Key Takeaways
- Weak currencies can benefit Japanese and European companies with substantial overseas business operations, leading to limited incentives for the countries to significantly strengthen their currencies.
- The U.S. is more accepting of Japan and Europe maintaining weak currencies as a check on the rise of Chinese exports, benefiting its allies in their competition with China.
- Currency hedging, whether through dynamic or fully hedged strategies, has delivered risk reduction and return enhancements for many developed international portfolios.
In today’s complex global economy, currency fluctuations play a crucial role in shaping investment outcomes. While we’ve previously emphasized the importance of currency hedging in a U.S. investor’s international portfolio, there’s a subtle aspect that often goes unnoticed: the positive impact of weak currencies for Japanese and European companies and U.S. tolerance of it as a check on Chinese exports.
Headlines often focus on the unhappiness caused by currency devaluation and volatility, particularly in the Japanese yen. However, a weak yen can actually benefit Japanese companies because many of these companies have substantial overseas business operations. The same holds true for most European companies. As a result, Japan and Europe reap the rewards of weaker currencies, and the incentives for them to significantly strengthen their currencies are limited.
Figure 1: A Closer Look at Revenue Sources
For each Fund’s full standardized and most recent month-end performance, please click the respective ticker: DXJS, DXJ, IHDG.
Based on the chart above, the U.S. S&P 500 index is about 60% domestic, while developed international strategies are around 40% Europe and Japan.
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S&P 500 Index:
- Approximately 40% of revenue for U.S. S&P 500 Index companies is derived from outside the U.S.
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The MSCI EAFE Index:
- Combining revenue from European and Japanese companies accounts for about 40% of the MSCI EAFE.
- Consequently, the incentives for Japan and Europe to significantly appreciate their currencies remain limited. For U.S. investors, this underscores the benefits of currency hedging, especially when U.S. interest rates are higher.
Geopolitical Considerations
Beyond economic factors, geopolitical dynamics also shape currency outcomes:
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Strong Dollar vs. U.S. Companies:
- While a strong dollar can hinder U.S. companies’ earnings growth, it benefits Europe and Japan—both U.S. allies in the competition with China.
- Weak European and Japanese currencies enhance the competitiveness of their products relative to Chinese counterparts.
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Tolerance for Weak Yen and Euro:
- Given its economy, the U.S. is more accepting of Japan and Europe maintaining weak currencies. This approach serves as an additional check on the rise of Chinese exports.
Lastly, let’s address the impact of interest rate differentials:
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Rate Cuts:
- When the U.S. begins cutting rates, the U.S. dollar will be under pressure.
- However, what truly matters for currency movements is the interest rate differential, not the absolute U.S. rate.
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Europe’s Response:
- There’s a high likelihood that Europe will either match or outpace U.S. rate cuts, ensuring that the USD-euro interest rate differential remains significant.
- Consequently, the U.S. dollar could continue to exhibit strength for some time.
Currency hedging, whether through dynamic currency hedging or fully hedged strategies, has delivered risk reduction and return enhancements for many developed international portfolios.
In summary, the incentives and U.S. tolerance for a weak yen and euro are important factors to consider in the current geopolitical environment. Thus, for a U.S. dollar-based investor, having some currency hedge could be a benefit.
Figure 2: Performance and Volatility of Various Ways of Hedging Currencies
For each Fund’s full standardized and most recent month-end performance, please click the respective ticker: DDWM, DWM, DDLS, DLS, IHDG.
This article originally appeared on WisdomTree's website and is reprinted on VettaFi | Advisor Perspectives with permission from the author. For more information, please visit WisdomTree.com
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