The likely interest rate cut this week by the European Central Bank (ECB) will impact investment portfolios around the globe. Even if your portfolio is completely U.S.-based, interest rate variances between two countries impact currency exchange rates, which then impact money flows worldwide as investors seek to maximize their returns.
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In the case of the Euro compared to the U.S. dollar (EUR-USD), with a reduction of rates in Europe, money would tend to flow to the U.S. as its interest rates would be comparatively higher. For this flow to happen, dollars must be purchased, which then strengthens the greenback. This strengthening will have consequences for the overall U.S. markets and produce higher risks for some sectors and lower risks for others.
It’s What’s in the Portfolio That Matters
Although there is a slight positive correlation between U.S. stocks and dollar strength, what really matters for investors is the makeup of their portfolios. In the grand scheme of things, a strengthening dollar doesn’t necessarily mean the overall stock market will automatically march higher or lower. Some stocks will move higher with a strong dollar, and others will move lower as a result.
For instance, companies that rely heavily on exports may not fare well in a strong dollar environment, while companies that import a lot of their raw materials could benefit from lower costs. This means the broader market has winners and losers, and astute stock pickers could beat indexed investments.
Industries with Strongest Headwinds
Investors that are loaded up with U.S.-based companies in sectors that rely heavily on exports to countries that use the Euro are most likely to face strong headwinds. Think about it, the manufacturing sector, particularly companies that produce goods for export, will find the price of what they are selling suddenly cost more in Euros. The U.S. company either needs to lower its prices, which reduces profits, or allow sales to slow, which also reduces profitability.
In addition, the U.S. tourism industry is a non-manufacturing sector that can slump when the dollar is strong. Tourists from Eurozone nations would require more Euros to visit the U.S. for vacation or business reasons, which naturally leads to a decrease in tourism revenue and a slowdown in the industry.
Industries with Strongest Tailwinds
With the dollar gaining strength, it becomes more affordable for American tourists to visit Europe, potentially leading to an increase in travel and tourism revenue for hospitality companies that cater to tourists in Europe. It is also likely that there will be more European travelers staying closer to home. This could create tailwinds for international airlines, hotels, and other businesses that cater to European travelers.
Other sectors that will experience an automatic pickup in profit margins are U.S. companies that import a large percentage of goods from Europe, such as high-end retailers or specialty foods.
Key Takeaway – Shifting Currency Values Will Create Winners and Losers
Overall, an interest rate cut by the ECB while the Federal Reserve leaves U.S. interest rates unchanged will cause the dollar to strengthen against the Euro. The impact of this, in terms of market sectors that strengthen or weaken, may more or less balance out and have little impact on the value of the broader market. So, a sudden strengthening of the dollar may mean little to index-based investors. However, stockpickers could have an advantage as there is ample reason to expect that the interest rate-inspired shift in currency values will create winners and losers.
