The US dollar has continued its recent weakness after the US Federal Reserve signalled that it might pause the tightening cycle that was initiated in April 2020. Short positions on the dollar have increased significantly over the past month, while markets have been pricing in the prospect of further rate rises by other central banks.
Indeed, the European Central Bank (ECB) increased its benchmark interest rate by 25 basis points, matching what could be the US Federal Reserve’s last rate hike in the current cycle. A week later, the Bank of England did the same. Yet it’s difficult to predict whether Christine Lagarde and her colleagues will continue down this road even though cost-push inflation persists across the continent. That's because recent research from the ECB suggests that banks have reduced credit access, a possible signal that rising interest rates are already dampening economic activity.
Regardless of whether the ECB and other central banks continue to tighten monetary policy, sentiment towards the US dollar may be souring due to signs that the domestic economy could be faltering. Even news that US employers added 253,000 jobs in April must be viewed in context. Labour market growth had certainly been slowing over the previous few months, and although the April figure appears to have bucked that trend, figures for the preceding two months were subject to significant downward revisions. Somewhat uncharacteristically, Warren Buffett, normally a zealous tub-thumper for USA Inc, has warned that the “incredible period” for the US economy is grinding to a halt and he has trimmed Berkshire Hathaway’s exposure accordingly.
Should events across the Atlantic preoccupy UK investors? Given the composition of the FTSE 100 and the number of constituents that report in US dollars, the trajectory of the greenback has a bearing on the performance of many investors’ portfolios. Around three-quarters of the benchmark index’s aggregate revenues are generated from overseas markets, so a strong US currency is beneficial for companies with dollar-denominated earnings that are converted back into sterling.
The Link Group’s UK dividend monitor for Q4 2022 indicates that the relative decline of the pound added £3.8bn to the value of UK payouts last year. And there are other effects. The pound’s relative showing against the dollar – a 24 per cent devaluation between June 2021 and September 2022 – not only resulted in an increase in the sterling value of dollar-denominated investments, but also made UK assets more attractive to potential buyers from abroad.
If we presuppose that the US dollar is setting off on a rocky path, are there any hedging strategies that can offset the impact of devaluation and, if so, are they even worth pursuing? The answer to the second part of that question will differ from investor to investor depending on the composition of their investment portfolios and whether they employ an active trading strategy.
In terms of equities, you could simply pursue the mirror image of the currency effect that partly underpinned the FTSE 100’s outperformance through 2022. That amounts to investing in US companies that derive the lion’s share of their revenues from outside home soil, particularly those whose costs are expensed in US dollars.
There are numerous candidates within the Dow Jones Industrial index on that basis, including the likes of Apple (US:APPL) and Microsoft (US:MSFT), along with iconic consumer brands synonymous with the US such as McDonald’s (US:MCD) and Coca-Cola (US:KO). Other companies such as Intel (US:INTC) generate up to 75 per cent of sales abroad, which is doubly advantageous when the direction of the dollar provides a pricing advantage over foreign competitors in the fiercely competitive semiconductor market. The likes of Caterpillar (US:CAT) and Dow (US:DOW) are also worth examining given their sizeable international earnings.
Unfortunately, whenever you use sterling to acquire shares from abroad, your money is initially converted into the currency of the asset you are buying, effectively leaving you with forex exposure. Theoretically, it would be prudent to buy when sterling has appreciated strongly against the dollar, but the irony is that the greenback has an inverse correlation with the main US stock market, so you might be paying a higher price for your asset. Therefore, you will need to gauge the impact of the dollar rate on earnings set against potential transaction effects. It could be argued that stock trading based on short-term forex activity is best left to hedge funds. Currency moves will affect returns, so that should be baked into investor considerations in terms of the size of risk premium they're targeting, but it probably isn’t advisable to alterh allocations based solely on these fluctuations.
