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. Currently, the dollar is strong and is well above the average for the past 10 years. The dollar's strength reflects a robust U.S. economy, low Federal Reserve interest-rate increases, and new tax changes that have encouraged companies to bring back profits from abroad.
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. The 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 are the implications of these adjustments when investing in the United States in a falling dollar environment? If you invest in a company that does the majority of its business in the United States and is domiciled in the United States, 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 United States 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 began outsourcing much of their manufacturing and even some service jobs to low-cost provider countries to exploit 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 2.744% of gross domestic product (GDP) in 2009.
However, 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 United States or by a country that links its currency to the United States, in a falling U.S. dollar environment, costs decline.
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 --> the gold and commodity indexes bottom --> bonds peak --> the dollar rises --> interest rates peak --> stocks bottom --> the cycle repeats.
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 over 20%, the commodity index was up around 10%, the metals index was up almost 15%, the dollar depreciated around 5%, and global food prices increased sharply. 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.
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 United States (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 United States, particularly 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 United States, 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.
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.