While most investors are concerned with the state of affairs in the U.S., it is also important to keep an eye on what is going on around the world. More and more it seems that the global economy is taking shape with circumstances in many parts of the world having a large impact on things at home. Moreover, many money managers suggest that a portion of an individual’s investments should be made overseas in order to diversify against a downturn in the U.S.
From an economic perspective, currency valuations are probably the most important factor to be concerned about. Depending on the state of various economies, the relative value of a dollar (or a yen, Euro, etc.) can fluctuate compared to other currencies. You will often hear about a “strong dollar” or a “weak dollar.” A strong dollar is when the U.S. dollar can be converted into a historically high quantity of other currencies. A weak dollar means that the U.S. dollar cannot buy very much of another currency. These factors have an impact on imports and exports because goods and services from a foreign nation are usually purchased in the currency of the producing nation. For example, if the dollar were strong, one would expect imports to be high and exports to be low because the dollar will buy a lot in a different country while it is expensive to purchase dollars with outside currencies. Alternatively, with a weak dollar you would expect high exports and low imports. For investors who choose to invest in foreign securities, there are additional risks to be concerned about. In addition to worrying about the performance of the company and its stock, foreign investors need to be concerned about currency risk. Currency risk is the risk of an investment losing value because of changes in the value of the foreign currency. For example, if you invest $1000 in a European company when there is a one-to-one exchange rate between the Euro and the dollar, you would have made a 1000 Euro investment. Assume the investment increases by 5% to 1050 and you choose to sell. If the exchange rate is now $0.85 per Euro (a strong dollar), your 1050 Euros will get you $892.50. So, even though your investment returned 5%, you actually lost money on the investment because of a change in the currency. Of course, the opposite can be true as well; if the dollar weakens during the period of investment, the return on investment increases.
The other major concern for U.S. investors is the amount of goods and services the country exports to other countries. The U.S. is a major exporter of products to countries around the globe, so U.S. companies and the U.S. economy are often dependent upon foreigners being able to purchase American goods and services. When other economies struggle, decreasing the disposable incomes and capital expenditures of those countries, the effects are often felt at home. In some cases, such as the Japanese collapse during the 1990s, the U.S. government can step in and boost up the foreign economy with investments or credit.
The European Central Bank is analogous to the Federal Reserve Bank of the United States. Therefore, the ECB attempts to maintain price stability for the currency of the European Union, the Euro. The central banks of the member nations of the EU are all part of the larger ECB system. Like the Fed, the ECB influences interest rates by controlling the rate at which member banks may borrow from the ECB.