How a strong or weak dollar affects investment returns

Among the many things advisers have to worry about, the direction of the U.S. dollar on foreign currency exchanges typically ranks somewhere between where to go out to dinner next Tuesday and how often to floss your teeth. But the dollar’s moves could have a big impact on returns from international funds this year — just as it did last year.

International stock and bond funds have been on a tear. The MSCI Europe, Australasia and Far East index (EAFE), has soared 25.55% the past 12 months, versus 25.80% for the Standard & Poor’s 500 stock index with dividends reinvested.

But much of EAFE’s gain has been because of the declining value of the dollar. When the dollar falls, U.S. investors get a bonus from currency translation. In local currency terms, EAFE has gained 13.62%. The effect on individual markets has been dramatic. Germany’s stock market is up 28.01% the past 12 months in U.S. dollar terms, for example, while it’s up 9.98% in euros. Similarly, the U.K.’s market gained 20.15% in dollars, but just 5.97% in pounds.

The dollar’s decline began in December 2016 when the trade-weighted dollar index hit 102.95. It’s 89.06 at this writing, a 13.5% decline. The bear market in greenbacks came as a surprise to many. After all, one key metric for evaluating the dollar is the differential between short-term interest rates of many countries. The U.S. federal funds rate has been slowly rising, while many global rates remain lower than a bassoon solo.

What ails the dollar?

“The U.S. economy is not the only one doing quite well,” said Ronald Simpson, managing director for global currency analysis at Action Economics. “The European Union is shooting the lights out, and the Bank of Japan has been very upbeat on the economy.”

In short, money has been moving to once-moribund economies, rather than out of them. Another worry has been U.S. protectionist policies.

“Those involved in international trade don’t like to hear about protectionism or uncertainty,” Mr. Simpson said.

Mr. Simpson remains upbeat about the dollar however.

“The tough talk about trade has brought people to the table,” he said. “If we’re talking about being pro-America, which the president should be, we’re well on the way to getting some better trading terms from these guys who have been taking advantage of us.”

So where are we now?

“We’re near the bottom,” Mr. Simpson said. “There could be more to go just from sheer momentum.”

But over the next few quarters, once tax cuts kick in, he thinks the dollar could strengthen.

For long-term investors, the dollar-effect tends to be somewhat of a wash. And, relative to the U.S. stock market, foreign stocks have been laggards for more than a decade. Even with last year’s robust returns, EAFE has averaged just a 0.71% annual average return in dollar terms and a 1.76% gain in local currency.

Nevertheless, if the dollar strengthens this year, international funds will face a headwind it didn’t have last year.