DAY HAGAN RESEARCH UPDATE
DOLLAR-DENOMINATED ETFs AND FOREIGN EXCHANGE RATES
Watching the dollar for clues on where to invest. Money goes where it is treated best, and for now, the U.S. dollar is king.
November 30, 2016
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An old investment adage is that “money goes where it is treated best.” And based on market action since the U.S. election, money is flowing into dollar-denominated assets and those that have historically performed well in a rising U.S. dollar environment. Over the past month, UUP, the PowerShares Bullish Dollar ETF, has gained nearly 3%. This compares with a -3.4% loss for FXE, the Euro Trust ETF, and -7% loss for FXY, the Japanese Yen Trust ETF. Emerging market currencies as measured by CEW, the WisdomTree Emerging Currency Fund, have declined by -3.7% over the past month.
While a strong dollar hurts U.S. companies that rely on international revenue from exports, it helps international companies that export to the U.S. EWJ, the dollar-denominated Japanese ETF, is down -1% in November, whereas the Yen-denominated MSCI Japan Index has gained 6.5%. In the long run (5+ years), studies have shown that currencies move from over- to undervalued based on purchasing power parity (PPP) and, in the end, currency gains/losses are negligible.
As shown on the chart below, the dollar index, which is currently overvalued, was considered undervalued in 2008, and has gone through long cycles of over- and undervaluation. This chart also illustrates how a currency can overshoot both to the upside and the downside, and by itself is not a good timing indicator. In essence, PPP for currencies is comparable to stock or ETF valuation indicators.
While in the long run currencies will ebb and flow, in the short term, the impact can be significant. Therefore, we are tuned into the dollar’s direction when making our allocation decisions. The dollar could be strong for several reasons: higher expected earnings and GDP growth in the U.S., higher expected relative interest rates, or global QE programs, which have impacted foreign exchange rates versus the dollar. Nonetheless, we can’t react to what may or should happen, we have to respect what actually is happening and invest accordingly.
As shown below, dollar sentiment is excessively optimistic. Dollar gains historically are impressive when sentiment is so optimistic. However, when sentiment starts to reverse, dollar weakness soon follows. But, as shown in the yellow highlighted area, it is not always immediate. This shorter-term indicator is something we are watching in addition to trend and momentum measures to determine the dollar’s next move and impact on or international exposure.
We currently have allocation to Emerging Markets through VWO (Vanguard FTSE EM) and AAXJ (iShares All Country Asia). The chart below shows the performance of VWO and the weighted underlying currency exposure of the fund versus the U.S. dollar (red line). For dollar-based investors, we would prefer to see this red line moving up and helping returns, rather than hurting them. As shown, the underlying currencies have been in a signficant downtrend for several months now. But as shown in the table in the top clip, the currency has added 59 basis points of performance to the fund over the past week. While it is still very early, this change in trend is encouraging.
Just over 27% of VWO is allocated to Chinese stocks, but the fund has no exposure to the Chinese Yuan, which has dropped by over 3% this year. This is because the fund invests in Chinese stocks listed in Hong Kong. The Hong Kong dollar is pegged to the U.S. dollar, so any depreciation/appreciation is limited. This is an important factor when selecting international funds for investment.
If the dollar continues to appreciate, investors would be better off investing in international funds that hedge the currency exposure. However, if the dollar has reached its peak, or trends sideways from here on out, the non-hedged international funds would be preferred.
Clearly Latin American market currencies have been hurt the most over the past month versus the dollar (with the exception of Turkey). Brazil is the heavyweight market in the region and dominates most Latin American indexes. As shown, BZF, the Brazilian Real ETF, has stabilized in a fairly narrow range just above its 200-day moving average (black line). This is a promising development and suggests that investors should consider a resumption of allocation to the Latin American composite funds.
In sum, currency fluctuations have a significant impact on dollar-based international ETFs. Investors should understand where their exposure lies within composite country funds. We feel that the underlying fundamentals in Emerging Market and Asian regional funds are supportive of allocation. We will continue to add to our international ETF exposure through unhedged ETFs in order to benefit from both currency and equity appreciation. We continue to favor composite funds over individual country funds in order to minimize both currency- and country-specific risk.
Have a wonderful week,
Day Hagan Investment Committee Consultant
Day Hagan Asset Management
— Written 11.29.2016
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