As you explore articles about investing, you notice how often the United States (US) dollar gets mentioned. It quickly becomes apparent that the US dollar plays a key part in the movements of many world markets.
As investors, it’s important to understand the reasons why.
The US dollar is the main currency of the world’s largest economy1 – the United States – as well as the official currency for a number of other countries. It is also the standard unit of currency in international markets for many commodities, including gold and oil.
In addition, it is the most popular currency used for trade between countries around the world. As a result, many economies, including Australia, are tied to the US dollar through their trade activity. With currency movements impacting the value of goods and services being traded between those countries, this leads to a flow-on effect with their economies and associated investment markets, such as equities.
We are all exposed to the US dollar in our day-to-day lives, even though we might not realise it. Chiefly because many of the things we need are either priced in US dollars or have been impacted by the US dollar.
Some examples are obvious, such as raw materials and energy. Think about oil price reports in the news or the price we pay for petrol. Some are less obvious, such as what we pay for technology and software, where the price for an iPhone or Microsoft software might be set in US dollars and converted.
Our exposure to the US dollar might also change as we get older. This is because drugs and medical technologies tend to have a global pricing component – inevitably in US dollars – and we usually spend more on healthcare as we age.
For investors, having US dollar-denominated assets in our portfolios can add important diversification to a portfolio. It can also help us to maintain our purchasing power into the future – if our US dollar exposed investments increase in value at the same rate our US dollar exposed expenses are increasing.
How is the US dollar linked to recent market volatility?
By better understanding how the US dollar impacts the global investment environment, we can more critically examine the factors driving market activity and investor sentiment.
The end of 2018 saw equity markets being quite volatile and there were a number of reasons for this, including movements in the US dollar.
Volatility was driven largely by the divergence in growth between the US (growing strongly) and the rest of the world (slowing, particularly across Europe and China). Strong US growth prospects and low unemployment were giving the US Federal Reserve good reason to continue raising US interest rates and to reduce quantitative easing. Other world central banks had less to cheer about, however, and most were holding interest rates stable.
The strength in the US economy supported the US dollar in strengthening against other currencies. We saw some emerging economies with high levels of US dollar-denominated debt were particularly impacted as the cost of servicing these debts increased.
During this time we also saw a complex geopolitical environment and many equity market prices were already quite high, relative to the earnings of those companies. Given the environment, it wasn’t surprising investors were skittish and quick to see the negatives in world equity markets.
It’s important to consider what level of US dollar exposure is appropriate for your situation
A well-diversified portfolio remains an important approach to investing for retirement, and US dollar exposure is one element that can add to diversification. What level is right for each of us will vary from person-to-person. A 50 per cent weighting to US dollar assets in your investment portfolio might initially seem large. However, when we consider our overall asset allocation – adding in our ‘outside super’ assets – it might not be as much. We should also consider the impact the US dollar has on our current expenses as well as what that impact might be in the future.
For example, if we have no US dollar-denominated assets our purchasing power may decrease in the future if the cost of goods impacted by the US dollar increase. So, the US dollar exposure in your portfolios can be seen to counterbalance this.
By liaising with your adviser, you’ll have specialist help to ascertain an effective weighting of all assets, including US dollar exposure in your portfolio.
1. Measured by nominal Gross Domestic Product against all other countries and correct as at January 2019. See www.focus-economics.com/blog/the-largest-economies-in-the-world