Don't Get Crushed by the Falling Buck
The dollar's decline has a lot of people scared. How to protect yourself without overreacting
(MONEY Magazine) – It was starting to look like the coast was clear. We've seen some good economic news lately: Corporate earnings growing at a double-digit pace, interest rates staying near historic lows, and even some long-overdue job growth. But now here's something new to worry about. In December the value of the dollar touched an all-time low against the euro. Sure, the dollar's been dropping steadily since 2002. (It's worth 35% less vs. the euro than it was back then.) But some market pros and even former Fed chief Paul Volcker warn of worse. If the slide in the greenback goes too far, too fast, it might not just blow up your portfolio. You could also face sky-high mortgage rates and a climbing cost of living. In other words, ugly all around.
So just how likely is a dollar doomsday scenario? As you'll see, the worst might actually be over. But there are some prudent steps you can take to keep from worrying about it.
Why the buck is down—and why that's dangerous The international currency market is dazzlingly complex, and experts can argue endlessly about what's really driving the dollar's decline. But here's the standard take: In the eyes of the rest of the world, Americans are starting to look like savings-challenged, credit-addicted gluttons. We consume more stuff from the rest of the world than we sell back to them, resulting in an annual trade deficit set to top $600 billion. We've racked up $2 trillion in consumer debt, and the federal budget deficit stands at over $400 billion.
What all this adds up to is that we've borrowed a lot of money from foreign investors—most notably China. About 40% of U.S. Treasuries, for example, are held by foreigners. If those investors start to think America is overextended, they may sell a lot of those assets, in the process selling dollars as they convert the money back into their own currency. Investment flows into the U.S. have already begun to weaken, and the currency market may be driving dollar prices down in anticipation of more of the same. "The foreign exchange market is basically saying, there's something about the U.S. economy that we do not like," says Arun Motianey, director of research for Citigroup Private Bank. This could set off a vicious cycle: Foreigners make less on dollar-denominated assets when the greenback falls, and that could prompt them to cut back their investment even further.
Here's how that hurts. For one thing, we could see higher interest rates. If non-U.S. investors sell enough bonds to push down prices, the yield on those bonds will rise. Lenders base their rates on bond yields, so that means everything from mortgages to credit cards to business loans will cost more. A cheap dollar also raises the cost of all that stuff we're importing, which could trigger inflation. "The entire American standard of living is artificially high right now, resting on the ability of Americans to borrow money from foreigners," says Peter Schiff, president of Euro Pacific Capital. Schiff worries that we could be headed toward an early-1980s-style recession with double-digit inflation, unemployment and interest rates.
The case against doomsday That's pretty scary. But plenty of investing pros think the dollar bears are full of it. "I don't want to be Pollyanna-ish, but we don't share their angst," says S. Kenneth Leech, chief investment officer of Western Asset Management. Indeed, he expects the cheaper dollar to boost U.S. exports, thereby narrowing the trade deficit and alleviating some of the currency market's concerns.
Western Asset Management is the world's fifth-largest bond investment firm, so Leech's opinion on the buck carries some serious weight—he's got a lot to lose. And as far as he's concerned, we've just seen a necessary correction. The dollar went through the roof in the late 1990s because the U.S. economy boomed as growth in the rest of the world stalled. Now that the global economy is healthier, overseas investors are more willing to invest beyond the U.S. In other words, they aren't running away from the greenback—they're diversifying. "In our judgment, the large move is behind us," says Leech, who profitably bet against the dollar last year.
The wild card in all of this is China. The dollar is still strong against that country's currency, the yuan, because the Chinese government has kept the exchange rate fixed. Schiff thinks this is "unsustainable"—he notes that the weak yuan has helped set off high inflation within China—but other observers say they have a hard time imagining China abruptly pulling the plug. It would run contrary to China's core economic development policies, says Milton Ezrati, senior economic strategist for Lord Abbett mutual funds. The Chinese prop up the dollar not because they love America but so we'll keep buying their blue jeans and DVD players.
How to sleep more soundly For a start, remember that a falling dollar is only a serious problem if it happens too fast. If you have a blue-chip stock fund, many of the big U.S. companies you own stand to gain if a cheap dollar opens up overseas markets to their products. That said, the big dollar swings we've seen are a reminder of how important international and inflation-hedging investments can be to a well-diversified portfolio. Since these assets often gain when the broad U.S. market falters, they'll smooth out your returns over time. What's more, they may do best just when higher interest rates and retail prices are pinching your pocketbook.
So whatever the dollar's near-term prospects, these four investment strategies make long-term sense:
• FOREIGN STOCKS Many financial planners say that, as a rule of thumb, you ought to have 10% to 15% of your portfolio in non-U.S. stocks. The currency play is just one part of the appeal. Many overseas markets look cheaper than ours based on price-to-earnings ratios, and they often follow a different economic cycle to boot. But when the dollar drops, an American investor who holds a stock that's denominated in euros makes money even if the share price doesn't budge. The simplest way to get the diversification benefit of foreign stocks is through an international fund that doesn't hedge its exposure to overseas currencies, such as Artisan International (800-344-1770). Just remember that foreign funds aren't a perfect haven from dollar drops, since the stocks can still lose money even after you account for currency moves. That's exactly what happened in 2002, when the greenback fell and foreign funds still racked up double-digit losses.
• FOREIGN BONDS If most investors could benefit from a foreign-stock fund, overseas bonds offer a somewhat narrower appeal. They can be a much more direct bet against the dollar than the equity funds, since a greater portion of their return may come just from currency swings. (After all, the bonds themselves will generally have fairly modest gains or losses in most years.) The problem is that many international bond funds hedge their currency exposure, eliminating some of the advantage when the dollar falls. One fund that stays mostly unhedged is American Century International Bond (800-345-2021). Foreign bonds could be 20% of your bond portfolio, says Andrew Clark, a senior analyst at Lipper.
• HARD ASSETS Remember, one of the risks of a weak dollar is rising prices. Commodity investments are classic inflation fighters, and many planners recommend a 5% to 10% allocation in one. Pimco Commodity Real Return Strategy (866-746-2602) fund tracks an index of commodity contracts, benefiting directly from rising prices for oil, precious metals and agricultural goods. This can be a volatile investment—in 1998 the index Pimco tracks dropped about 30%—so it's suited only for those with plenty of stomach for short-term risk. A more conservative way to make a similar bet is Charles Ober's T. Rowe Price New Era (800-638-5660), which invests in the stocks of commodity producers like mining companies and oil conglomerates.
• INFLATION-PROTECTED BONDS The most straightforward hedge against inflation is inflation-protected Treasuries, or TIPS, which are designed to automatically pay more income as the consumer price index rises. You can buy them directly by going to treasurydirect.gov, or get an entire portfolio of them through Vanguard Inflation-Protected Securities fund (877-662-7447). TIPS are a pretty conservative investment, so if inflation and the falling dollar really worry you, you can consider making them the lion's share of your overall bond portfolio.