In the world of international investing, there exists a force often underestimated by many investors: currency movements.

While the allure of diversifying portfolios by venturing beyond domestic borders is undeniable, the impact of fluctuating exchange rates on investment returns can be profound and, if ignored, potentially detrimental.

Currency movements refer to the changes in the exchange rate between two currencies. These fluctuations can significantly affect the return on investment (ROI) for those holding international stocks.

When an investor in the United States decides to buy stocks or bonds domiciled in a foreign market, the investment’s value and returns are subject to not only the performance of the asset itself but also the ever-changing landscape of currency exchange rates. This dual exposure introduces an additional layer of risk — and opportunity — in international investing.

The impact of currency movements on investment returns is twofold. 

• On one hand, if the investor's local currency strengthens against the USD, the USD-denominated return might surpass the local currency return, offering a bonus gain from favorable currency exchange movements.

• Conversely, a weakening of the local currency against the USD can eat into the overall return, making the investment less profitable or even resulting in a loss when converted back to the investor's home currency.

The Impact of Currency Movements on Returns

Currency movements hold a significant sway over the profitability of international investments.

This influence stems from the basic principle that when you invest in foreign assets, you're also implicitly betting on the currency of that asset's country.

Consequently, the return on your investment in USD terms is not solely dependent on the asset's performance but also on how the local currency fares against the USD during your investment period.

The Dual-Edged Sword of Currency Fluctuations

1. Enhanced Returns through Strengthening Local Currency

When the local currency strengthens against the USD, investors find themselves in a favorable position. For instance, if you, as a USD investor, put money into a market where the local currency then appreciates against the USD, you gain an additional return on conversion back to your home currency. This extra profit is over and above any returns generated by the performance of the asset itself.

To illustrate, consider an investment in European stocks where the Euro strengthens against the USD over the investment period. If the stocks appreciate by 10% in Euro terms and the Euro appreciates by 5% against the USD, the total USD-denominated return would be more than 10%, thanks to the currency exchange gain.

2. Diminished Returns due to Weakening Local Currency

Conversely, a weakening local currency can erode the USD-denominated returns of an international investment. This situation is akin to having the wind in your face; not only do you need your investment to perform well, but you also need it to outperform sufficiently to offset any losses from currency depreciation.

Imagine investing in a country whose currency then depreciates against the USD. Even if the investment appreciates in local currency terms, when converted back to USD, the return could be negated or lessened by the depreciation of the local currency.

This scenario underscores the risk currency movements pose to international investors, potentially turning a profitable move in local terms into a break-even situation or a loss when accounted for in USD.

A Closer Look at Currency Impact with Real Examples

To bring this concept to life, let's look at the performance of international equity strategies over the last 10 years.

Let’s start by looking at the currency return over various holding periods for US-based investors with exposure to the MSCI EAFE Index (developed markets) and the MSCI Emerging Markets Index.

The currency return is calculated as the difference in annual returns between the investment measured in US dollars and the investment measured in local currency.

• If the difference between US dollar returns and local currency returns is positive, the US-based investor has achieved a higher rate of return than its local peer

• If the difference is negative, i.e. the US dollar has depreciated over the holding period, the local investor has achieved a higher return than its US-based counterpart

From the above chart, it’s no surprise that US investors are disenchanted with their international strategies. Currency returns to US-based investors have been consistently negative over the last 10 years. 

• Investors in the MSCI EAFE Index have lost 2.66% a year to adverse currency movements

• Investors in the MSCI Emerging Markets Index have had a -2.61 % return hit due to currency movements

• The only period with positive FX returns for investors in Developed International Equity markets has been over the last year

When looking at single-country returns the picture becomes even more disappointing. For example, over the last 10 years, US-based investors in the MSCI Japan Index have lost 3.8% a year due to the appreciation of the USD versus the Yen.

The only developed market where currency did not factor in was Switzerland. The Swiss Franc is the only currency to have held steady with the USD over the last decade.

Even investors with exposure to European equity markets suffered losses in the range of 2.4% to 2.7% a year due to the appreciation of the US dollar versus the Euro.

When you look at emerging markets the message is the same. The US dollar has been a massive performer relative to most EM currencies.

The scale of currency losses is in some cases eye-popping. For example, the MSCI Turkey Index has returned 30.7% in Turkish Lira, but only 0.09% in US dollars.

Currency returns have been a significant source of losses to US Investors holding international investments over the last decade.

Predicting currency returns is as difficult as predicting stock and bond returns. The academic literature has shown a strong tendency for currencies to trend over long periods, but eventually revert to some equilibrium.

In the next section, I offer up some of the key drivers of currency movements in the hope of stimulating your understanding of the effect of currency on international equity and bond market returns.

In the end, as an investor, you will need to have some sort of view on the direction of the US dollar.

The currency return component is just too big of a piece to ignore or assume away as irrelevant.

Even absent any insight before you invest in international markets give yourself a margin of error to compensate for the additional risk of currency fluctuations on your US-denominated portfolio.

Key Drivers Behind Currency Movements

Currency values fluctuate due to a complex interplay of various factors. Understanding these drivers is essential for international investors to navigate the forex impact on their investments.

