Between 2003 and 2008, the value of the U.S. dollar fell compared to most major currencies. The depreciation accelerated during 2007 and 2008, impacting both domestic and international investments.
TUTORIAL: Economic Basics
The impact of the rise or fall of the U.S. dollar on investments is multi-faceted. Most notably, investors need to understand the effect that exchange rates can have on financial statements, how this relates to where goods are sold and produced, and the impact of raw material inflation.
The Home Country
In the U.S., the Financial Accounting Standards Board (FASB) is the governing body that mandates how companies account for business operations on financial statements. FASB has determined that the primary currency in which each entity conducts its business is referred to as "functional currency." However, the functional currency may differ from the reporting currency. In these cases, translation adjustments may result in gains or losses, which are generally included when calculating net income for that period.
What does all this technical-speak mean when investing in the U.S. in a falling dollar environment? If you invest in a company that does the majority of its business in the U.S. and is domiciled in the U.S., the functional and reporting currency will be the U.S. dollar. If the company has a subsidiary in Europe, its functional currency will be the euro. So, when the company translates the subsidiary's results to the reporting currency (the U.S. dollar), the dollar/euro exchange rate must be used. For example, in a falling dollar environment, one euro buys $1.54 compared to a prior rate of $1.35. Therefore, as you translate the subsidiary's results into the falling U.S. dollar environment, the company benefits from this translation gain with higher net income.
Why Geography Matters
Understanding the accounting treatment for foreign subsidiaries is the first step to determining how to take advantage of currency movements. The next step is capturing the arbitrage between where goods are sold and where goods are made. As the U.S. has moved toward becoming a service economy and away from a manufacturing economy, low-cost provider countries have captured those manufacturing dollars. U.S. companies took this to heart and started outsourcing much of their manufacturing and even some service jobs to low-cost provider countries to exploit those cheaper costs and improve margins. During times of U.S. dollar strength, low-cost provider countries produce goods cheaply; companies sell these goods at higher prices to consumers abroad to make a sufficient margin.
This works well when the U.S. dollar is strong; however, as the U.S. dollar falls, keeping costs in U.S. dollars and receiving revenues in stronger currencies - in other words, becoming an exporter - is more beneficial to a U.S. company. Between 2005 and 2008, U.S. companies took advantage of the depreciating U.S. dollar as U.S. exports showed strong growth that occurred as a result of the shrinking of the U.S. current account deficit to an eight-year low of 2.4% of gross domestic product (GDP) (excluding oil) during 2008. (For background reading, see Current Account Deficits.)
However, just to complicate matters slightly, many of the low-cost provider countries produce goods that are unaffected by U.S. dollar movements because these countries "peg" their currencies to the dollar. In other words, they let their currencies fluctuate in tandem with the fluctuations of the U.S. dollar, preserving the relationship between the two. Regardless of whether goods are produced in the U.S. or by a country that links its currency to the U.S., in a falling U.S. dollar environment, costs decline. (For more insight, read Floating And Fixed Exchange Rates.)
Up, Up and Away …
The price of commodities related to the value of the dollar and interest rates tends to follow the following cycle:
Interest Rates are Cut Gold and Commodity Index Bottom Bonds Peak Dollar Rises Interest Rates Peak Stocks Bottom Cycle Begins Again
At times, however, this cycle does not persist and commodity prices do not bottom as interest rates fall and the U.S. dollar depreciates. Such a divergence from this cycle occurred during 2007 and 2008, as the direct relationship between economic weakness and weak commodity prices reversed. During the first five months of 2008, the price of crude oil was up 20%, the commodity index was up 18%, the metals index was up 24% and the food price index was up 18%, while the dollar depreciated 6%. According to Wall Street research by Jens Nordvig and Jeffrey Currie of Goldman Sachs, the correlation between the euro/dollar exchange rate, which was 1% from 1999 to 2004, rose to a striking 52% during the first half of 2008. While people disagree about the reasons for this divergence, there is little doubt that taking advantage of the relationship provides investment opportunities. (For related reading, see Forex: Venturing Into Non-Dollar Currencies.)
Profiting from the Falling Dollar
Taking advantage of currency moves in the short-term can be as simple as investing in the currency you believe will show the greatest strength against the U.S. dollar during your investment timeframe. You can invest directly in the currency, currency baskets or in exchange-traded funds (ETFs).
For a longer-term strategy, investing in the stock market indexes of countries you believe will have appreciating currencies or investing in sovereign wealth funds, which are vehicles through which governments trade currencies, can provide exposure to strengthening currencies.
You can also profit from a falling dollar by investing in foreign companies or U.S. companies that derive the majority of their revenues from outside the U.S. (and of even greater benefit, those with costs in U.S. dollars or that are U.S.-dollar linked).
As a non-U.S. investor, buying assets in the U.S., especially tangible assets, such as real estate, is extremely inexpensive during periods of falling dollar values. Because foreign currencies can buy more assets than the comparable U.S. dollar can buy in the U.S., foreigners have a purchasing power advantage.
Finally, investors can profit from a falling U.S. dollar through the purchase of commodities or companies that support or participate in commodity exploration, production or transportation. (For more on this strategy, read Commodity Prices And Currency Movements.)
The Bottom Line
Predicting the length of U.S. dollar depreciation is difficult because many factors collaborate to influence the value of the currency. Despite this, having insight into the influence that changes in currency values have on investments provides opportunities to benefit both in the short and long-term. Investing in U.S. exporters, tangible assets (foreigners who buy U.S. real estate or commodities) and appreciating currencies or stock markets provide the basis for profiting from the falling U.S. dollar.