Currency Movements and Your Portfolio
The Opportunities — and Pitfalls — of a Fluctuating Dollar
As of this writing, the U.S. dollar is coming off sharp gains relative to its currency counterparts around the world. Such a situation — or its reverse, a falling dollar — is likely to have profound effects on the global economy and financial markets, not to mention on individual businesses, consumers and investors.
In other words, shifts in the value of any currency create financial winners and losers. Understanding why can give you insight into your portfolio’s past performance, as well as ideas about how you might position it appropriately for the future.
Foreign Exporters Benefit
When the dollar is strong, it is a boon for foreign companies that sell products to Americans. Why? Because the profits they receive in dollars are worth more after those dollars are converted back to their local currency.
Simultaneously, when the dollar is gaining in value compared to, say, the Euro or Japanese yen, foreign travel or imported goods become more appealing to anyone with dollars to spend. In other words, Americans suddenly find themselves with increased buying power overseas.
In this environment, a Japanese automaker will be at a relative advantage in the U.S. market compared with an American competitor, as the company abroad can either price its cars lower and increase sales, or boost earnings by keeping prices steady. Foreign tourism companies also benefit, as more Americans find travel abroad affordable.
Local Exporters Do Not
Some businesses, of course, will be less enthusiastic about a stronger dollar. For example, it hits U.S.-based exporters especially hard, given that these companies receive foreign profits in the now less-valuable local currency.
Also, consumers abroad who want to buy U.S. products encounter higher costs. That means lost sales for the producers or, if they choose to hold down prices, lower profits. Thus, American automakers become less competitive abroad, as do U.S. travel and leisure companies, such as hotels or tour operators, if their businesses depend on a steady stream of foreign tourists.
Effects on Commodities
A rising U.S. dollar tends to push down the cost of oil and other commodities priced in dollars. Lower oil prices are a boon not only for consumers but also many businesses (outside the energy sector, of course, where some companies directly benefit from high oil prices).
When oil is cheaper, the price of gasoline tends to follow. Whatever money consumers save at the pump is money they can spend elsewhere. In fact, according to AAA, lower gas prices provided the equivalent of a $14 billion tax cut to consumers in 2014.
Thus, a dollar that maintains its strength and oil prices that remain relatively low — neither of which can be assured — could provide a relatively favorable backdrop for U.S.-focused consumer-oriented companies, given the increased disposable income available.
Impact on Stocks
A company’s share price tends to follow its earnings over time. Accordingly, you would expect stocks of companies helped by a strong dollar to encounter a tailwind, while the shares of firms penalized by a robust currency face an added headwind.
Certain sectors are more likely to be exposed to foreign currencies. According to Zacks Investment Research, for example, information technology and energy companies, on average, derive more than half of their revenues from overseas, thus making them more vulnerable than many other industries to the effects of a strong dollar.
Utilities and telecommunications companies represent the other extreme, remaining mostly domestically focused. Also, small-cap stocks tend to be less exposed to foreign markets (even though many smaller companies reside in the technology sector).
Multiple Factors to Consider
Bear in mind that these rules of thumb come with many exceptions. What’s more, the dollar is always fluctuating in value. Nobody knows if the strengthening trends will continue, although current market sentiment appears to reflect a consensus in favor of a strong dollar for some time.
In the end, lots of factors drive stock prices, and the effects of currency movements represent just one. Moreover, markets are forward-looking, meaning that your portfolio needs to reflect not what’s happened already, but what’s next for the markets. Your financial advisor can help you tailor your investment portfolio to economic and market conditions.
Sidebar: What Drives Currency Movements?
When the dollar is strengthening against, say, the Euro, it means that each dollar you own can be exchanged for more Euros than before. It also means that foreign money in your drawer from your last trip to Italy will be less valuable than before.
In fact, every currency in the world sees its value constantly fluctuating, influenced by various factors. These include expectations for economic growth, central bank monetary policy, inflation projections and geopolitical worries.
The dollar’s significant strengthening that began in 2014 was the culmination of many factors. But, at its core, it stemmed from a U.S. economy in much better shape than its counterparts around the world.
Making the Most of Dividend Income
ADAM LEVINE, CPA, CFP®
Dividends, the portion of earnings that a company or fund distributes to shareholders, may seem like a relatively small component of your overall portfolio. However, dividends can play an important role in your financial success over time.
You have probably heard that it is a good idea to reinvest your dividends, and it is true that reinvestment can help your portfolio grow more quickly. However, for some investors, such as those who are retired, regular dividend distributions can provide a potentially useful source of income. The course of action that makes the most sense for you will depend on your individual needs.
Reinvesting vs. Withdrawing Cash
With dividends you have two basic options:
Reinvest for long-term growth. If you are primarily concerned with growing your portfolio over many years, reinvesting dividends might be an appropriate strategy. Because of the power of compounding, reinvested dividends have the potential to boost your return over time, assuming your investments gain in value. Automatically reinvesting has an added benefit of forcing you to stay disciplined about saving.
Withdraw as cash. If you are primarily concerned with paying monthly expenses and other cash flow needs, taking dividends in cash may be the right decision. Retirement is a particularly good time to weigh the benefits of taking your dividends in cash.
Drawing your income directly from investments can provide you with a supplemental source of cash flow if your other income sources are insufficient to meet expenses. Also, using dividends for income keeps your principal invested, potentially preserving your retirement savings.
Understand the Risks
Reinvesting dividends can have some drawbacks. By adding to your holdings in the same stock or fund, you may be increasing your exposure to that investment and therefore your risk. A growing position in a particular investment can also throw your portfolio’s asset allocation off balance, which may mean incurring costs when selling shares to rebalance.
To avoid some of these disadvantages, consider setting up your accounts to deploy dividend distributions directly into a separate investment or, if you want to keep your funds available for future investment opportunities, a money market fund.
Do Not Forget About Taxes
Reinvesting dividends can also present challenges during tax time. For taxable accounts, each purchase you make with dividends must be added to your cost basis, meaning the original value of the investment when you bought it. (Inherited and gifted assets have different tax basis criteria.)
When you sell the investment, the higher cost basis is used to calculate your capital gain or loss. A careful accounting of your changes in cost basis — including increases from all of your reinvested dividends — prevents you from over- or underpaying your income taxes. None of this is relevant to your assets held in retirement accounts, because dividend reinvestments are taxed the same as your regular contributions when you begin taking distributions.
Re-evaluate Your Strategy
Bear in mind that dividends are not guaranteed, and you should be comfortable with the risks of investing in the types of assets that offer dividends. Whether you originally decided to reinvest dividends, it is worth a conversation with your financial advisor to assess whether it is still the appropriate choice for your current situation.