“Ev’rybody’s try’n to hide, to getaway from that stormy sky. Perhaps it’s a sign of what we’re headed for” – Ray Davies, the Kinks
Due to the recent credit rating downgrade of our nation’s debt from AAA to AA+, and the subsequent plunge in stock prices, attention has turned to the Federal Reserve’s meeting on September 20th, to support financial asset prices with some form of monetary stimulus. Typically with a rating downgrade, the cost of borrowing goes up. However, here in the US the opposite holds true; interest rates have declined in part because investors know the US has both the ability and willingness to issue more debt to pay off any bondholder keen on lending to a country addicted to debt and consumption. So, the true by-product of this mostly symbolic action of a rating downgrade is further deterioration in the US dollar. For US residents this means currency debasement.
According to a white paper recently published by Merk Investments, nearly 90% of the average US personal investor's assets are exposed to US dollar risk. To comprehend fully the adverse effects of currency debasement, let’s examine the following scenario. Assume you’re fifty years old, plan to retire in ten years and travel. You have assets you want to protect and decide to follow Vanguard founder John Bogle’s advice, using your age as a percentage of assets to invest in bonds. You decide on a ten-year US Treasury bond for half of your portfolio.
For illustrative purposes, let’s make a few assumptions:
- Your principal amount invested is US$100,000; the coupon rate is equal to the yield on the bond; and you’ll hold the bond to maturity
- For the sake of simplicity, you’ll use all the semi-annual coupon/interest payments to pay for current living expenses
- The US dollar’s performance against a basket of currencies will be identical to the previous ten years (from 6/2011). The dollar, as measured by the Federal Reserve, depreciated by nearly 32% (inflation adjusted) over this time period.
Ten years later, the bond matures and your $100K (US$) principal investment is returned. The money looks, smells, and feels like a hundred grand, but is it? You’re excited to be in retirement, and kick off your travels by going skiing in Canada. But on arrival you find that one US dollar (US$1) buys you only sixty-eight (C$0.68) Canadian cents - not even close to the dollar it bought ten years ago in 2011 (e.g. the Canadian and US dollar traded at parity on 1/20/2011). You’re perplexed, frustrated, and angry and ask yourself: why has my buying power collapsed?
As you’re driving towards the mountains, you see a billboard with a larger than life image of jolly Uncle Sam skiing and the slogan:
~ Buy US Bonds ~ “Think of Yourself Ten Years from Now” (from an original 1936 US Savings Bond advertisement)
Theater of the Mind - Illustration #1 – (similar in style to the old wartime savings bond posters) Uncle Sam skiing in an oversized, red, white, and blue ski sweater, while sporting his classic top hat and vintage Jean Vuarnet sunglasses – snow and cash flying everywhere as he flies off a cliff.
So, in essence, you lent the US government $100,000 dollars (US$) and in return ten years later, the treasury pays you $68,000 dollars (US$) in purchasing power. That is but one bitter taste of currency debasement.
Short-term bliss in exchange for long-term pain
More dollars in circulation will eventually work their way into a productive asset. Put another way, surplus dollars will be used to purchase assets, such as stocks and commodities. Not only do these assets become inflated, but this wealth effect and the higher level of spending contribute toward prices being bid up, just like what you’re seeing currently at both the pump and grocery store. Regardless of whether you travel outside the US, the meat, coffee and vegetables on your dining table, along with the gas in your tank, are costing you more money - that is but one consequence of printing money with the dial on infinity. In turn, price inflation forces interest rates higher, which takes us back to the root of the problem - issuing $2.3 trillion dollars in debt obligations and money creation. With higher interest rates comes more expensive debt service. In other words, the surplus dollars in circulation force the dollar exchange rate lower while eventually pushing interest rates higher, inevitably leading the US Treasury to issue more expensive debt to cover its liabilities. Higher borrowing costs siphon money from a potentially productive use to one that now results in a dead-end.
Unless Ben Bernanke can influence leaders in Congress to enact fiscal discipline, rein in check writing on Uncle Sam’s account, and get lucky with a US economy that provides real, sustainable economic growth, the vicious cycle continues. Investors holding primarily US dollar-based assets are at risk of holding a portfolio that may appreciate in nominal price, but is denominated in a currency that, given current policy, will likely debase most or all of your portfolio return, providing you little or no real growth in your assets. By holding only US dollars, you’re betting on both a Fed Chairman and a Congress to win the race to sound economic policy and rock-solid fundamentals.
Theater of the Mind - Illustration #2 – wide-eyed Ben Bernanke as a downhill skier, his face bulging out from a dome-style ski helmet with a logo above his forehead that reads “
AAA AA+”. Both arms and one-leg flailing, while one ski remains on the icy course.
Think of owning mostly US dollar-based assets in the same context as owning one stock. By holding concentrated stock you incur elevated levels of risk, primarily event risk (i.e. risk of a severe decline in the market price of an asset arising from an unforeseen occurrence). Say, for example, you own only Merck (MRK) shares, and you wake up one morning to the news that the company has been charged by the FDA with fraud and negligence in a multi-billion dollar product liability suit. Consequently, your shares drop like a stone and so does your wealth. Holding only US dollar-based assets has many of the same risks; suppose a new currency regime gains momentum and supplants the US dollar as the world’s reserve currency; or after years of debt and money creation, inflation roars from 3.60% to 9%. You get the picture: by diversifying away from a concentrated US dollar-based portfolio, you help reduce the risk of a further decline in purchasing power and standard of living that are the result of a downhill slide in the US dollar.
Steps to help you diversify away from a concentrated US$-based portfolio
Let’s examine an Asset Allocation model popular among many financial advisors, and is also featured in the book The Investment Answer.
