Dealing with a Devalued Dollar

We were recently asked by a client about the potential for significant devaluation of the U.S. dollar in the near future, and how we are approaching this issue. This topic has been in the headlines a lot recently, so I thought the response was worth sharing with others who might have similar questions. 

As the U.S. economy has become increasingly intertwined with the rest of the world, currency exchange rates impact us as producers, consumers and investors. A weaker dollar can be “inflationary” by making the items that we import more costly and by making it more expensive to travel abroad. On the other hand, it can also improve the competitiveness of our economy by making our exports less expensive for other countries.  

Investors in foreign stocks and bonds benefit from a weakening dollar as it allows returns denominated in foreign currencies to be exchanged back into more dollars. Likewise, the large American corporations in which we invest can benefit from a falling dollar when converting foreign income back to dollars. The net impact to any specific company or individual is not as simple as declaring that a weaker dollar is bad or good. And despite headlines that would lead one to believe that a decline in the dollar is inevitable and is bad, the future remains difficult to predict. 

So how do we position our clients’ portfolios in light of this ambiguity? First of all, we do not attempt to make short-term predictions about any market, including currencies. Our investment approach is driven by a longer-term perspective. If the U.S. continues to follow policies that are detrimental to the long-term health of the economy, we would expect to see a gradual and continual decline of the dollar versus the currencies of nations whose governments were making better decisions. 

Given the long-term expectation of a weaker dollar, one must decide (1) which alternative currencies to hold, and (2) how to gain exposure to those currencies. 

Currencies, historically, have been one of the most volatile and unpredictable instruments. Consider that as recently as early this year many experts were predicting that the dollar was headed toward parity with the Euro. In a dynamic world, policy shifts are made all the time - particularly in democratic countries - which makes it difficult to select one or two currencies to substitute for the dollar. Therefore, we diversify into a basket of currencies, including some from developed countries, developing countries and emerging countries.  

We believe that the U.S. economy is mature and will be outperformed by the latter two types of countries on an ongoing basis. There will be fluctuations, but they will occur within a definite trend. Rather than try to identify those short-term intervals that produce sharp re-valuations, we prefer to establish a more permanent position to diversify our exposure to the dollar.  

Maintaining a long term “short” position in the dollar (a bet against the dollar) can be quite expensive, so we have chosen to accomplish essentially the same thing through the use of non-dollar-denominated investments. There are three ways that we have built up that position over the last ten years. First, we have indirect exposure to foreign currencies that occur naturally through the ownership of large, global companies with a large portion of their earnings generated outside the U.S. Second, we have allocated 15% to 20% of clients’ portfolios to strictly foreign companies. Finally, and more recently, as our concern for the long term health of the dollar increased, we moved a significant portion of our clients’ fixed income portfolios into non-U.S. holdings, including some emerging market exposure. 

In summary, rather than engaging in short-term speculative bets for or against the dollar, our clients’ portfolios are permanently and naturally hedged to an appropriate degree through the diversification of their investments across domestic and foreign stocks and bonds. We believe this is the most prudent and balanced approach in the face of uncertainty.