Here are the primary forces influencing currency movements:

1. Interest Rate Differentials

Interest rates set by central banks directly influence currency values.

Higher interest rates provide higher returns on investments in that currency, attracting foreign capital and causing the currency to appreciate.

Conversely, lower interest rates tend to depreciate a currency, as they offer lower returns on investments denominated in that currency.

Monitoring central bank policies and interest rate forecasts can provide insights into future currency movements.

2. Monetary Policy Expectations

Central banks use monetary policy to control inflation, manage employment levels, and stabilize the economy. These policies affect investor perceptions and expectations, impacting currency strength.

An expansionary monetary policy (e.g., increasing money supply) might weaken a currency, while a contractionary policy (e.g., reducing money supply) can strengthen it.

Investors often react to monetary policy signals before actual changes occur, affecting currency values in anticipation of future actions.

3. Economic Performance and Inflation Differentials

The economic performance of a country influences its currency's strength.

Strong economic growth attracts foreign investment, boosting demand for the country's currency and causing it to appreciate.

Conversely, economic slowdowns can lead to currency depreciation.

Similarly, inflation differentials between countries can affect currency values.

A country with lower inflation rates compared to others will see its currency appreciate, as its purchasing power increases relative to other currencies.

4. Political Stability and Economic Policies

Political events and stability can have immediate effects on currency strength.

Countries with stable governments and sound economic policies tend to attract investment, supporting their currencies.

Political uncertainty or poor economic management, on the other hand, can scare away investors, leading to currency depreciation.

5. Speculation and Market Sentiment

Lastly, currency markets are also driven by speculation and market sentiment.

Traders' perceptions of future events can cause currencies to move even without changes in fundamental indicators. For example, if traders believe a currency will strengthen in the future, they may buy large amounts of that currency, causing it to appreciate in the short term.

Understanding these key drivers behind currency movements can help investors anticipate potential changes in exchange rates and adjust their international investment strategies accordingly.

While it's challenging to predict currency movements with certainty, being aware of these factors allows investors to make more informed decisions and potentially mitigate currency risk in their international portfolios.

It’s tempting to assume that currency returns will be a wash over long periods. Most advisors make this assumption, but in my opinion, that’s a mistake.

You need to have a view of both the attractiveness of the investment in local currency terms and the likely changes in the currency relative to the US dollar (if you’re a US-domiciled investor)

Investing in US-traded ETFs or mutual funds such as the iShares EFA or EEM tickers does not immunize you from currency fluctuations. You just don’t see the return to currency but it’s still there.

There are specialized investment products that hedge out the currency return such as the iShares Currency Hedged MSCI EAFE ETF (HEFA) but it comes at a cost in terms of higher expense ratios and the variability of hedging conditions.

• Currency movements are a pivotal, yet often overlooked, element in the realm of international investing.

• The impact of exchange rate fluctuations can significantly influence the returns on international investments, for better or worse.

• Investing internationally offers the allure of diversification and the potential for enhanced returns, but it also introduces the challenge of dealing with currency movements.

• By acknowledging and actively managing this "hidden force," investors can make more informed decisions, better protect their investments, and possibly even turn currency movements to their advantage.

• As the global economy continues to evolve, the importance of understanding and managing currency risk in international investments cannot be overstated.

Investors making international investments must ask themselves:

The default assumption that most advisors use is that currency movements wash out over the long term. This is a dangerous misguided assumption. The data on currency movements do not support such a conclusion.

At the very least you need to consider the outlook for the US dollar.

• If you think that the USD will remain strong then expect a ding to your international investments.

• If you think that the USD will depreciate you can expect international investments to provide an incremental return due to currency

Asset Allocation Performance Review

High-Level Observations:

• Conservative portfolios with a heavier allocation to bonds are still recovering from the 2022 capital market collapse but the trend is up. Over the last three years, the GF Low-Risk strategy is only up 2.1% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 5.1%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities. The GF High-Risk strategy is up 3.8% on an annualized pre-cost basis over the last three years. over the last 5 years, the strategy is up a respectable 8%.

• In the last few weeks, both US Small Cap and International Equities have come back to life. The dependence on US Large Cap is, hopefully, lessening as more asset classes close the gap. Over the last 3 months, US Large Caps are still leading the pack with the S&P 500 up 11.9%, but US Small Caps are not that far behind with a gain of 10.2% while International Developed Markets (EAFE) are up 9.6%.

• Bonds failed to insulate the fall of equities in 2022 due to the historically low interest rates prevailing before the correction. The conditions today are different with the 30-Day SEC yield on the iShares Agg ETF at 4.31%. Given an inflation rate of around 3%, bondholders are now getting a positive real return. That’s great news for retirees in need of maintaining their purchasing power.

• As the Federal Reserve lowers interest rates (timing unknown, but most likely in the second half of this year) the yields on cash investments and CD’s will drop, and bonds will likely benefit as the long end of the yield curve drops in response to looser monetary policy. Bondholders will be getting a short-term boost to bond prices (capital appreciation) but also lower yields in the future. That’s the bet that Wall Street is making, but the gains will go to current holders.

Weekly Performance Attribution

Source: iShares, as of 3/12/2024

A Bit of Humor Never Hurts

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