I can always tell when the U.S. dollar is on the decline. Not so much from my daily glance at Bloomberg, but more from the stack of emails that make their way into my inbox from friends back in Australia. They usually go something like this: “G’day mate – Looks like the Aussie dollar is catching up to the U.S. Could I send you some money to do some shopping for me?” Fundamentally, a sagging dollar actually helps sales of U.S. exports as those goods become less expensive to foreign markets. It’s one of the benefits those outside the U.S. enjoy when the dollar declines.
Within the U.S., there’s a lot of concern regarding the decline of the dollar and what impact that has domestically. You can’t read any financial news for more than a few minutes without coming across a doomsday article, forecasting the end of the U.S. dollar as the world reserve currency. And whilst some points raised by economists are valid, I’d like to share a few insights into how a falling dollar is not all bad and, more specifically, how Moneta Group clients are actually hedged against this decline.
The first point to note is that by targeting a positive inflation target (typically around 1.5 -2 percent), U.S. Economic policy by way of the Federal Open Market Committee (FOMC) indirectly anticipates a steady, long-term decline in the dollar. Obviously, as things get more expensive at a domestic level, the purchasing power of one U.S. dollar will decline. Of course, the fear in the markets today is not that the dollar is falling, but rather the rate at which this is occurringand it’s a real concern. Part of the recent decline however, has been due to the reversal of “flight to safety” cash inflows at the genesis of the financial crisis, which resulted in a sharp increase in the dollar. In an address to the Economic Club of New York last week, Federal Reserve Chairman Ben Bernanke said:
“As financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains.”
Of note is Bernanke’s willingness to even address the dollar (normally the territory of the Treasury Department). He went on to say:
“The Federal Reserve will continue to monitor these developments closely. We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability. Our commitment to our dual objectives, together with the underlying strengths of the U.S. economy, will help ensure that the dollar is strong and a source of global financial stability.”
To monitor the value of the dollar, the Federal Reserve uses the U.S. Dollar Trade Weighted Index, which measures the value of U.S. Dollar against 26 world currencies (these economies cumulatively represent over 90 percent of all trade with the U.S.). Below is a chart of this index since it’s official inception in 1997, and whilst the recent decline is alarming, it is important to note that the index is still trading above the lows of March 2008.
So what is Moneta Group doing to protect our clients’ portfolios from this decline? The answer to that question lies in our commitment to Modern Portfolio Theory and asset diversification. Amongst the universe of asset categories, international equities purchased in foreign currencies provide a natural hedge against a falling U.S. dollar. None of the pure international equity funds on Moneta Group’s ‘preferred list’ hedge foreign currency risk. This means that when the mutual fund buys stocks on a foreign exchange, they pay for the stock in the foreign currency and do not buy or sell corresponding currency contracts (or any derivative designed to offset foreign currency exposure). Since the returns of a U.S.-based, international equity fund are calculated in U.S. dollars, these un-hedged (to currency) international equity funds reap the benefit of both the return of the stock and the appreciation of the foreign currency.
In surveying the YTD returns for the major indices, you can see how the dominating return of the MSCI EAFE Index (an index that represents foreign stocks from the perspective of North America) is a function of both the recent rally in global equity markets and the decline in the U.S. dollar.
|Index Returns||From 12/31/08
|Dow Jones Industrial Average||17.02%|
|S&P 500 Index||23.67%|
|MSCI EAFE Index||32.82%|
|DJ Wilshire REIT||12.26%|
|Dow AIG Commodity||12.48%|
In addition to the exposure clients receive through their allocation to International Equities, it is important to note that approximately 50 percent of revenues derived from companies in the U.S. Large-Cap category (companies with a market capitalization of more than $10 billion), actually originate from foreign sources. Exposure to the U.S. Large-Cap category is part of Moneta’s recommended core equity holding, representing anywhere from a 40 – 60 percent allocation. As globalization increases, more and more large-cap companies will likely find themselves operating in overseas markets and in foreign currencies. It therefore follows that the income derived from these operations will be enhanced by a weaker dollar.
Another benefit that most Moneta Group clients will have likely seen as a result of the decline of the dollar, is the return associated with their exposure to Commodities. It’s no secret that commodity prices, such as oil, gold and precious metals, have climbed of late. That pickup likely reflects both a revival in global economic activity—especially in resource-intensive emerging market economies—and the recent depreciation of the dollar. Commodities such as oil and gold are priced in dollars so they become cheaper when the dollar declines.
Whilst massive debts, weak growth, low interest rates, two wars and high unemployment point to the dollar’s continued decline, you can rest assured that Moneta Group’s disciplined approach to asset allocation allows our clients the opportunity to capitalize on the inherent volatility of world currency markets. As for me, I’m off to the post office to mail the harvest of a long “Black Friday” shopping spree to my mates back home.