The return of King Dollar

Friday, October 3, 2014, Vol. 38, No. 40

The market’s game ball in the third quarter goes to the U.S. dollar.

The U.S. dollar rose 7 percent, boosted by the comparative hawkishness of the U.S. Fed. The currency has now advanced for 11 consecutive weeks, its longest winning streak in nearly 20 years (although the uptrend actually started in mid-2011).

What should you know about the return of King Dollar?

A dollar move of this magnitude punishes commodities and commodity-linked currencies. Compounding the pain for commodity investors, the Chinese continue to resist calls to stimulate the “old” investment and export economy in order to reach annual growth targets.

Over the quarter, corn has fallen 26 percent, wheat 19 percent, silver 17 percent, oil 13 percent and gold 7 percent. Commodity-linked currencies like the Australian and New Zealand dollars have fallen 6.5 percent and 9.5 percent, respectively.

Reactions in the commodities and currencies markets are direct. Reactions in the equities market are indirect.

For U.S. investors investing in U.S. markets, a stronger dollar reinforces prices, as foreign investors shift into dollar-denominated securities.

For U.S. investors investing abroad, a stronger dollar reduces the value of foreign-denominated returns.

To demonstrate, the MSCI Ex-USA stock market index fell 5 percent for the quarter in U.S. dollar terms, while gaining 1 percent when denominated in the various local currencies.

Rarely do currency returns overwhelm equity returns, but that’s exactly what has happened this quarter. Currency weakness in Brazil, New Zealand, Japan and Australia robbed unhedged U.S. investors of positive returns.

Fortunately, those invested in emerging Asian countries like China suffered no ill effects as many of these countries peg their currency value to the U.S. dollar, effectively doing the hedging themselves. Regionally, the strong dollar cost deducted over 3 percent from emerging market stock returns and 6 percent for European and Asia Pacific returns according to MSCI.

Clearly, the bulk of the currency erosion occurred in Europe and Japan. Central banks in both locations have committed to increase monetary stimulus, while the U.S. central bank withdraws monetary stimulus. This has created a “central bank arbitrage” trade as investors sell euros and yen while purchasing dollars.

For bond investors, the deduction in unhedged foreign bond returns matters all the more. With low yields worldwide, currency movements hold greater influence. The resultant rush to dollar-denominated Treasuries has pushed yields down towards their lowest levels on the year.

Bottom Line: The 7 percent rise of the U.S. dollar in the third quarter dictated investment results. Holders of weak dollar investments like gold, commodities and hard currencies took a beating, and may want to reconsider their positioning.

Performance for equity investors depended upon denomination. Greater earnings and price volatility should be expected as the consequences of a firmer dollar, pitted against valuation differentials, ricochets throughout global markets.

Fortunately, the stronger dollar will reduce inflationary pressures and therefore the timing and/or degree of Fed policy response. Should international stimulus catch, higher economic growth paired with less Fed fear could fuel more market upside. Good King!

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.