Currency Headwinds Taking Center Stage

This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

As a CIO, one of the things I do is review research reports from big firms with names we all know, like Merrill Lynch and Goldman Sachs, as well as research from some smaller firms that we think have useful insight into markets and market-moving events. Over the past couple of days, I couldn’t help but notice how many times I saw the words “currency headwinds” when the discussion came to the current earnings season.

I even brought our PR team in to assess the situation. They reported that during the first 26 days of January 2014, “currency headwinds” appeared 112 times in major financial and business media, according to media database company Factiva, versus 513 citations during the first 26 days of 2015. This is a clear sign to me that corporations and analysts are concerned about currencies.

Connecting the dots from here is rather easy. A surging U.S. economy causes the dollar to rise against foreign currencies → Weakening trends in Asia and Europe causes the Euro and Chinese renminbi to fall against the dollar → The rising price of goods from U.S. multinationals via their rising currencies causes revenues to fall → Declining earnings of U.S. multinationals like McDonald’s or Boeing or Cisco.

Note the influence of currencies on corporate revenues can add up to a double whammy. That is, sales made on the European continent in Euros are negatively impacted when converted into dollars. Further, prices European buyers pay for U.S. goods are higher, making them less competitive and subject to declines from “cheaper” suppliers domiciled on the continent.

Given the evidence of momentum in the U.S. economy and the reports coming out of Europe, and, to a lesser degree, China, currencies represent an issue investors need to keep an eye on. The chart below, which I got from Standard & Poor’s, shows the percentage of revenues of large cap S&P 500 companies generated outside the U.S. in 2013 (the 2014 figures are waiting for all the 10Ks to be filed). As you can see, about half of the revenues are exposed to currency risk.

Consumer Discretionary40.96%
Consumer Staples39.79%
Energy  54.64%
Information Technology    56.60%
Financial ServicesN/M
Weighted Average Non US Sales
Among S&P Large Cap Stocks
Source: Standard & Poor’s

Of course, it’s not like investors and chief financial officers take this lying down. They hedge using currency derivatives and their knowledge of the marketplace. And mutual fund managers can hedge too. So, if you try your own kind of hedge, you could undo what CFOs and portfolio managers are already trying to do for you. But this doesn’t mean you can’t take some steps to protect yourself.

First, you could consider using mutual funds where the active management can offer some hedge protection. I would never recommend a wholesale conversion, but some areas of your portfolio might merit a closer look.

Second, if you are an ardent disciple of asset allocation, now might be a good time to consider your share of small cap exposure. According to S&P, small cap stocks have just 15% of their revenues outside of the U.S., versus just over 46% for large cap stocks. But there’s more: Smaller companies that can source overseas, then assemble and sell here are, unlike their large cap brethren, better positioned to capitalize on the current trend in the dollar.

Third, consider the opposite effect of the dollar appreciation on companies in the Eurozone. Their products are getting cheaper for Americans to buy; we expect prices of everything from imported salami to BMWs to decline over the next 6 to 12 months. That means European countries will sell more, which could help the struggling top line of European business. Think about using international diversification as a way to capture the benefits.

Currency often fluctuates, but over the long term, it’s hard to make money by betting on currencies. Currencies self-correct, so if the Euro gets too low against the dollar, the U.S. would buy more goods denominated in Euro, pushing down the dollar and pushing back up the Euro. This cycle will have implications for your portfolio, which is why it’s important to be thinking about the impact currencies can have on the assets you hold.

Click here to see the article on Forbes.

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