The factors that influence the value of national currencies are notoriously complicated; one of my professors liked to say that only two people in the world understand currencies, and they disagree. But recent events have brought the normally obscure world of currencies to the forefront of the financial news.
The Russian ruble has fallen over 50% in value due to falling oil prices and the ongoing impact of international sanctions; indeed, Russia’s credit rating was recently cut to “junk bond” status by one rating agency, which will raise Russia’s borrowing costs even more. After avoiding much of the fallout of the great recession, the Canadian dollar has fallen over 20% against the US dollar, again due largely to falling oil prices. The euro has been battered by several forces, including snail’s pace economic growth, the threat of deflation and the recent election of a leftist government in Greece, which may demand forgiveness of its debts to the European Union (EU) and could potentially lead to Greece leaving the EU. Amid all the turmoil, the US dollar has increased 20% in four years against an index of six major currencies and increased over 13% in the last seven months alone.
The most abrupt shock came on January 15th when the Swiss central bank announced it would no longer maintain its program to keep the Swiss franc at a consistent level with the euro. This program required the Swiss to either buy euros or sell Swiss francs, but since the Swiss economy has been seen as stable and the franc has been in demand, the Swiss had to buy an increasing amount of euros. They ultimately decided the cost of keeping the currency artificially low was greater than the economic impact of the franc increasing in value. The markets were taken completely by surprise, the Swiss franc rose 20% overnight against the euro, currency traders suffered big losses and Europeans who had taken out loans priced in Swiss francs scrambled to make higher payments.
But just what does it mean if a currency is “strong” or “weak”? If currency A is strong against currency B, a unit of currency A will buy more units of currency B; conversely, it will take more units of currency B to buy a unit of currency A. Travelers from country A will enjoy an advantage in country B because their home currency will buy more. Likewise, it will be cheaper for country A to buy goods from country B, and it will cost more for country B to buy goods from country A. Over time, currency strength or weakness can have significant impact on the balance of trade, and in particular could be a new challenge to the recent strength in US exports. It would cost 14% more yen for a Japanese company to buy a US export today than six months ago, even if the price in dollars was unchanged, but an import from Japan would cost 14% less in US dollars.
As with many financial relationships, it is the degree and rapid pace of recent currency shifts that are harder to digest than simply the level of one currency to another. For example, even though the euro is at an 11-year low against the dollar, it traded even lower for the first several years of its existence. The Canadian dollar was at its current level against the US dollar as recently as 2009 before the Canadian dollar strengthened and spent several years at “par”, or equal value, with the US dollar. (This was a bit of a blow to the American pride of residents of border states who were used to the advantage over the Canadian dollar in daily life.)
Aside from travel, currency fluctuations can have real consequences for investors. US companies that generate large profits overseas have seen the value of those profits shrink in US dollar terms. To the extent that many of their costs are based in dollars, those profits shrink even more. As part of cost cutting to offset the currency impact, US companies cut capital spending at the end of 2014 and orders for “durable goods” which last for more than three years fell 3.4% in December. Procter & Gamble was hit by both sides of the currency dilemma, with big business in Russia (the plummeting ruble makes those profits worth less in US dollars) and a large headquarters and employment in Switzerland (the soaring Swiss franc means its costs in Switzerland grew much faster than its business there ever could). P&G’s sales in the fourth quarter were down 4%, its profits were down 31%, and it said currencies could reduce profits by $1.4 billion in 2015. Overall, analysts now expect the S&P 500 to show fourth quarter sales growth of 0.5% and per-share profit gains of 3.3%; at the start of 2015, the expectations were for sales growth of 1.3% and earnings growth of 4.2%.
Currency fluctuations affect investors in mutual funds holding international stocks or bonds as well. (Some foreign debt is issued in US dollars and is not affected by the issuer’s currency.) Investment returns are generated in the local currency and then translated to US dollars for US mutual funds. Positive returns in local currency could be offset if that currency were weak against the US dollar, and poor returns in local currency could be bolstered if that currency were strong against the US dollar.
Recent fund returns reflect this additional risk. In 2013, an index of European stocks was up 24.1% and in 2014 was down 7.3%. A similar index of European stocks which was “hedged” by using currency futures to eliminate currency fluctuations was up 20.5% in 2013 and up 4.7% in 2014. An index of the euro was up 3.8% in 2013 (contributing to the return of the unhedged stock index compared to the return of the hedged index in local currency) and was down 12.4% in 2014 (more than wiping out the small positive return of the hedged stock index in local currency and resulting in a loss for the unhedged fund). The more focused the international investment, such as individual country funds, the greater the currency risk.
The worst approach for individual investors is to fall prey to pitches that encourage trading in foreign currency futures. Futures trading usually involves a lot of “leverage” (borrowed money) to magnify the normally minor moves in currencies. When currencies make big moves, futures accounts can suffer huge losses very quickly. According to the Wall Street Journal, brokerage firms report that two-thirds of individual currency futures traders lose money and the average retail account lasts only four months before either the trader throws in the towel or the firm shuts down the account.
Currency fluctuations do add another element of risk to international investments, but like other risks it is somewhat mitigated by diversification and a long-term approach. While the headlines are intriguing and the factors underlying currency moves can supplement an investor’s education, they are not a reason to make reactionary changes.