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Ameriprise Financial, Inc. : Evaluating the Strength of the Dollar

01/23/2012 | 04:50pm US/Eastern
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A quick glance at the U.S. Dollar (DXY) Index shows that, since the start of the year, the dollar is fractionally higher. But this index, which is an often-cited proxy for relative dollar strength, has its limitations. It is a weighted index of the dollar's value against six foreign currencies: the euro, yen, pound, Canadian dollar, Swedish krona, and Swiss franc. The euro alone accounts for over half of the weighting. Because of the narrow composition of the index, it can provide an incomplete picture of how the dollar is faring against excluded currencies, including those of some important investment destinations for U.S. investors.

Even for purposes of analyzing foreign developed market equity returns for dollar-based investors, the DXY index can provide a misleading reference point. As one would suspect, this should not be especially true for returns from within the Eurozone, given the euro's high weighting in the index. In fact, equities within the Eurozone are higher by 4.8 percent year-to-date in dollars and 5.0 percent in euros. For all of 2011, Eurozone equities lost 20.1 percent in dollars and 17.6 percent in euros. This differential is a reflection of the euro's 3.1 percent decline versus the dollar and not dissimilar to the 1.5 percent rise in the DXY. The same similarity of returns can be seen in Japan year-to-date, where the Nikkei index is higher by 3.7 percent in yen and 3.5 percent in dollars, as the yen/dollar relationship is virtually unchanged. However, in 2011, the DXY would not have suggested the wide disparity in relative returns for dollar- and yen-based investors, given the yen's low weighting in the index. Calculated in yen, the Nikkei lost 17.3 percent, while in dollars it declined only 12.2 percent.

Not surprisingly, given the absence of any emerging market currencies in the DXY, the disparity of returns accounted for by currency movements can be even more pronounced with emerging market investments. Year-to-date, the MSCI Emerging Markets index is higher by 6.0 percent in local currencies, but 8.6 percent in dollars, despite the DXY being virtually unchanged. In 2011, when the DXY rose 1.5 percent, the Emerging Markets index lost 20.4 percent in dollars, but just 14.9 percent in local currency terms.

This kind of wide differential is especially pronounced in returns so far this year, but mostly to the benefit of U.S. investors, as the dollar has fallen sharply against some emerging market currencies. For example, in Brazil local currency equity returns are higher by 9.8 percent, while in dollars these returns jump to 16.0 percent. In Chile, the differential is 2.4 percent versus 8.0. In Mexico, it is 0.8 versus 6.6. The same disparity is evident in Asia although it is somewhat less pronounced, with the exception of India. There, the respective returns are 8.3 versus 14.5 percent. In Korea it is 6.8 versus 9.1.

It is one thing to be aware that relative currency strength in any particular country may differ significantly from an index. It is something else again to understand what is driving it.

In the case of emerging markets, the first thing of note is how sharp a turnaround this year's currency strength represents from the second half trend of last year. In Brazil, the real weakened by almost 20 percent against the dollar over the final two quarters of 2011, but has strengthened almost uninterruptedly since the start of the year for a six percent gain.The story in Chile is the same. After falling by 11 percent in last year's second half, the peso began a rally at the start of the year that has seen it rise by five percent in just three weeks. The same is true in Mexico, India, and Korea.

These trend reversals come as many emerging countries are shifting toward easier monetary policies in an effort to stimulate growth, having achieved some success in their fight against inflation. Expected economic growth differentials with developed markets in 2012 are beginning to attract investment flows, especially as concerns over the Eurozone have eased in the past few weeks, and given the abundance of liquidity in the developed markets. The Conference Board forecasts economic growth in advanced countries of just 1.3 percent in 2012, compared to 5.1 percent in emerging countries. For all of 2011, emerging market equity funds saw outflows totaling five percent of assets. Yet for the first three weeks of this year they have seen inflows totaling 0.7 percent of assets. Regional Latin America funds experienced outflows of 12 percent of assets in 2011, but have seen that pace fall to just 0.2 percent so far this year. Asia Ex-Japan funds have seen a similar turnaround, going from outflows of seven percent in 2011 to inflows of 0.4 this year. In addition, interest rate differentials versus developed markets remain attractive. The overnight rate in Brazil is 10.5 percent, in Chile 5.0, Mexico 4.5, in South Korea the seven day repo rate is 3.25 percent, and in India the repo rate is 8.5 percent. In contrast, in the U.S. it is 0.25, in the Eurozone it is 1.0 percent, in the U.K it is 0.5, and in Japan 0.1 percent.

Inexpensive valuation metrics suggest that emerging market equities may have further room to run. But rising risk appetites are fragile and easily derailed. A lot has to go well for recent gains to be extended. U.S. economic data needs to continue its recent improvement, Europe needs to continue to make gains in solving its debt crisis, and China needs to avoid a hard landing. The news on all three fronts has been encouraging of late. Let's see if it continues.

Important Disclosures:

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The U.S. Dollar Index (DXY) measures the dollar's value against a trade-weighted basket of six major currencies.

The Nikkei index is a price-weighted average of 225 stocks of the first section of the Tokyo Stock Exchange.

Morgan Stanley Capital International Emerging Markets index, an unmanaged market capitalization-weighted index, is compiled from a composite of securities markets of 26 emerging market countries.

Investments which concentrate in geographic regions may expose an investor to greater volatility: for example, currency fluctuations, differences in security regulation, accounting standards, foreign taxation regulations and political risks. These risks may be enhanced in emerging markets.

It is not possible to invest directly in an index.

Brokerage, investment and financial advisory services are made available through Ameriprise Financial Services, Inc. Member FINRA and SIPC. Some products and services may not be available in all jurisdictions or to all clients.

© 2012 Ameriprise Financial, Inc. All rights reserved.

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