Our ACM International ADR and Global strategies feature unique, high-quality international companies, many of which do not have a U.S.-based equivalent or competitor. This is the most important reason for investing in ADRs in my mind, and given that the overwhelming majority of our clients are U.S.-based, this foreign-focused strategy expands a typical investor’s opportunity set and provides diversification over a purely US-centric portfolio. Notably, the foreign equity investing advantage does not just reside in each company’s business model. There is also an additional diversification benefit inherent in ADR investing through the exposure to multiple currencies outside the U.S. dollar.
ADRs that trade in American markets represent ownership in foreign companies and their daily pricing is a function of both the share price movement in its own currency plus the foreign exchange, or Fx, changes that reflect the local currency’s stock price movement vis-à-vis the United States dollar. For U.S. investors, appreciation of the foreign currency adds to the stock’s local price appreciation and dividend income. This is frequently overlooked and possibly underappreciated. Many express anxieties about dollar stability because of the increase in U.S. federal debt from the recent increase in deficit spending. Some doomsayers even predict a dollar crash. To be clear, such crash fears are common, overblown, and inconsistent with actual dollar fluctuations, which have been fairly muted. Instead, since WW II, the dollar has been the center of the world’s financial system and today accounts for over 90% of the globe’s more than $6.5 trillion in daily Fx transactions. This reserve currency role is backed by an unmatched financial infrastructure, trusted judiciary, and global military presence, which are not likely to change anytime soon. Moreover, U.S. debt ratios to GDP are not out of line with much of the developed world. Japan and Europe carry heavier levels of debt in proportion to their GDPs. That said, the value of the dollar is subject to fundamental drivers in the marketplace and fluctuations will occur, including, at times, double-digit depreciation against several foreign currencies. This provides an opportunity for enhanced ADR investment returns.
There are several currency models used to ascertain fair value and the implied likely direction of the U.S. dollar. Examples include Purchasing Power Parity, Fundamental Equilibrium Exchange Rate, and Behavioral Equilibrium Exchange Rate models. All of these and others have failed to reliably predict short-term movements in the greenback. Part of this reflects the longer-term metrics used in these models with balance of payments and purchasing power valuations being specific examples which rely on slower moving factors to predict longer-term currency direction. Central bank policies, interest rates differentials, relative GDP performance, and capital flows exert considerable short-term influence and can push a currency well above or below the “fair value” predicted by the above-mentioned models. We believe this is the case with the U.S. dollar, currently above its fair value against several currencies, according to these models.
The U.S. trade balance recently reached an all-time annualized record deficit following February’s $71 billion deficit, which is the amount by which the U.S. imported more than it exported. This may be accentuated near term, as the U.S. economy rebounds faster from the pandemic than others. The longer-term trade balance deteriorating trend is nonetheless clear. Yet, short-term trade deficits are not necessarily bad for the deficit country’s currency and the U.S. deficit is typically financed by borrowing through placement of U.S. treasury and agency debt with foreign entities. Foreigners are perfectly happy owning U.S. debt, a very deep, trusted, and liquid asset. Thus, capital flight and currency collapse, which frequently plague many emerging market currencies such as the Argentine peso, are not risks for the U.S. dollar.
Even so, a persistent and worsening trade deficit creates downward pressure on any currency, including the greenback. A cheaper dollar helps reduce the deficit by making foreign goods more expensive, and domestic goods more competitive in the global marketplace. With the trade balance recently reaching a 12-month trailing $740 billion deficit, and lacking commensurate foreign capital inflow into U.S. long-term securities or direct investments, the necessary financing balance must come from short term capital flows, which is known as “hot money”. Those inflows also bring a higher risk of flowing back out of the U.S., potentially putting pressure on the dollar. We also note the dollar still appears overvalued. Valuation models run from simple to complex but many consistently show dollar overvaluation, in some cases by more than 20%. On the other side, the euro, Swedish krona, and surprisingly to some, the Japanese yen appear somewhat undervalued. Combining the trade deficit trend with overvaluation against most currencies, as well as improving foreign productivity readings, suggests a convincing thesis for a negative or weak dollar outlook.
There are other factors at work, but the above discussion helps explain the 12% slide in the dollar from its safe-haven-driven peak in March 2020 during the height of pandemic fears. The dollar has strengthened a bit year-to-date due mostly to rising U.S. interest rates relative to other countries (which attracts hot money), and possibly, perceptions of an earlier start to a Fed tightening cycle compared to other central banks. But as mentioned above, we believe this will have a transient impact. Historically, dollar cycles are typically much longer than the business cycle, on average about fourteen years roughly split into seven years of strength and seven years of weakness. Thus, monetary and political explanations for the U.S. dollar are not adequate in predicting the longer-term direction. As shown in the U.S. dollar index graphic below, the dollar weakened for seven years in the stagflation 1970s era, followed by six years of strength engendered by Reagan’s inflation fighting ending in the mid-1980s at the Plaza Accord. Ten years of dollar weakness ensued through 1995, then strength for seven years during the dot-com buildup, and nine years of weakness during China’s economic growth surge. The 2011 Arab-Spring kicked off dollar strength ending in early 2017, a level almost matched in March 2020. The recent current trade deficit deterioration is indicative of the 2000s suggesting the greenback may be at an early stage of another weakening trend.
What is most notable about such currency fluctuations is how they affect the value of foreign stocks. A weaker dollar translates foreign share prices into higher dollar valuations, in addition to amplifying the dollar value of growing earnings of those companies. Therefore, foreign equity markets provide better-than-U.S. equity returns in times of dollar weakening due to the foreign currency tailwind. We believe this makes ADR investing in your portfolio more important now than at any time over the last decade.