This sets up a scenario in which the Fed is becoming less supportive even as the ECB is becoming more forceful, which in turn would be positive for the dollar against the euro. This shift was reflected in the initial reaction to the rate cut in the CurrencyShares Euro ETF (FXE), which fell from $136.58 to $132.12 in the ten sessions from Oct. 25 through Nov. 8.
If the euro were indeed to experience more sustained weakness on the dollar, the market impact could be more substantial than what has been brought about by the dollar-yen move of the past six months. Europe is a more important trading partner for the United States, and it represents a much larger portion of the U.S. Dollar Index than the yen: 57.6% versus 13.6%.
The Implications of Dollar Strength
If the stronger-dollar scenario indeed unfolds, what could investors expect?
The first outcome would likely be a more challenging environment for the market. Multinational companies that earn a large portion of their revenues overseas could be impacted negatively by a stronger dollar, among them 3M (MMM), Phillip Morris International (PM), Avon Products (AVP), International Business Machines (IBM), Texas Instruments (TXN), and Oracle (ORCL).
On a sector basis, a rising dollar would likely have a disproportionately negative impact on materials and technology stocks, which have exhibited the highest negative correlation to the greenback. Gold stocks, in particular, would face further challenges if the dollar were to pick up steam. Energy stocks could also be vulnerable given crude oil’s sensitivity to currency movements.
On the other side of the equation, health care and financial stocks have shown the lowest negative correlation with the dollar, indicating that these groups could outperform in a strong-dollar scenario.
Third, and perhaps most important, investors in unhedged international funds would likely experience underperformance barring substantial gains in the underlying markets. One solution to that problem would be currency-hedged ETFs. Year-to-date in 2013, the weak yen has led to substantial outperformance for the WisdomTree Japan Hedged Equity Fund (DXJ), up 35.5%, relative to the iShares MSCI Japan ETF (EWJ), which is ahead 24.3%.
In the coming year, funds such as WisdomTree Europe Hedged Equity Fund (HEDJ) or the db X-trackers MSCI EAFE Hedged Equity Fund (DBEF) — both of which have lagged their unhedged counterparts in 2013 — could see a similar benefit.
The Bottom Line
The currency markets are notoriously fickle, and making investment decisions solely on the basis of expected performance for the U.S. dollar is unwise. However, given the possibly divergent paths of the Fed and ECB, investors need to be on alert for the implications of currency movements in the year ahead.
Keep a close eye on the dollar-euro relationship as we move into 2014.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.