The U.S. dollar has limped through most of 2017, but suddenly the greenback is surging. That could mean a day of reckoning is at hand for investors who piled into what's been among the hottest market trades of the year: international stocks.
The greenback has climbed by about 1 percent against the euro and near-3 percent against the Canadian dollar over the last month. Its surge on Thursday is a big change from the dollar drop of between 6 percent and 10 percent against a number of global currencies in 2017, including 10 percent against the euro.
For investors who own international stocks — which are handily beating the this year — the falling dollar has been a windfall. Confidence had eroded so much that the dollar fell to its lowest levels in nearly three years before the recent reversal.
Now investors holding big gains in international stocks face a potential day of reckoning if the recent dollar surge isn't just a blip in a longer term declining pattern.
Usually, when people buy foreign stocks, their dollars get transferred into that country's local currency. When those dollars appreciate in value, the investment gets a boost when converted back into U.S. funds. When a euro-denominated index rises by 10 percent and the euro climbs by 10 percent against the greenback, the U.S. investor will have made 20 percent. Using actual index returns, year-to-date, the MSCI All-World Index has risen by 5.7 percent in euros, but 18 percent in U.S. dollars, while the FTSE 100 has climbed by 5 percent in euros and 8.9 percent in USD.
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Dean Popplewell, vice president of currency analysis and research at OANDA, a currency data and trading firm, said he thinks the dollar is nearing a bottom, but that Trump is still a wild card, and uncertainty around the Federal Reserve's future and the U.S. tax overhaul could keep the dollar lower for a little longer. But he is optimistic on the greenback's future. If the United States can clean up its act, geopolitical events stay stable, and if 10-year Treasury yields rise above 2.5 percent — it's around 2.4 percent now — then the dollar could see a more sustained increase. "We're starting to see smart money willing to buy the U.S. dollar, but now we need to get more clarity on the Fed and other issues," Popplewell said.
That contrasts with the factors that previously had led to the dollar slump in 2017: "People were expecting Trump to follow through on his campaign promises of fiscal stimulus and tax cuts, which would have given the dollar a massive boost," Popplewell said. Prospects for tax reform are higher than they had been for much of the year.
Ken Orchard, co-manager of T. Rowe Price's International Bond Strategy fund, doesn't think the resurgence of the dollar will last. Disappointing U.S. inflation figures, positive election outcomes in France and Germany, Bank of Canada rate hikes and strong GDP growth in other parts of the world pushed the dollar back up but aren't built to last in building a longer-term dollar trend.
Inflation looks like it may pick up, the Federal Reserve could hike rates again in December, while the European Central Bank is sounding more dovish. Orchard said he expects the greenback to rise over the next three to six months. "Our view is that this has become overextended. The dollar has bottomed for now," he said.
That dollar weakness is good for U.S. stocks, too. Market-beating hedge fund manager Daniel Loeb of Third Point wrote in a letter to investors last Friday that he is very bullish on the U.S., and it's still his largest stock market weighting, because economic growth is improving due to the weak U.S. dollar, among other factors. But he has also increased exposure to Europe this year and cited "synchronized global growth" as the reason for his overall bullish stock views.
Investors have started moving more money to international stock markets as a result of the U.S. stock market being the priciest globally. Orchard thinks that's a safe bet, as far as the dollar effect. Over the next two to three years, the dollar trend will continue to be a tailwind for that migration of market money. The dollar will likely continue to fall, largely due to economic cycles in other countries. The U.S. economy is moving into a later stage, while Europe and other nations are moving more into the middle cycle. "At some point the Fed will stop hiking rates, while other central banks will start hiking them," he said. "That should drive a decline in the dollar."
From mid-2011 to late 2016, the U.S. dollar strengthened close to 30 percent against developed and emerging currencies, but Orchard is not alone in thinking that the recent reversal will be a blip and the dollar will continue to be weak, boosting the attractiveness of international stocks.
Some investors may want to take on currency risk, especially if they think it will work in their favor. So far this year, investors would have made more money buying unhedged versions of international stock funds, but that would change if the dollar appreciates.
Hedging, which uses options and other derivatives to eliminate currency risk, is difficult and potentially costly for an individual to do, but a number of mutual and exchange-traded funds come with hedged and unhedged options.
For investors who don't want their portfolios to hinge on the whims of currency investors, hedged products are the way to go, says Katrina Dudley, co-manager of Franklin Templeton's Franklin Mutual European Fund. Her fund is hedged, which means investors only gain or lose money on the value of the assets she holds. If her fund rises by 10 percent in euros, American investors will see a 10 percent gain. "You get that gain regardless of what happens to currency," she said. "With hedging, you're neutralizing that impact, so you can deliver those gains to shareholder in U.S. dollars."
While there is a cost to hedge — think of it as insurance against rising and falling currencies — it's minimal when using liquid currencies, like the USD and the euro. For her, though, it makes sense to have that protection. American investors are buying stocks in U.S. dollars, they're spending in U.S. dollars, and they're retiring with U.S. dollars, so why have their savings subject to currency movements in other markets?
Orchard is seeing a growing demand for hedged products — his fund comes in both a hedged and unhedged option — but he does point out that those with long time horizons of about 20 to 30 years likely don't need to hedge. Over time, currency movements tend to work themselves out. But those who need money sooner or don't want to take on short-term volatility should consider hedged securities.
Whether one should hedge or not is, ultimately, a personal choice, though Dudley thinks most foreign stock–owning Americans shouldn't take the risk. "I believe if you're a U.S. dollar investor, then you should be going for the hedged option," she said.
— By Bryan Borzykowski, special to CNBC.com