Make a Buck off a Sagging Dollar

published 7 January 2010

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.

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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.

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.

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%.

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.

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.”

The case for other commodities, including energy and base metals, such as copper and aluminum, is similar. Like gold, these hard assets are priced in dollars but consumed globally. When the value of the dollar declines, commodity prices automatically increase, creating a useful hedge against a weak dollar and inflation. Over the next decade -- as in recent years -- demand from emerging markets will drive commodity prices. T. Rowe Price calculates that emerging nations accounted for more than 80% of the new demand for natural resources over the past decade. So investing in commodities is an indirect way of investing in developing countries.

T. Rowe Price New Era (PRNEX), managed by Charlie Ober, invests in stocks of natural-resources companies. It gained 44.8% in 2009 and has produced a fine long-term record as well. Indexers have an intriguing ETF alternative in market vectors RVE Hard Assets Producers (HAP). This global commodity-stock fund provides exposure to energy, agribusiness, precious metals and base metals. It appreciated 46.1% in 2009.

When it comes to hedging a shrinking dollar with stocks, you have two choices: You can buy shares of foreign companies, or you can invest in U.S. companies with large overseas operations. Both strategies have merit. The earnings and assets of foreign companies are denominated in local currencies. When those currencies appreciate against the U.S. dollar, U.S. firms that generate substantial revenues and profits outside the U.S. benefit from a declining dollar when the foreign earnings are translated into greenbacks. Whichever tack you take, we suggest you favor exposure to emerging markets, where economic growth is strong and consumer markets aren’t yet saturated.

Bank of America Merrill Lynch has found that 40% of the profits for companies in Standard & Poor’s 500-stock index are generated abroad. Merrill says stocks with large overseas footprints that still sell at attractive prices include Coca-Cola (KO), Nike (NKE), Omnicom Group (OMC), Avery Dennison (AVY) and Becton, Dickinson (BDX). If you prefer investing through a fund, consider Jensen Portfolio (JENSX), which invests in blue-chip growth companies, such as Procter & Gamble and Oracle. Half of the revenues of Jensen’s current holdings come from abroad.

If you like investing in companies that regularly raise their dividends, you’ll love Matthews Asia Dividend (MAPIX). Manager Jesper Madsen says stock yields are higher in Asia than in the U.S. and that earnings and dividends in Asia are climbing much more swiftly. Investors in the Matthews fund are essentially buying assets and rising income streams in 13 currencies, including the yuan and South Korean won, many of which should appreciate over time. The fund gained 48.0% in 2009, after losing a relatively modest 26.0% the previous year.

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