By Ryan Gilmer, TOPS ETF Portfolios
International investing has gone through several developments as assets have grown over time. At one point, holding international investments was an odd thing. Today, any well diversified portfolio should have a significant allocation to international investments. Even though the use of international investments has been gradual over many years and the practice is now well accepted, many investors still struggle to understand important nuances of investing internationally.
Possibility the most misunderstand aspect of investing internationally is the impact currency changes can have on investment returns. Many investors are disenchanted with their international holdings as they have underperformed US stocks over the past five years. However, much of the performance over the past 5 years can be attributed to the strong U.S. Dollar.
Experienced global investors should recognize international equities and currencies will cyclical over time, and there is good reason to believe that they will come back into favor sometime soon. In fact, year to date, we have started to see this change. Returns for both developed and emerging markets indexes are largely ahead of U.S. stock indexes in 2017.
Trends will Change over Time
While is easy to focus on the most recent trend of U.S. outperformance, it is more helpful to look over a longer period, encompassing multiple market cycles. The following chart looks at relative returns from 1999.
Data provided by Bloomberg
The graph shows annualized stock market performance for emerging markets (FTSE Emerging Markets All Cap China Inclusion index), developed international stocks (FTSE All-World ex US index), and US stocks (S&P 500) from 1999-2016. The Vanguard FTSE Emerging Markets (VWO) tracks the emerging market index, while Vanguard FTSE All-World ex-US (VEU) tracks international stocks. The iShares Core S&P 500 (IVV) tracks domestic names.
Both emerging markets and developed international markets outperformed US equities for every calendar year from 2003 – 2007. Much of this was fueled by a significant period of dollar weakness. Conversely, US stocks outperformed for five of the last six years, a period of dollar strength. This outperformance has been well documented, tempting many to abandon international exposure.
We believe, at some point, international currencies will strengthen against the dollar leading to international equity outperformance. So far in 2017, this has been the case, yet it is too early for us to claim the cycle has shifted.
Currency Cycles over Time
An important factor in how international investments fare relative to US is the value of the dollar. The following graph shows the US dollar trade weighted index over a 30-year period, from 1987 to present day. The graph shows how the dollar has performed relative to basket of currencies including the Japanese yen, the euro, the British pound, the Canadian dollar, and the Mexican peso, among others.
Data provided by Bloomberg
Some observations from the graph include:
- The peak of dollar strength occurred in 2002, while the trough of dollar weakness occurred during the financial crisis of 2008
- The index traded in a range between 80-100 for 12 years between 1987-1999, but from 2002-present, the range has expanded to roughly 70-100
- The last time the dollar was this strong was May of 2003 (almost 14 years)
The following graph looks at the data another way. The blue line shows a ten-year rolling percentile ranking for dollar strength, with 100% being the strongest and 0% being the weakest. Said another way, it takes the dollar index and compares it to all the values over the prior ten-year period, and assigns a ranking of 0-100. The orange line does the same thing, but with a twenty-year period.
Data provided by Bloomberg
These tools help to show the cyclical nature of currencies. The periods between 1997-2002 and 2015-2017 show the dollar trading at ten year highs. During the period from 2004-2012, the dollar traded at ten year lows. While periods of dollar strength or weakness can persist for years, historically speaking, the dollar has neither strengthened nor weakened indefinitely. Eventually, the cycle changes, as we all learned in economics class. When it does, it can have big impacts on relative returns of US and international equities.
Conclusion
Investing is an increasingly global endeavor. According to Standard & Poor’s, in 2015, 44.3% of S&P 500 company revenues were generated outside the United States. Because so many US companies are multinational in nature, some investors argue holding a portfolio of exclusively US stocks is sufficient diversification because these companies do much of their business overseas. Along with the fact that investing in local companies helps to capture diversification through global economic cycles, this approach fails to recognize another key component of international stock returns – the change in value of the dollar.
Many businesses want to lock in or hedge currency movements so that they can focus on their core products and limit the effects of currency movements on their revenues and profits. Due to this reality, exposure to U.S. companies is not necessarily an adequate way to diversify currency exposure. We feel investors should maintain foreign currency denominated investments for diversification – especially maintaining this discipline following periods of dollar strength.
ETFs offer hedged and non-hedged currency choices. With TOPS, we utilize hedged positions such as BNDX for fixed income. However, we do not hedge currency risk for equities. While the full scope of the reasoning is beyond this article, currencies impact fixed income to a greater degree than equities, and we want the underlying fixed income fundamentals to drive returns, rather than the currency movements. Likewise, hedging currency in some markets can be cost prohibitive.
Predicting changes in trends is difficult. Even though patterns emerge over long time frames, currency movements are notoriously difficult to predict in the short run. Much of the dollar strength of the past 5-7 years has been due to stronger US economic growth and higher interest rates relative to Japan and Europe. It’s unclear exactly what may catalyze a change from dollar strength to dollar weakness, as periods of both can persist for years until they eventually change. Even so, the weight of the evidence suggests that maintaining international exposure is still an important part of a well-diversified portfolio. Likewise, the direction of the dollar will have a large impact on the relative performance between domestic and international equity performance.
This article was written by Ryan Gilmer, CFA, who is Vice President – Investment Management at TOPS ETF Portfolios, a participant in the ETF Strategist Channel.
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This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal.
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Source: Bloomberg for historic price and return references.
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