The Dollar’s Weakness Should Resume

Focus:

Alexander Young Image Alexander Young Equity Market Strategist, S&P Capital IQ

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?