One of our highest-conviction ideas for 2015 is the ongoing strength of the U.S. dollar against foreign currencies. While this trend actually started in 2011, we believe that it has the ability to persist for several more years. Our view is primarily predicated on what we see as the likely drivers of dollar strength and their similarities to catalysts behind past periods of prolonged dollar strength. Most notably, the long-anticipated policy and economic divergences between the U.S. and other developed market economies are becoming reality.
While a strong dollar can be beneficial for Americans traveling abroad, how can U.S. investors take advantage of this trend in their portfolios today? In our view, the most straightforward way would be to incorporate currency strategies that benefit from a rise in the U.S. dollar. However, the most common topic we’ve been discussing with investors is where a bullish dollar strategy1 fits in their portfolios. As we show below, dollar bull strategies can provide a variety of benefits to a traditional portfolio of stocks and bonds.
Low to Negative Correlations with Most Major Asset Classes
While we previously highlighted the efficacy of dollar bull strategies when paired with international equity positions, the U.S. dollar has historically exhibited low to negative correlations with a variety of other asset classes.2 As we show in the table below, domestic bond, equity and commodity returns have exhibited a modestly negative correlation over the past 10 years. In asset allocation, investing in noncorrelated assets is a central tenet of diversification.
Asset Class Correlation vs. U.S. Dollar as of 11/30/14
For definitions of indexes in the chart, please visit our glossary.
Inherently, the value of diversification stems from two themes: Does the investment move counter to other assets in the portfolio (negative correlation), and if so, does it do so with enough magnitude to make a meaningful impact (i.e., volatility)? While the relationship between the dollar and domestic equities/bonds will cycle over time, it has generally been very low or negative over the last 10 years. While viewing individual portfolio components in isolation is informative, understanding how all pieces fit together in a portfolio is really what matters to investors.
Traditional 60% Equity/40% Bond Portfolio
Over the last 10 years, a period in which the U.S. dollar was roughly unchanged (the currency component added only 1.4% per year), the incorporation of dollar bull strategies into diversified portfolios provided significant risk reduction and return retention for the overall portfolios. Starting with a portfolio made up of 60% global equities and 40% U.S. bonds3, we analyzed the value of incrementally adding the dollar bull strategy into the portfolio. As shown in the chart below, a portfolio including a 10% allocation to a dollar bull currency strategy preserved more than 94% of the annual returns, while reducing portfolio risk by 15%. A 20% allocation would have resulted in 88% of annual return, while reducing risk by almost a third.4