising inflation. Inflation can climb when economies import goods from countries with stronger currencies, since it takes more of a weak currency to buy the same amount of goods priced in a stronger currency. Currently, low economic growth has resulted in deflation, or falling prices, becoming a bigger risk than inflation in many countries. A deflationary mindset is undesirable because once consumers begin to expect regular price declines, they may start to postpone spending and businesses may begin to delay investment, resulting in a self-perpetuating cycle of slowing economic activity.
- Relief for debtors. A weak currency can boost inflation, and therefore incomes and tax receipts, while the value of debt is unchanged, making it easier for local currency borrowers to pay down debts. Alternatively, a weak currency makes paying back debt issued to foreign investors and priced in foreign currency more expensive. Much of the developed world still has high debt burdens, making inflation somewhat desirable.
The zero-sum game of currency competition
While some countries may be helped by lower currencies in the short term, the benefits may be counterbalanced by negative effects elsewhere. Recall that exchange rates are relative: As one currency declines, another must go up. Therefore, for every winner there's a loser, and not all currencies can weaken at the same time—it is a zero-sum game.
If multiple countries try to compete by devaluing currencies for too long, there can be longer-term costs to the global economy. If competing on currency fails to bring an increased market share of global exports, countries may resort to protectionism, instituting trade barriers. Such moves may limit the benefits of free trade and make economic activity less efficient, which can reduce global economic growth.
We don’t believe what we're experiencing should really be called "currency wars." In countries where interest rates are already very low and deflation is a threat, central banks are simply using the remaining tools available to fight deflation.
International stock investors are also affected
We believe the U.S. dollar is likely to remain strong in the intermediate term due to diverging global monetary policies. While earnings could get a lift in countries with weak currencies, it's important to remember that investment returns are reduced by the translation back to U.S. dollars.
For companies that earn foreign revenues in currencies stronger than the currency of their home country, the size of the gain in earnings depends on where costs are incurred. For instance, sales generated in the U.S. translate into more euros for eurozone companies than they did a year ago. If the costs to generate these sales were denominated in euros, the impact on earnings could be higher than if they were denominated in U.S. dollars.
Currency has eaten into returns in some foreign markets
Foreign returns over the past year are lower after converting to U.S. dollars
Source: Charles Schwab & Co, Bloomberg, as of 1/29/2016. Indexes are: Deutscher Aktienindex (DAX), Nikkei-225 Stock Average (Nikkei), Australian Securities Exchange (ASX 200), and Toronto Stock Exchange Index (TSX).
When you own a foreign stock in a falling local currency, your investment returns can be reduced because it takes more of that currency to translate back to U.S. dollars. However, when we studied historical evidence, the impact of long cycles of dollar strength on the relative performance of international stocks to U.S. stocks was inconclusive.
During the first long-term cycle of dollar strength that we studied, from the start of 1974 to the end of 1990, the relative performance of international stocks wasn't strongly connected to changes in the U.S. dollar. The second multi-year cycle of dollar strength was during the technology boom of the late 1990s, which boosted demand for U.S. technology stocks and contributed to the outperformance of U.S. stocks relative to international stocks.
International stocks should not be avoided just because of U.S. dollar strength, though. Currency translation is only one factor for performance. To help protect returns, however, hedging currency is likely a good idea, since we believe the U.S. dollar could rise further. Because using derivatives to hedge currency is expensive for individual investors, we prefer products such as ETFs and mutual funds that hedge currency exposure for international stock allocations.
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