What’s the impact of a strong dollar on US equities?

As inflation gripped markets, and ongoing volatility from the pandemic continued to rattle the finance sector, the dollar’s attraction as a safe haven grew. 

Higher interest rates in the US also added to the currency’s popularity, as foreign investors seeking higher returns drove its its value to multi-decade highs relative to its peers.

For investors looking to understand the impact of a strong dollar, history can show the winners and losers.

“A strong dollar carries out the same companies every time [a rise] happens,” says Ben Kumar, senior investment strategist at 7IM.

Companies that make the majority of their earnings abroad, including Caterpillar, the industrials firm, will be hurt by the converse decrease in global currencies, as their foreign revenues will be worth relatively less when exchanged back into the dollar.

“But most companies in the US make the majority of their money in the US, and so they are insulated from the impact of the strong dollar than the rest of the world,” Kumar adds.

The case for the US

UK investors have tended to shy away from what they perceive as a complex market, but it is a mistake for them to be underweight the US at this time, says Rupert Rucker, investment director at Schroders.

A lot of European investors will be looking at the strength of the dollar and will think it is more expensive, he says, but these premiums are justified.

“The return on capital here is higher than anywhere else in the world, partly because it is more capitalist and the incentives for companies are aligned with shareholder return, and partly because the economy is a lot stronger and that’s going to persist.”

A much lower reliance on energy imports than Europe has also shielded the US from some of the price uncertainty seen over the past few months, and should continue to do so in future.

You can get US exposure cheaper in Europe.David Harrison, Rathbones

Although a slowdown in overall activity in the next few months is likely, both businesses and households have got reasonably strong balance sheets too, and that should insulate them from the disruption occurring within global markets, says Eric Papesh, portfolio specialist for US equities at T Rowe Price.

One of the areas a strong dollar will impact is mega caps, as they will rely more on international earnings, which will be worth less as the purchasing power of Europeans or Asians will be diminished, impacting a company’s revenue scheme.

The companies to look at are those who benefit from lower importing costs.

These could be European prestige autos, says Stuart Clark, portfolio manager at Quilter. 

Foreign beneficiaries

Another area to look at is companies headquartered in Europe but with most of their sales in the US, says David Harrison, manager of the Rathbones Greenbank Global Sustainability Fund.

“You can get that US exposure cheaper in Europe at the moment, for example LVMH or Inditex.”

The benefit of these companies, which along with the rest of Europe will be hit the hardest in the coming months, is that investors can see how they managed during the financial crash in 2008.

“[These companies] got stronger through it,” Harrison adds.

Managing currency risk

When it comes to investors managing their currency exposure, it is a necessity to have a very good understanding of the companies their portfolios are invested in, says Papesh.

When the dollar appreciates, every unit of profit generated in a non-dollar currency translates into fewer dollars when brought back to the US. “It’s never really that simple though,” he adds.

Investors need to understand the specifics of the individual businesses within their portfolio, looking not just at where their sales occur, but what their cost base looks like.

If you just buy the headline index, you are getting everything.Stuart Clark, Quilter

They should also be focusing on whether revenues and expenses are in the same currency, or if there is a mismatch, whether the company hedges that FX exposure.

Otherwise, they are exposed to fluctuations in exchange rates which will add to the risk of owning these stocks.

“There are a lot of variables to consider and having a good grasp of both where and how companies are making money, goes a long way to effectively dealing with volatility across currency markets,” Papesh says.

Something else for investors to have in mind is to make sure to do a lot of analysis, whether picking stocks or funds.

This is especially true if investors are gaining their US exposure through passive funds or indexes.

“If you just buy the headline index, you are getting everything, and there will be some gremlins hidden within that index that you might want to try and avoid,” says Clark.

He points out that US fund managers are much more likely to avoid style drift, which aids investors to understand what they are putting in their portfolios.

“US fund managers tend to fit in their style boxes quite nicely, more so than international fund managers,” he says.

Don’t sacrifice on quality, because you don’t have to.David Harrison, Rathbones

A large or mid-cap manager will be seeing the current sell-offs in the market as opportunities to buy “amazing businesses” with compound growth rates that, although slightly lower, are still looking better compared to the rest of the market.

Conversely, Clark adds, value managers are happy as they see growth investing as being “completely oversold”.

“In the US those agnostic multi-cap go-anywhere managers are few and far between.”

Harrison recommends avoiding companies that have substantial debt on their balance sheets, especially when it comes to those who are close to needing re-financing.

Sometimes it is the more boring companies that have the most opportunity, he adds.

“Don’t sacrifice on quality, because you don’t have to.”

sally.hickey@ft.com