The dollar is a long-term basket case - as measured by the U.S. Dollar index, which values the dollar against a basket of foreign currencies, the dollar is roughly half as valuable as it was in the mid-1980s. How far it may fall, and how fast, of course, is impossible to forecast. In the near term, a serious flare-up in the Eurozone could cause the dollar to spike temporarily, for instance. How should planners play this dollar uncertainty to ensure the best outcome for clients?
"One thing is certain, planners can no longer ignore currency risk," says Axel Merk, president and chief investment officer of Merk Funds, the Palo Alto, Calif.-based group of currency mutual funds. In addition to currency considerations, there are macroeconomic complications planners need to factor in as well when designing portfolio strategies because fluctuations in currencies have an impact on the wider economy.
It helps to take a larger look at what the weaker dollar means to the U.S. economy, for example, before drilling down to the impact on any given client's portfolio. Whether a weaker dollar is good or bad for the U.S. economy is the subject of much debate. Industries and consumers heavily dependent on imported commodities like oil will face inflation when the dollar weakens. But exporters will find their global competitiveness has improved.
"An orderly decline of the dollar is a good thing," argues economist John Canally Jr., senior vice president and investment strategist at LPL Financial. Canally notes it is particularly welcome news for exporters who find their products become cheaper in the local currency. The expanding export sector will improve the U.S. employment picture, but he also cautions the decline could lead to higher inflation. "The weaker dollar could be passed through to consumers, but the reality is the pass-through is not straightforward or on a one-to- one basis," he says.
Not every analyst is so sanguine about the prospect of low inflation in the U.S. if the dollar keeps weakening. "That's what the government would like you to believe, but U.S. consumers are like a frog in a slowly boiling pot," says Merk, citing potential increases in the cost of oil and other imports that would result from a lower dollar. He adds, "Inflation is a most cruel tax, even if you don't notice it immediately."
Planners have many approaches to playing the uncertain dollar, beyond explicit hedging of currency risk in their portfolios. Most approaches hinge upon the forecast that the dollar will keep declining against the currencies of developing countries, regardless of what happens to the euro.
Brian Gendreau, market strategist with Cetera Financial Group, says, "The falling dollar is good for certain sectors, like energy and technology, and to a lesser extent manufacturing." He notes that most U.S. large-caps are globalized companies, and they too could potentially benefit. His favored method of implementing this point of view is through sector ETFs.
Gendreau, who is also a finance professor at the University of Florida, notes that the dollar doesn't have to keep declining to make this strategy work. "The fact that it has already weakened makes export sectors that more competitive," he says.
Tim Knepp, chief investment officer of Genworth Financial Asset Management, agrees: "Planners would be well served by having exposure to equities of companies that are selling into markets outside the U.S., particularly emerging markets." A weak dollar is part of this story, but beyond this the growth of emerging market economies and their new middle classes makes these equities all the more appealing, he argues.
DEBT IN RUPIAHS AND REALS
Equities, however, can be subject to dramatic sell-offs. A less volatile approach is to invest in foreign fixed income. High-yield foreign bonds offer attractive returns relative to Treasuries, and perhaps some safety as well - as long as you don't anticipate a foreign recession.
Ben Marks, president and chief investment officer of Marks Group Wealth Management in Minnetonka, Minn., for instance, favors emerging market debt of countries like Brazil or Indonesia, priced in the local currency. "It pays a higher yield and is consistent with our outlook for a weaker dollar," he says. "As these foreign currencies appreciate, it will benefit this strategy."
Of course the most direct hedge against a weakening dollar is to buy foreign currencies outright. "The problem financial planners face is the dollar may be weak but other major currencies aren't appealing either," says Giulio Martini, chief investment officer of currency and quantitative strategies at AllianceBernstein. The euro has serious structural problems and may not survive in its current form. The yen, too, has a limited future as a strong currency. The pound is essentially a "small-scale version of the dollar," according to Martini. The Chinese currency has access problems with tight capital controls by China.
What are the attractive currencies? Martini likes Scandinavian currencies, the Swiss franc and the currencies of commodity producing countries, as well as emerging economies. The currencies of this latter group of countries can be volatile. Investing in a basket of currencies or via a currency mutual fund are possible solutions.
As in all currency investing, it is important that planners adopt the right time frame. Currencies are driven by many competing factors in the short term and one challenge facing planners is not to count on the dollar weakening immediately. For those betting on a weaker dollar, Martini advises planners to look for returns "over a three- to five-year period."
THE BIGGER PICTURE
Of course disorder in currency markets is something else advisors need to plan for, at least in the short term. Despite recent deals, Greece could still leave the Eurozone, followed perhaps by Portugal. After the initial shock and upheaval, banishment of these weaker, peripheral economies which have been holding the Eurozone back, would likely result in a strengthening of the euro vis-Ã -vis the dollar.
It also makes sense for planners to consider the larger, macroeconomic framework behind the dollar's long decline. Most analysts agree that the long term weakening of the dollar can be traced in some fashion to the Federal Reserve's "easy money" approach. Merk, who is a pronounced dollar bear, says that "the dollar is being driven down, down, down, mostly because the U.S. seems to have a better printing press than the rest of the world." Of course budget deficits, the threat of inflation and global unease about the state of the U.S. economy play roles as well.
But few doubt that the weakening dollar has anything to do with keeping the fed funds rate near zero. "The relative decline of the dollar primarily has to do with Fed policies, such as low interest rates and quantitative easing," says AllianceBernstein's Martini. With U.S. interest rates so low, there is little motivation for foreigners to buy U.S. fixed income. Weaker inflows into the U.S. weaken the dollar.
One more factor driving the dollar down is the composition of the new Fed board as of January. "The dissenters are not on the board, and the Fed has an open avenue for more money printing," Merk says. A weaker dollar and rising inflation are possible results, making it all the more important for advisors to have a currency strategy in place going forward.
David E. Adler contributes regularly to Financial Planning and Barron's, and is the recipient of two CFA Institute research grants on tax-efficient investing. His most recent book is Snap Judgment.
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