One of the most overlooked factors of successful investing is to follow the flow of money. A general rule of thumb is that you always want your investments denominated in currencies that are appreciating. If you don’t pay attention, investment gains can be negated by currency losses. With nearly every country in a race to devalue their currency against the rest of the world to make it cheaper for other nations to buy the goods they produce, it’s very important for investors to ask themselves questions like:
- What countries is capital flowing into?
- Why is it headed there?
- What could reverse this flow?
- What assets is it being invested in?
The US Dollar is typically considered a “safe” currency, meaning that money will flow into the US to buy Treasury Bonds during times of economic uncertainty. Since most people in the US invest the bulk of their portfolio in US assets, let’s take a look at the value of our dollar against other currencies.
Below is a chart of the US Dollar Index, which measures the dollar against a basket of 6 major currencies (the Euro, Japanese Yen, Pound Sterling, Canadian Dollar, Swedish Krona and Swiss Franc).
USD – Long Term Chart
After falling for 8 years, the US Dollar has been stabilizing since 2008. We have to break down the components to find out why.
Europe
The main reason it appears the US Dollar is stabilizing is because Europe is in far worse shape than the US and about 75% of the US Dollar Index is comprised of Euro-nation currencies. With terrible demographics, nations swimming in debt and major entitlement liabilities, the prospects do not look good for the Euro in the long-term.
Japanese Yen
After 16 years of appreciating against the US Dollar, the party may be over for Japan. New leadership is changing the policy in hopes of finally pulling Japan out of 20 years of deflation. They are flooding the market with stimulus to devalue the currency, creating an exodus out of Yen. While helpful (hopefully) to the economy and Japanese stocks, this makes Japanese bonds possibly the worst investment you can own.
Canadian Dollar
The Canadian Dollar has been strengthening against the US Dollar quite a bit due to its commodity oriented economy. Canada is a major producer of fertilizers, mining related materials and energy. The Australian Dollar is similar in nature to due its similar economy. These are most likely the best choices out of the other developed nations for diversifying against the US Dollar. (this chart shows the value of the US Dollar falling against the Canadian Dollar)
Emerging Nation Currencies
We have to look at Emerging Nation currencies, which are not represented in the US Dollar Index, to get a feel for where the money has been flowing. Many Emerging Nations post better demographics, higher rates of growth, higher interest rates and stronger fiscal positions. Long-term, this is what you want your investments denominated in as a hedge against a US-based portfolio. The caveat is that these currencies are highly correlated to economic growth, making them highly correlated to stocks. The WisdomTree Emerging Currency ETF, a basket of 15 EM currencies, has appreciated about 7% against the US Dollar over the past 6 months. This extra boost is also why EM bonds posted double digit returns in 2012.
While the outlook for the US Dollar is brighter than the Euro or Yen, it remains greatly beneficial for US investors to diversify by owning assets around the world in currencies that should appreciate against the US Dollar in the long run.
-Nick