The tide has turned against the U.S. Dollar. The dollar rose during the crisis as it became a refuge for investors seeking safety. Now, investors are worried that their life raft is springing leaks. And rightly so, for in Thursday’s article titled “Is the Almighty Dollar Dead?” Columnist Dan Burrows says:
It's an axiom of economics that debtors love inflation. The flip side, or course, is that creditors despise it. Why lend money today only to get paid back in devalued bucks tomorrow? That spells trouble for the almighty dollar -- and puts pressure on investors to hedge against it’s almost certain further decline, market professionals say.
I have written previously on Seeking Alpha that the US Government has borrowed massively and devalued the dollar. Over the past decade, the declining dollar has yielded foreign investors a negative real rate of interest. No wonder our foreign creditors are heading for the exits. In his Smart Money column, Burrows goes on to say:
True, the dollar is by no means dead -- but it's certainly wounded and the prognosis for the next few years looks likely to keep the world's reserve currency in the intensive care ward. It's not hard to see why. As the U.S. government goes hat in hand borrowing money to fuel unprecedented deficits, the rest of the world (our creditors) is understandably concerned.
After all, more than 50% of the world's debt is denominated in dollars. As the greenback falls, those creditors, most notably China, get paid back with something much less than they bargained for. Indeed, the U.S. Dollar Future Index, a measure of the greenback against a basket of major currencies, has crumbled nearly 11%, to less than 80, from a 52-week high of more than 89 in early March. That might not sound like much, but it has some pros feeling certain that a full-blown currency crisis is only a matter of time. [emphasis mine]
This is not merely the opinion of a financial columnist, it is Government Policy. Ben Bernanke, in his Nov. 21st 2002 address to the National Economists Club in Washington DC said:
"inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation."
Burrows goes on to say:
Keith McCullough, chief executive of ResearchEdge, a New Haven, Conn., research firm, says a currency crisis is all but inevitable. "The first 10% of the correction is fine," McCullough says, "but once you get below the 81 line on the U.S. Dollar Index, I call that crashing the buck." [emphasis mine]
In the shorter term that's worked out well for equity investors -- the weaker dollar is reflating their 401(k)s, McCullough says. After all, paltry interest rates and a weak dollar make equities more attractive than cash or overpriced bonds in such a scenario. A weak dollar also boosts exports and corporate revenue generated overseas. But eventually the dollar's decline will come back to eviscerate folks' portfolios. "People don't understand the correlation between the bond market, the currency market and the equity market," he says. "You have the stunning confluence of a crashing Treasury market and a crashing currency market. This hasn't happened before. The stock market is the one market that hasn't been affected yet, but it's just a question of when."
What Does This Mean For Investors?
I agree with McCullough on most points. I agree that a declining dollar will depress the US Bond market and increase interest rates. I just don’t buy the connection that this will also crash the US equity market. A weak dollar is a plus in some ways and a negative some ways for US Equities. Certainly rising interest rates will hamper a recovery in stock prices. But, because nearly half of the S&P 500 profits are generated overseas, a weak dollar helps boosts exports profits generated overseas. As a further plus for U.S. Equities: these overseas profits are magnified when they are converted from stronger currencies into a weaker dollar.
The outlook for US Equities is a moot point. For those nervous about the near term future of U.S. Equities (including the Author), one can stay invested in equities and still hedge against a declining dollar by investing in Non-U.S. assets. Paradoxically, the decline in the dollar will have the opposite effect on foreign firms. Because their currencies are more expensive, their exports will suffer. However, their earnings and dividends will be produced in stronger currencies, which have appreciated against the dollar.
Since I don’t agree with all the recommendations made by the commentators in Dan Burrow’s article, I’m not going to repeat them here. You can read the full article “Is the Almighty Dollar Dead?”
It doesn’t hurt to have significant exposure to Non-US Denominated Assets. It hedges against the risk of a significant US downturn, and a significant drop in the dollar.
I am a fan of ETFs, because of their lower expenses and their superb tax efficiency. If you are new to international investing, the first place to start is with broadly diversified low-cost index funds with low turnover and rock-bottom fees. The following market-cap weighted funds are well-diversified and some of the least risky ways to invest overseas:
Index Funds Of Equities Throughout The Developed World
- iShares MSCI EAFE Index (EFA)
- Vanguard FTSE All-World ex-US ETF (VEU)
- Vanguard FTSE All-World ex-US Sm-Cap ETF (VSS)
Index Funds Of Equities Throughout Emerging Markets
Disclosure: Author holds none of the positions mentioned above. Author is long U.S. Equities & Real Estate, Foreign Developed Equities & Emerging Markets Equities, TIPs and WIP.