After an ugly start, the past year was a good one for most kinds of investments. One glaring exception was the U.S. dollar, which steadily lost value against most of the world’s major currencies. And the dollar’s prospects for 2010 and beyond don’t look promising. U.S. economic growth is sluggish. The nation is running huge budget and trade deficits, and we don’t save nearly enough money, so we must import massive quantities of foreign capital each year to help close those yawning gaps. Over the next ten years, the outlook for the dollar is “bleak,” says Rob Arnott, who manages more than $43 billion for Research Affiliates.
The reason for Arnott’s pessimism can be summed up in a four-letter word: debt. Arnott says the ratio of all public-sector debt -- a figure that includes the debts of federal, state and local governments, as well as those of such government-sponsored enterprises as Fannie Mae and Freddie Mac that are now nestled on Washington’s balance sheet -- to gross domestic product is a towering 141%.
To understand the currency implications, consider who holds our debt. Because of the shortfall in domestic savings, foreigners hold $3.5 trillion of government IOUs and have been funding about half of Uncle Sam’s annual budget deficit, which now runs at about $1.5 trillion. “The U.S. is not yet struggling to repay debts, but at some point creditors will become concerned about where the money will come from,” says Tim Speiss, of Eisner LLP, a New York City accounting firm.
What a debtor can do
A government facing this kind of predicament basically has four viable choices. It can drastically cut spending, raise taxes or undertake a combination of the two. Or it can “monetize the debt,” which is econo-speak for printing more money to help repay a mountain of principal and interest. (A fifth option, defaulting on our debt, is unthinkable.)
Some tax increases and spending cuts are certainly possible. But, politicians being politicians, we’ll wager that U.S. policymakers prefer the politically expedient path of printing money aggressively to monetize the debt. As with other products, money loses value when you produce too much of it. That implies that the currency will be debased even further, eventually resulting in higher inflation (which will make it easier for the U.S. to repay debts) down the road.
If the government is successful, the dollar’s fall will be orderly, maybe 3% to 5% a year. But there is a risk that a steady decline could turn into a rout. Of course, as with any other investment, short-term performance is almost impossible to predict. The buck could rally if traders again become fearful, as they did in late November over concerns that Dubai would delay debt payments owed by its flagship holding company. Or the dollar could appreciate if interest rates jump more in the U.S. than in other places.
The good news is that it’s easier than ever to purchase protection against a sagging dollar by investing in foreign currencies, commodities and stocks. Even if you’re not bearish on the dollar, you should still consider the benefits of diversifying your portfolio by adding some exposure to foreign economies and currencies.
If you think the dollar will fall, you must first ask, Against what? Michael Hasenstab, the ace manager of Templeton Global Bond, doesn’t find any of the other major currencies -- the euro, yen and British pound -- attractive, either. Japan, the U.K. and most of Western Europe suffer from the same ailments that afflict the U.S.: mounting government debt, stagnant economies and aging societies. Hasenstab prefers the currencies of developing nations with strong financial positions, such as China and Brazil, and such commodity exporters as Chile, Malaysia and Indonesia.
From Poland to Mexico
You can invest in emerging-markets bonds through Pimco Emerging Local Bond (symbol PLBDX), run by Mike Gomez. Pimco invests in 15 markets, including Poland, South Africa, Mexico and Thailand. Over the past decade, says Gomez, who is based in Munich, bonds denominated in emerging-markets currencies have been compelling alternatives to emerging-markets stocks. The bonds have returned nearly as much as the stocks but with only one-fourth the volatility. Gomez says that about 40% of his returns stem from currency gains; the rest flow from gains on the bonds (of course, the bonds could lose value if local interest rates rise or if an issuer defaults). The fund’s Class D shares, which are available without a sales charge through many discount brokers, returned 30.3% in 2009 after losing 11.1% in 2008, and recently yielded 5.2% (all 2009 figures are through December 4). Annual expenses are 1.35%.
For a lower-cost alternative, consider WisdomTree Dreyfus Emerging Currency Fund (CEW). This exchange-traded fund, launched last summer, uses futures contracts to provide exposure to money-market rates of 11 emerging-markets currencies, including the Polish zloty, Chinese yuan and Chilean peso. The currencies are equally weighted and rebalanced quarterly. The fund’s annual fee is 0.55%.
Gold is tough to value. It has no intrinsic value -- meaning that unlike other financial assets, it doesn’t produce a stream of interest or dividends. But consider the environment in which this classic indicator of fear and loathing typically flourishes: excessive expansion of the money supply; large fiscal stimuli and big deficits; lack of faith in a government’s policies and a nation’s currency; rising inflationary expectations; and low or negative real interest rates on short-term investments. In 2009, the year of the latest gold rush, when bullion’s price soared 34%, at one point exceeding $1,200 an ounce, all of these conditions applied.
Can gold continue to glitter? In our view, yes. Martin Murenbeeld, chief economist for DundeeWealth, a large Canadian fund manager, has done research that shows a strong correlation between money-supply growth and global liquidity on the one hand and high gold prices on the other. Economist Ed Yardeni notes a link among high U.S. deficits, debt and gold prices.
Consider gold an insurance policy against further degradation of the dollar. Central banks can print money, but not gold. That’s one reason that India and other developing countries with bulging foreign-exchange reserves are diversifying out of dollars and buying some gold. “Gold has been rising against all currencies,” says John Hathaway, manager of Tocqueville Gold Fund. “I wouldn’t be surprised to see gold prices double in three years.”
When investing in gold, your main decision is whether to buy bullion or mining stocks, which are more volatile than the metal itself. The rise of ETFs that track the price of gold has made it easy to invest in the metal without actually taking possession of it. The gold standard in this category is SPDR Gold Shares (GLD). It returned 37.1% in 2009 and an annualized 21.1% over the past five years.
Funds with strong track records in owning gold stocks include USAA Precious Metals and Minerals (USAGX), Tocqueville Gold (TGLDX) and Vanguard Precious Metals and Mining (VGPMX), a low-cost fund that allocates half of its assets to precious-metals miners and half to miners of industrial metals. In 2009, the funds returned 69.4%, 89.8% and 79.7%, respectively.