As the Dollar Soars, Consider Diversifying Into Foreign Stocks

Investing in overseas markets is often a sound idea, and the combination of lower share prices and weaker currencies could make those markets particularly good value now.

Written by Conrad de Aenlle / August 12, 2022

Quick Bites

  • Holding a portion of your investments in foreign markets is a good way to diversify your portfolio and improve your risk/reward balance.
  • With the dollar at multi-year highs against other currencies, this may be an especially opportune time to buy foreign stocks.
  • If and when the conditions that sent the dollar higher reverse, the dollar value of foreign stocks may get a double boost from improving business conditions and a favorable foreign-exchange backdrop.

The U.S. dollar is at multi-year highs against currencies like the euro and yen. It might be time to buy abroad.

Your strong dollars will let you pick up shares of foreign companies at lower prices, or else more of them for the same amount. You also stand to benefit when the economic dynamics that have propelled the dollar higher reverse, creating better business opportunities for the companies you have bought.

Here’s a hypothetical example of the impact of currency fluctuations on share prices. Let’s say a European stock was selling for 20 euros a share at the beginning of last year when a euro was worth about $1.23. The price that an American investor would have paid for one share of that stock was $24.60, give or take.

Today, with Europe languishing in a bear market, just as the U.S. is, that 20-euro stock might have become a 15-euro stock. With the euro around an even $1, a dollar-based investor can buy it for $15, 39% less than a year ago.

That is quite a discount, and assuming the company’s long-term earnings prospects have not meaningfully deteriorated, the stock has become a bargain. Someone who buys it at that price stands to gain 64% if it recovers to where it was a year ago and if the euro regains the ground it lost against the dollar.

How plausible is that scenario? Well, foreign stocks tend to be bargains to begin with.

Inside this article

  1. Cheaper companies
  2. Interest rates
  3. Dollar reversal
  4. Choose ETFs

Cheaper companies

The MSCI EAFE Index, which comprises a broad range of markets in developed economies outside North America, recently traded at a price-earnings ratio of 12.7. The PE ratio is a common valuation measure for market indexes or individual stocks; lower numbers mean an asset is cheaper because it costs less to buy each unit of earnings. Meanwhile, the PE ratio for the S&P 500 at the same moment was 16.1, making the American index considerably more expensive.

As for currencies, they rise and fall against one another due to several factors, and they all seem to have aligned to drive up the dollar. An important one is interest rate differentials.

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Interest rates

When rates on assets denominated in Currency A rise and assets denominated in Currency B either fall or else rising at a slower pace or not at all, investors find it sensible to shift their holdings from B accounts to A accounts to capture the higher and rising interest payments. And right now, with the Federal Reserve aggressively raising rates and other central banks doing so only half-heartedly, the dollar is most definitely Currency A.

For similar reasons, countries that are expected to experience relatively strong economic growth tend to see their currencies strengthen; this favors the dollar, too. According to the International Monetary Fund, economic output is forecast to increase next year by 2.4% in the U.S., 1.9% in the euro area and 1.3% in Japan.

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Growth forecasts may favor the U.S., but economists are grading on a curve. Recession fears are swirling worldwide. When a recession is seen to be on the way, there is a flight to safety, which typically touches down in American markets. This, again, benefits the dollar.

But in currency trends, as with much else, what goes around comes around. If a recession arrives, central banks will have to undo at least some of their interest rate hikes; the Fed has been more aggressively hawkish, so it probably will have to ease more aggressively, too, eroding the rate differential that has aided the dollar.

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As monetary policy eases, a new cycle of economic growth would draw closer, which also would limit the dollar’s appeal.

Dollar reversal

Whatever the catalyst might be, the dollar appears due for a reversal. Gabriela Santos, a global market strategist at J.P. Morgan, said in a recent report that “The U.S. dollar looks overvalued versus a basket of currencies [and that] this suggests a depreciating trend over a multiyear horizon.”

Owners of foreign stocks already enjoy a cushion from those markets’ far cheaper valuations. Foreign companies that export goods and services to the U.S. are benefiting, meanwhile, from the competitive edge their weaker currencies give them; not only are their stocks cheaper when priced in dollars, but so is everything they sell. Those factors may limit the additional pain that owners of foreign stocks have to endure while waiting for the economic backdrop to change.

And the wait may not be that long. There is no indication yet that stocks have bottomed or that the dollar has peaked, of course, but markets tend to anticipate changes in trends, often well in advance, rather than wait for confirmation that they have occurred. The dollar has already had its rally, and there may be further to go. But with the dollar’s big upward move, the big downward moves everywhere in stocks, and the fact that foreign markets are far cheaper to begin with, foreign stocks could offer a better risk/reward proposition.

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Professional investors seem to be coming around to that view. The latest installment of Bank of America’s monthly survey of global fund managers found that managers are more pessimistic about stocks in emerging markets and Europe than American stocks, yet they have begun to increase their allocations to those overseas markets, relative to other asset classes, all the same. This combination–a light but growing affinity for foreign stocks–may herald a more persistent positive reappraisal.

Choose ETFs

If you’re inclined to give foreign stocks a chance, it’s probably best to do it through an exchange-traded fund than through individual stocks or even a mutual fund, especially if you have limited investing experience. Some obvious candidates are offered by BlackRock under its iShares brand: The fund that tracks the MSCI EAFE Index has the ticker symbol EFA, and the one that follows the broad-based MSCI Emerging Markets Index trades as EEM.

ETFs have lower costs than mutual funds, and they tend not to hedge their exposure to foreign currencies. The ones that do hedge will make that apparent in their names, such as iShares Currency Hedged MSCI EAFE. Remember, one aim of investing abroad is to capture a reversal of the dollar’s strength. Also, there is a cost to putting on a hedge; funds that hedge currency exposure typically underperform their unhedged counterparts over the long term.

There are no guarantees, of course, but if the dollar heads back down the way it came and foreign economies and stocks outperform, you may make enough to pay off your overseas vacation.

About the Author

Conrad de Aenlle

Conrad de Aenlle

Conrad de Aenlle is a writer and editor with more than 30 years of experience in topics related to financial services and investment, including market performance, portfolio management, economics, retirement issues, estate planning, taxation and insurance.

Full bio

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