If our outlook is correct, foreign exchange should add 1.1 percentage points annualised to the returns that investors derive from dividends, corporate profits, and valuation changes of non-US equity investments relative to investments in US equities. Such a boost assumes a broadly diversified portfolio that is not hedged against currency risk.
Our expectation of an easing in the dollar’s value is one reason we believe investors will earn higher returns on non-US equities than US equities in the decade ending 30 September 2033.2
The exceptional run-up in the value of the US dollar was partially justified by attractive valuations 10 years ago and stronger fundamental US economic conditions over the last decade. However, we believe the dollar has gone too far and that a correction to our fair-value estimate will drive dollar depreciation in the decade ahead.
Economic fundamentals will continue to anchor long-term exchange rates
Notes: Our US dollar index and fair-value estimates are proprietary measures that compare the US dollar with an equity market-capitalization-weighted basket of the euro, the Japanese yen, the British pound, the Canadian dollar and the Australian dollar. The non-US dollar currencies’ index weights reflect the relative weights of MSCI World Index constituent regions and countries that typically trade goods, services and securities in those currencies. The fair-value estimates are based on the portion of exchange rate movements that can be explained through differentials in relative economic strength, measured by productivity (GDP per capita at purchasing power parity), interest rates and inflation.
Sources: Vanguard calculations, based on data from LSEG (formerly Refinitiv) and the International Monetary Fund, as of 30 September 2023.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly is in an index.
Currencies can deviate from their fair values for brief or even extended periods due to factors both rational and irrational. In the long run, however, fundamental economic conditions do a good job of explaining currency values. We expect that will continue to be true, which implies some depreciation and a return to fair value for the dollar based on our outlook for those fundamentals over our 10-year forecast horizon.
We have identified four cross-border variables that drive the value of the dollar (see bar chart below). The first two are particularly important over longer periods:
1. Productivity differences. A larger increase in the value of goods and services produced per capita in the US compared with many competing countries was a key driver of the dollar’s appreciation in the last decade. We expect the US to maintain its productivity edge, given higher public and private investment and technological innovation, but see a less compelling case that relative US productivity gains will match those of the last decade, easing pressure for the dollar to rise further.3
2. Long-term real (inflation-adjusted) interest rate differences. Higher 10-year rates imply higher expected returns and attract capital from yield-seeking investors. In the last decade, real rates tended to move higher in the US relative to other regions, adding to the dollar’s strength. We expect that trend to persist, albeit at a slower pace.
Drivers of the US dollar:
We expect depreciation despite, not because of, continued relative US economic strength
Notes: A proprietary Vanguard index suggests the US dollar was undervalued in 2013. We estimate that about 28% of the dollar’s 3.1% average annual rise during the decade that ended 30 September 2023 owed to faster productivity and interest rate growth in the US compared with most other countries. Conditional mean reversion—the market’s tendency to eventually correct under- and overvaluations relative to fundamentals—explains about one-third (32%) of the increase. The remaining 40% rise does not appear justified by fundamental economic conditions, leaving the US dollar overvalued. We expect the dollar to return to fair value in the coming decade, thanks to conditional mean reversion. Historical index attribution and the decomposition of our median dollar forecast into the drivers shown are based on an error correction model.
Sources: Vanguard calculations, based on data from Refinitiv and the International Monetary Fund, as of 30 September 2023.
3. Policy rate differences. Changes in short-term (two-year) bond yields reflect expectations for central banks’ policy rates. We expect differences in cross-border short-term rates to continue to make a negligible positive contribution to the dollar as global inflation and policy rate differences converge in line with our economic outlook.
4. Inflation rate differences. Conventional wisdom suggests that higher inflation in one country should weaken its currency. When central banks have credible inflation-targeting frameworks, however, research finds that—all other factors being equal—upturns in inflation strengthen their currencies. That’s because accelerating price gains for goods and services also lead to higher expected interest rates. Cross-border inflation differentials boosted the dollar modestly in the last 10 years but likely will be a small force for depreciation going forward.
Even if the US confounds our expectations by delivering meaningfully better productivity or higher long-term real rates than other countries in the coming decade, we think these factors will only modestly offset, rather than cancel out, the looming depreciation of the dollar. That said, overvaluation is not necessarily an indication that a dollar sell-off is imminent, especially if the global economy is headed for recession.
We have high conviction that the US dollar will correct over the long term to levels implied by fundamental economic forces. But identifying the catalyst for a weakening dollar is difficult, and its volatility could lead to an abrupt correction or further deviations from fair value. For those reasons, we would caution investors against trying to time currency markets and instead encourage them to view our forecast as an argument against continued US outperformance and amodest long-term tailwind for globally diversified portfolios.
1 Our forecast of a 1.1% annualised decline reflects the median in the distribution of 10,000 Vanguard Capital Markets Model (VCMM) simulations for 10-year annualised changes in the US dollar against an equity market-capitalisation-weighted basket of the euro, the Japanese yen, the British pound, the Canadian dollar, and the Australian dollar. The dollar’s decline almost certainly will not prove linear.
2 Vanguard believes investors should accept currency risk in their international equity allocations. Doing so lowers the correlation between international and domestic equity returns and hedges domestic inflation risk. Alternatively, we believe the currency risk in international fixed income allocations should be hedged. If unhedged, the volatility of such holdings can increase to equity-like levels, reducing the ability of bonds to provide ballast in portfolios.
3 To understand the influence of cross-border productivity differences on currency values, imagine a one-widget, two-economy world. If it costs $1.50 to produce a widget in the US and the equivalent of $2 in the other country, theory says the exchange rate must be equivalent to $1.50/$2, or $0.75/foreign currency unit (FCU). If US productivity grows, the US could sell its widget for less—say, $1.10. Assuming no change in non-US productivity, the exchange rate would fall to $1.10/$2 equivalent, or $0.55/FCU—that is, the dollar would appreciate.
Investment risk information
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
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