By: Investor Solutions, Inc.
Have you spent your greenbacks in Europe lately? If you are an American and have recently traveled to Europe, you can attest to the fact that your U.S. dollars bought you far less wine, cheese and souvenirs than ever before. At last count the Euro was trading at 1.31 against the U.S. dollar (or the inverse: one U.S. dollar bought you a crummy 0.76 Euro). Since 2002, the dollar has lost over 35% of its value, as compared to the Euro. As an investor, should you worry? What can you do to help protect against currency weakness?
Overview of Economic Impact
Before we begin talking about the dollar in terms of your investment portfolio, let’s cover some basic economics. There are three culprits that are fueling the currency challenge. The growing national debt, budget deficit and trade surplus are the primary contributors to our dwindling currency value. While interest rate hikes by the Fed have helped mitigate the dollar’s modest slide recently, the general pattern of the dollar has been to descend in value. However, the decline is nothing as compared to the dizzying two-year slide in 2004, down from its abnormally high levels in 2000-2002.
As consumers, a falling dollar makes imports more expensive-that’s bad. On the bright side, a weakening of the dollar actually benefits U.S. manufacturers by allowing them to export goods abroad more cheaply. This can help them compete more effectively against foreign competition, which (in theory) would be positive for the U.S. trade imbalance. Furthermore, you could argue that cheaper U.S. exports could possibly attract more foreign investment in the U.S. businesses which may subsequently promote more economic growth and create new jobs.
The biggest economic impact the falling dollar might have is that foreign investors holding U.S. securities and debt instruments are garnering lower returns for their investment, once it’s converted back to their local currencies. This could have devastating effects on U.S. financial markets if foreign investors decide to withdraw their money in droves. But, that is a worst case scenario and I’m not trying to make predictions (considering I’m not an economist). I’m simply considering the possibilities.
Despite its recent weakness, the U.S. dollar is still the most important currency in the world’s currency markets. The fact is that much of the business is conducted in the global marketplace is carried out in U.S. dollars and many foreign currencies are tied to the U.S. dollar. And while there is a growing trend demonstrating a shift toward Euro-denominated international bank deposits, a large percentage of international banking deposits are still held in U.S. dollars. Therefore, I am comfortable in predicting that a total bust of the U.S. dollar is highly unlikely.
The Dollar’s Slide
The Euro is not the only currency that the U.S. dollar has shown weakness against. The British pound, Canadian dollar and Yen have also show strength when compared to the greenback. The chart below depicts a one year period of the dollar’s decline against the Euro.
You have to ask yourself, since the dollar is shrinking in value, should you invest any differently than you did before? Well, that depends.
If you are like many of the investors that I encounter, you are likely to have sizeable concentrations in domestic (specifically large cap and mid-cap) securities, with very little foreign exposure. If you fall into that group, then you should consider some foreign alternatives. If however, as an enlightened investor you’ve been exposed to the benefits of Modern Portfolio Theory early, I trust you’ve already realized the tremendous positive impact that low correlated assets (i.e. small, value, foreign, foreign small/value) can have on your portfolio. The global portfolio that we have long advocated, consisting of 50% U.S. based securities and 50% foreign securities have certainly reaped enviable performance over the last several years.
Funds that invest in international securities can actually help protect investors from a falling dollar. All other things equal, if the currencies of the foreign markets you are invested in (i.e. Euro) strengthen while the dollar continues to fall, these investments will be worth more when converted back into dollars. What a great way to hedge the greenback.
But currency protection is not the only reason to consider overseas investments, and I’m certainly not advocating any market timing strategies. After all, I’m a passive kind of girl. Instead, foreign positions should be owned for the value they bring to your portfolio (risk control and return maximization). Long term investors should defy the temptation to chase global performance, and should not be alarmed by short term movements in the dollar.
While the U.S. is still the largest market in the world (as measured by market capitalization), investors who exclude international markets are missing out on half of the investment opportunities available to them in the global economy. An easy way to attain this foreign exposure is through un-hedged international index funds. But, here is a word of caution. Most “global funds” don’t offer true international exposure. In fact, many global funds often hold half the portfolio in U.S. securities. If you own a global fund but were hoping for pure international exposure, you may want to reevaluate your position.
As we’ve discussed, the weakening dollar can have far reaching impacts. Shopping in Europe is just not as fun as it used to be. So ladies, if you find a fabulous pair of Manolo Blahnik stiletto heels next time you’re in Paris, consider waiting until you find them in New York instead.
Yes, we might have to wait some time before the dollar bounces back and Europe is once again affordable. Big deal. Just try not to let short term currency fluctuations influence the way you invest. Over time everything gets sorted out into the averages. You should always maintain exposure to foreign currencies, whether or not the dollar is going up or down. If anything, these times should serve as a reminder of the benefits of global diversification-nothing more.