After the market dropped through the floor in 2008 and early 2009, investors breathed a collective sigh of relief as the S&P 500 Index ended the latter year up 26%. And while few would quibble with those kind of returns in a single year, the real action took place abroad. The MSCI Emerging Markets Index posted an eye-popping 75% return last year, topping performance charts across the globe. And while many market prognosticators are predicting big gains for international markets again in 2010, a few folks are sensing a growing threat from a seemingly unlikely quarter.
Don't bet your bottom dollar
The debt crisis in Dubai couldn't rattle foreign investors, but folks who are betting on making big bucks in foreign markets this year may have another enemy -- a rebounding dollar. After falling precipitously throughout 2009, the U.S. dollar has staged a rally in recent months. The greenback surged about 5% versus other major currencies in December, and it just hit a 10-month high against the euro in January. With weak domestic economic conditions and yawning trade and budget deficits, many investors were counting the dollar down for the count for some time to come. But given new concerns over fiscal woes in emerging economies like Greece and potential credit tightening in China, the dollar is staging a comeback, which could cut into profits for U.S. investors who hold foreign assets.
Currency risk is one of those additional layers of risk people take on when they invest abroad. A strengthening dollar means that one U.S. greenback buys more of other currencies, and other currencies buy fewer U.S. dollars. When domestic investors buy a foreign stock under such a scenario, their investment return is curtailed, since their foreign investment will buy fewer dollars once the exchange is made back to U.S. currency.
One talking head predicting potential pain for foreign investors is Alexander Green, investment director of The Oxford Club. Green predicts that the dollar will soar against the yen and euro this year, given that both Japan and Western Europe are growing more slowly than the U.S. and have greater fiscal imbalances. And with the Fed likely set to raise interest rates toward the end of the year, Green feels the stage is being set for a surge in the dollar. If he's right, a lot of investors could feel the pinch.
The currency of business
Seasoned investors interested in counteracting any currency effects can invest directly in an exchange-traded fund that tracks the movement of the U.S. dollar against a basket of other major currencies. The PowerShares DB U.S. Dollar Index Bullish ETF
If the dollar does continue to strengthen in 2010, watch out for the hit that U.S.-based multinationals could take. A strengthening dollar means that foreign consumers buy fewer American goods because they become relatively more expensive. For example, such an effect could hit IT players like Oracle
Ultimately, few analysts are currently calling for a stronger dollar in 2010. But given the encouraging economic data we've seen in recent days, I wouldn't necessarily bet on the dollar getting a whole lot weaker. It may bounce around a bit at depressed levels, but I think from here, there's more upside to the dollar than downside.
Still, that doesn't mean that investors should dump their foreign holdings in fear of a rebounding dollar. They should just be aware that they may face some headwinds in this corner of the market, and adjust their expectations accordingly. In other words, don't count on foreign markets to put up the same kind of numbers this year as they did in 2009.
Concentrate on the long term
Despite the possibility of a rising dollar in 2010, investors should continue to invest in foreign markets, both developed and emerging. Investing is a long-term pursuit, and your first priority should be to buy good companies for the long run, rather than to manage short-term currency fluctuations. Fortunately, there is an easy way to get quick access to a broad swath of top-rate foreign companies -- by investing in international mutual funds. Investing in the very best foreign funds will help offset some of the risk of a rising dollar, by making sure your investment return is larger to begin with! That's why it's so important to choose your foreign investments carefully in this environment.
Focus on well-diversified and reasonably priced international funds. For example, Vanguard International Growth (VWIGX) looks for fast growing large-cap companies such as Brazilian oil company Petroleo Brasileiro
If you're looking for more top-shelf foreign investing ideas, be sure to check out the Fool's Rule Your Retirement investment service. With your free 30-day trial, you'll get access to the best mutual fund investing ideas, as well as first-rate personal financial planning advice for the new decade.
Investing abroad will always come with certain risks, but with a little bit of guidance and preparation, investors can make the most of foreign opportunities, no matter what the dollar does in the meantime.
Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement newsletter. At the time of publication, she did not own any of the companies mentioned herein. Petroleo Brasileiro is a Motley Fool Income Investor recommendation. The Fool owns shares of Oracle. The Fool's disclosure policy hesitates to bet against the buck.