Alec Young, S&P’s international equity strategist, explains why the US dollar has been stronger lately—and why he doesn’t think it will last. He also recommends how investors should play it.

While currency diversification is by no means the only reason to invest internationally, it remains a powerful part of the equation. The weakening US dollar has greatly enhanced dollar-denominated returns in foreign stocks in recent years, to the benefit of American investors.

To illustrate: In 2006, the MSCI Europe, Australasia, and Far East (EAFE) index, the leading developed international equity benchmark, was up 23.5% in US dollar terms vs. a 13.8% local currency gain — a currency difference of 9.7%, in other words. By contrast, the MSCI Emerging Market index was up 29.2% in US dollars last year vs. a 25.6% local currency gain — a boon of only 3.6%.

Since the currencies of many key emerging markets are pegged to the US dollar, emerging market equities get less of a boost from dollar weakness than their counterparts in the United Kingdom, Europe, and Japan. So far in 2007, however, the US dollar has stabilized, rising slightly against a trade-weighted basket of foreign currencies. While the MSCI EAFE index is up 4.4% this year through February 20 in US dollar terms vs. a 2.8% gain for the Standard & Poor’s 500, foreign outperformance would be greater were it not for the dollar’s rise.

So, what’s driving the greenback’s gains? And will this trend continue? Currency markets began 2007 expecting an imminent policy easing by the Federal Reserve amid worries about a housing-driven US economic slowdown. Since then, however, S&P Equity Strategy believes expectations have changed. Fed funds futures, on better-than-expected economic data, have likely pushed back the first rate cut to December from a previous expectation of the second quarter, which was widely anticipated two months ago. This has created a more attractive US yield environment and bolstered the greenback.

However, given tightening by the European Central Bank, Bank of England, and Bank of Japan, coupled with continued Asian and Middle Eastern foreign reserve diversification, further gains in the US dollar are more or less dependent on expectations for a Fed tightening.

And based on S&P Economics’ view that [Ben] Bernanke and friends aren’t likely to tighten policy again in the current cycle, we expect US dollar weakness to resume. We look for the trade-weighted US dollar index, which measures the dollar’s performance vs. the euro, pound sterling, yen, Canadian dollar, Swiss franc and Swedish krona, to decline roughly 5% in 2007.

A resumption of modest, orderly dollar depreciation would enhance US investor returns in international equities. We recommend maintaining a 20% total portfolio allocation in foreign stocks, with 15% in developed overseas markets (EFA) and 5% in diversified emerging markets (EEM).

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