With the U.S. dollar staging a surprising rally, some market watchers say that investors who have piled into foreign stock and bond funds may get burned.
After all, if the dollar continues to move up against other currencies, returns on foreign investments will suffer.
Unlike European investments, “the vast majority of international stock and bond holdings in the U.S. are not currency hedged,” said Bradley Kay, an exchange-traded fund analyst at Chicago-based Morningstar Inc.
Those who took on currency risk last year were rewarded: Foreign currencies rallied right along with their underlying equity markets.
As U.S. investors fled domestic stock funds and put some of their money into foreign funds, the Morgan Stanley Capital International Europe, Australasia, Far East index gained 27.75% in dollar terms in 2009, and the MSCI Emerging Markets index ran up 74.5%. On a similar price basis, the S&P 500 index gained 23.45%.
But the profitable combination of strong foreign markets and a falling dollar is unlikely to be repeated this year, said Anthony Welch, a partner at Sarasota Capital Strategies Inc., Osprey, Fla.
The 5% surge in the dollar last month vs. other major currencies occurred as fiscal crises in Dubai and Greece revealed underlying problems outside the United States. Those concerns caused dollar bears to pull back on short bets.
For market technicians, the move up in the dollar was significant because it broke a down trend going back to May.
Historically, “the dollar tends to pick a trajectory and stick with it. If there is a change (in trend) it can continue for a while,” said David Waddell, chief executive of Waddell & Associates Inc., Memphis, Tenn.
The dollar rally looks different from the last run-up that began in the summer of 2008, analysts say, when investors rushed into U.S. dollars out of panic.
Now, with the U.S. economic picture looking somewhat better than that of other developed nations, investors have driven up the dollar on fundamentals.
Analysts expect some modest dollar appreciation this year, up to 10% against the euro and yen, with the euro holding up a bit better.
Currencies of emerging markets are expected to hold their own or even appreciate against the U.S. dollar.
Nevertheless, emerging markets holdings could be especially vulnerable to a decline after having surged last year, some observers say.
“If emerging markets currencies start falling against the dollar (and) emerging markets holdings fall (in price) too, we'll have the opposite of what happened last year,” said Mr. Welch, who co-manages the Currency Strategies Fund.
What's more, a strong dollar and higher short-term rates in the United States, the latter of which helped spark the dollar's rally last month, could force the unwinding of dollar “carry trades,” which could in turn create selling pressure on emerging markets assets. Carry traders may pay off their dollar-denominated short-term financing as rates rise and the dollar appreciates, and then sell the assets they hold, which are believed to include sizable holdings in emerging-markets debt and equity.