S&P 500 Index - 12%
Fama/French US Large Cap Value Index - 12%
Fama/French US Small Cap Index - 6%
Fama/French US Small Cap Value Index - 6%
Dow Jones Wilshire REIT Index - 6%
International Value Index - 6%
International Small Cap Index - 3%
International Small Cap Value Index - 3%
MSCI Emerging Markets Index - 1.8%
Fama/French Emerging Markets Value Index - 1.8%
Fama/French Emerging Markets Small Cap Index - 2.4%
Fixed Income (40%):
Merrill Lynch One-Year US Treasury Note Index - 10%
Citigroup World Government Bond Index 1-3 Years
(hedged) - 10%
Barclays Capital Treasury Bond Index 1-5 Years - 10%
Citigroup World Government Bond Index 1-5 Years (hedged) - 10%
Within Equities, 18% is in foreign stocks, and therefore the common risk element is foreign currency risk. Because the Fixed Income allocation includes global bonds without foreign currency exposure, we’ll focus there.
Fixed Income or Bond Allocation (40%):
Citigroup World Government Bond Index 1-3 years (hedged) – 10%
Citigroup World Government Bond Index 1-5 years (hedged) – 10%
Merrill Lynch One-Year US Treasury Note Index – 10%
Barclays Capital Treasury Bond Index 1-5 years – 10%
First, both Citigroup World Bond allocations, as represented by the DFA Two & Five [pdf files] Year Global Fixed-Income Funds, are “hedged”. So, if the US dollar continues to weaken, your “world” or foreign bonds won’t provide you any currency diversification benefit because the foreign currency exposure has been neutralized. Second, the Citigroup/DFA allocations hold primarily corporate and government debt of developed countries, so you’re subject to both sovereign and credit risk. In other words, by owning the “hedged” DFA bond funds, you’re retaining a majority of the risk, but are deprived of the foreign currency exposure that provides most of the diversification benefit within an asset allocation.
Within the current bond portfolio, we instead take the 20% allocation in “hedged” foreign bonds, swap them for foreign bonds denominated in local currency and assume foreign currency risk. If the US dollar continues its descent, you will benefit from holding bonds denominated in a foreign currency.
Because emerging economies provide both a stronger fundamental outlook and greater diversification benefits than their older, developed brothers, we’ll target emerging/developing market bond and currency funds. Several investment managers including TCW, Pimco, Van Eck (EMLC), WisdomTree (ELD), and Morgan Stanley (EDD) offer “local currency” bond funds.
For illustrative purposes only, we highlight the following funds:
- 1-5 Year: Pimco Emerging Local Bond Fund (PELBX)
- 1-3 year: Pimco Developing Local Markets Fund (PLMIX)
Both funds hold sovereign and corporate debt of emerging economies that in aggregate show greater overall financial strength, and higher levels of real growth than their developed market counterparts. They hold similar duration risk (i.e. a bond fund’s price sensitivity to changes in interest rates) to the DFA funds, and therefore won’t add portfolio volatility from an equivalent rise in interest rates. And last, both funds provide a pickup in yield to compensate for the foreign currency risk.
In summary, we identified key elements of risk such as sovereign and credit risks, and other important factors such as cash flow, yield, and prospects for growth. From there, we determined that the two hedged Citigroup/DFA World bond funds provide little diversification benefit, giving us more reasons to find alternative funds to improve the portfolio’s overall risk/return profile. The result: greater financial strength and higher levels of economic growth consistent with reduced levels of sovereign and credit risk; and higher yield and cash flow, while maintaining a similar level of duration risk. By decreasing the bond portfolio’s reliance on solely US dollars, we effectively lowered the event risk inherent in a concentrated US dollar position, and thereby enhanced overall portfolio diversification.
More steps to offset the effects of a weak US Dollar
Next, because the by-product of a weak dollar is higher inflation and eventually rising interest rates, let’s look at replacing the allocation “Treasury Bond Index 1-5 Years” with Treasury-Inflation-Protected-Securities (TIPS). The “1-5 Year” allocation is represented by the DFA Intermediate Government Fixed-Income Fund (DFIGX). To protect against both rising inflation and a weak dollar, we’ll target a hybrid TIPS fund holding both US dollar- and foreign currency debt. Fund managers including BlackRock/iShares and State Street/SPDR offer both domestic and foreign currency-based TIPS funds. For illustrative purposes only, let’s highlight the iShares Global Inflation-Linked Bond ETF (GTIP). (Note: you can also create your own hybrid position by combining a global TIPS fund with a domestic TIPS fund.) This fund provides some protection against both risk factors – domestic inflation and a weak dollar. The global TIPS fund provides an immediate pickup in real distribution yield, but also exhibits higher price sensitivity to a rise in interest rates. However, note that a rise in treasury interest rates is mostly driven by inflation expectations; so if rates rise, holding TIPS as opposed to a fixed-rate fund such as DFIGX, will allow you to be compensated for the higher level of prices, counteracting much of the interest rate risk.
At this point, you hold a more globally diversified portfolio, with potentially as much as 44.8% (18% in foreign stocks / 26.8% in foreign bonds) of the portfolio in foreign currency denominated assets, and most importantly, enhanced diversification and protection against further declines in the US dollar. By maintaining your modest position in One-Year US Treasuries, you retain both a diversifying agent and source of liquidity within your portfolio, while limiting your exposure to interest rate risk.
With regard to the power of currencies, and specifically the damaging effects of a spiraling US dollar, by making adjustments within a standard asset allocation, you’ve helped protect yourself from multiple sources of risk - declining purchasing power, rising inflation, and ascending interest rates - all of which ultimately cause a decline in your standard of living.