European Vacation? More Expensive Now, But…

If you booked your European vacation six months ago, your travel budget may get less respect than an American asking directions in broken French.  True, the dollar-euro exchange rate will make your excursion to castles, cathedrals, and cafes a bigger economic event than you planned, and a $100 bill may no longer cover a nice meal for two, but at least your European stock investments should be having the “time of their life”, like a tourist joyfully climbing the Eiffel Tower, easing the hit to your bank account as the dollar “went on vacation” from being a strong currency over the last six months.

Euro strength may be getting most of the headlines, but US dollar weakening against most currencies proved true recently.  With the currency effect additive to international equity returns for US investors, the changing exchange rate contributed 850 basis points to dollar-based foreign equity returns for the first half of 2025.  Major currencies strengthened against the greenback. Not only the euro (+13.84%), but also the Swiss franc (+14.41%), British pound (+9.71%), and Japanese yen (+9.15%).  A move to this degree represents a rare event, for sure.  You have to go back to 2009 to find a two-calendar-quarter dollar slide of comparable magnitude.  This move confused many since interest rate differentials no longer appear to be the driving force behind the dollar’s direction.  Instead, there’s been a reassessment of the structural risk premium brought on by mounting US debt concerns as well as new, seemingly erratic tariff policies.  US efforts to change the international trade order induced reticence by foreign investors to add to US assets thus far in 2025.  Important due to the high reliance on foreign capital to finance the US net international investment position, this NIIP deficit stood at $24.61 trillion as of March 31, 2025, amounting to 85% of current GDP.  A slowing of the global flow of capital to the US puts pressure on the dollar.  The euro appears to be the primary beneficiary due not only to the better goods and services trade balance (‑$918 billion for the US in 2024 versus +$160 billion for the EU), but also Europe’s lesser fiscal deficit as a percent of GDP (7.0% for the US in 2024 compared to 3.1% for the EU).

While the first half of 2025 reset the dollar’s value against the world’s currencies based on a reappraisal of structural factors, this may not continue in the short-term.  Indeed, it’s possible we could see a dollar recovery or partial snapback depending on the degree of trade deficit improvement from newly implemented tariffs.  That said, we believe longer-term negatives will continue to weigh on the dollar.

Source: ICE U.S. Dollar Index

One key trend is the de-dollarization of central bank FX reserves.  Many foreign countries hold foreign exchange reserves through investment in our US treasuries, agencies, and corporate debt.  Back in 1978, the dollar’s share of foreign reserve currencies stood at 85%, but it has fallen to less than 58% as of the end of 2024.  The decline accelerated over the past three years due to the US blocking Russia’s access to the SWIFT system, basically freezing $300 billion in Russia’s reserves.  Other countries took note, fearing this action if they upset the US, and started to trim their own dollar reserves.  Other than the decade of the 1990s, the dollar has steadily declined in its proportion of the world’s total currency reserves, dropping a little less than 1% a year over the past 10 years.  Interestingly, the introduction of the euro in 1999 stopped the dollar’s climb as the world’s reserve currency in the ‘90s decade.  We don’t yet know the extent of the fall in the dollar’s share of foreign currency reserves in early 2025. The IMF COFER data is not yet available, but it’s a safe bet the decline accelerated.  The introduction of reciprocal tariff day in early April appears to be a watershed moment, possibly eroding other nations’ trust in America as the cornerstone of the global economy.

Many correctly argue there’s not a legitimate replacement for the US dollar as the king currency for reserves.  Other currencies, with the possible exception of the euro, lack the greenback’s market liquidity, extensive usage in international transactions, and are based on weaker economies as well as markets with less stable financial institutions.  That said, we note the foreign currency reserve statistic, as the moniker implies, only applies when countries hold reserves in foreign currencies, not their own currency. While global trade expanded 75% over the last 10 years to $33 trillion, currency reserves have changed little, up less than 6% to $11.7 trillion.  Clearly, countries globally opt for less US dollar currency reserves in proportion to their trade base.  Notably, dollar aversion induced many central banks to stock up on gold.  Viewed increasingly as a better safe-haven compared to the dollar in this age of increasing geopolitical tension, central banks accumulated gold over the last three years at a pace not seen in modern history, adding more than 3,200 metric tons through the end of 2024.  Total bank reserves in gold, estimated to be 37,755 metric tons, now accounts for an estimated 18% of total reserves.

Another reason for less need to hold dollars is the continuing shift toward the use of other currencies in global trade.  Here the dollar has been much more stable over the last decade, but recent developments suggest a change underway.  We’re seeing countries in Europe, South America, and especially Asia moving away from dollar-based trade.  Notable non-dollar trade examples include transactions between Brazil and China, and Saudi Arabia and China, which no longer use the greenback-based petrodollar for energy transactions.  ASEAN countries, historically using the dollar exclusively, now use local currencies.  Further, we think the upcoming EU–Mercosur trade deal may shift Europe–South America trade toward the euro as the principal currency.  These developments and other factors led David Roche, a former Morgan Stanley strategist, to predict an overall 15% to 20% depreciation of the dollar over the next five to ten years.  While not placing too much reliance on the accuracy of this prediction, we think he has the underlying trend correct.

As tariffs will likely lead to some decoupling between the US and Europe as well as the US and Asia, we expect Europe and Asia to grow stronger through greater trade connectivity with each other.  In particular, European importers benefit from the stronger euro which makes commodities and other inputs cheaper.  We note the largest economies in each region – China and Japan in Asia and Germany in Europe – enjoy ample liquidity which should continue to be a favorable backdrop for risk assets.

As to that European vacation, why not go on holiday in the USA?  Explore a new US city, hike one of the many beautiful, majestic US national parks, or take that trip to tropical Hawaii.  Your dollar will go further.  Let your European stock investments have the fun in Europe.

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