Will a Falling Dollar Derail Your Plans for Retirement?
How much are you willing to pay for a tank of gas? We've all watched as gas prices hit record highs, but what would you do if you filled your tank and paid by credit card only to discover on your monthly statement that you paid $80 to fill an economy car. No, this is not some future doomsday projection of oil prices. This scenario recently happened to a colleague on business in Europe.
You're not planning a trip to Europe, so you ask, "Who cares?" Well, the consequences of a weakening dollar are not limited to overseas transactions. It's important for you to know exactly how the declining US currency affects Americans state-side.
What does this mean to you?
The US dollar is considered the world trading currency. This means that most goods and services are priced in US dollars. Any prolonged weakness will cause countries trading with the US to raise their prices in anticipation of further decline. Many commodities such as, oil, coffee, chromium, copper, and iron have already set record prices due to the decline in the dollar. As the prices for foreign imported goods increase, so do the prices for the raw materials and parts used by US businesses. As a result, the price will also increase on all goods produced within the US. In short, Americans will pay more and receive less.
This economic effect is known as inflation and its impact is particularly devastating to retirement and savings portfolios. This decline in the US dollar means a reduction in the purchasing power of the dollar and a corresponding reduction in the standard of living for those who earn, spend and save US dollars. In short, a weaker dollar means that Americans will work harder for less.
What is going on with the US $?
In December of 2004, the dollar hit an all time low against the euro at $1.3667. This was down sharply from $1.20 in September of 2004. (Source: Associated Press MSNBC.com, December 30, 2004)
The Euro isn't the only currency rising against a falling dollar. The Australian dollar is trading at six month highs and the Japanese Yen is near its highest trading rate in 8 months. The Canadian Dollar has just moved to multiyear highs against the US currency. (Source: Jubak TheStreet.com, November 10, 2004)
Foreign investors are closely watching the huge US deficits in the federal budget and trade accounts. According to the Commerce Department the trade deficit of the USA was $618 billion in 2004. The Congressional Budget office projects a $400 billion budget deficit for 2005 and the current US national debt is nearly $7.7 trillion.
Budget deficit = spending more than tax revenues collected. Trade deficit = buying more imports than you sell exports. National debt = Accumulated deficits + accumulated off-budget surpluses
A major cause of the current deficit is the result of increased growth rates in the U.S. When the U.S. grows faster than other world economies, we consume far more goods and services from overseas than they consume from us. This creates the imbalance in our trade accounts that we are experiencing today.
We also need to be mindful of the effects that the flow of foreign investment dollars into the US has on our economy. The US markets had a larger return on capital than Europe or Japan for the last 20 years. Foreign governments such as China and Japan have also purchased large amounts of US Treasury securities as a reserve, in order to back their own currencies and guard against the dollar from falling too fast and hurting their economy.
Worldwide currency traders recognize these trends. And investors view the increased spending on the war in Iraq, the massive cuts in tax revenues and the possibility of Social Security privatization as signs that budget and trade deficits will continue to escalate.
What are the Professionals saying?
Bill Gross the managing director for PIMCO, one of the worlds largest fixed income managers said, "Real interest rates in the United States will have to be kept low". He goes on to say, "Too much debt in a finance-based economy precludes raising interest rates like we have in the past and while that keeps the patient/economy breathing; it leads to asset bubbles, potential inflation, and a declining currency over time." Bill Gross hints at a continued slide in the value of the dollar but the real question is: what does this mean?
There are three main schools of thought regarding America's current economic situation with respect to the falling dollar.
Reduction of the trade deficit perspective
Some experts say that the dollar's fall is good because it makes US exports less expensive and that higher demand will cut the trade deficit. This group also contends that global financial markets are awash in so much money that the US can borrow much more than seemed possible 20 years ago.
The dollar may decline in value, according to this view, but the decline would be gradual and would help reduce American trade imbalances by making exports cheaper and imports more expensive.
The Bush administration goes one step further, arguing that America's huge foreign debt simply reflects the eagerness of others to invest here.
"Productivity has been remarkably high in the last few years," said John Taylor, deputy secretary of the treasury at a recent conference. "Foreigners want to invest in the United States. That's what the gap illustrates."
International investor perspective
A second school of thought holds that foreign governments like China and Japan will continue to finance American borrowing and keep the dollar strong because they are determined to sustain their exports and create jobs.
International investors own $1.9 trillion of the $3.8 trillion of marketable U.S. Treasury securities. (Source: Gilbert Bloomberg.com, November 17, 2004)
Possible Dollar collapse perspective
A third school, which includes officials at the International Monetary Fund, worries about a collapse in the dollar that would send shock waves through the global economy.
Former U.S. Treasury secretary Robert Rubin warned last November that the dollar's recent decline could accelerate and interest rates could rise if politicians in Washington don't act quickly to narrow the federal budget deficit.
Alan Greenspan speaking at a banking conference in Frankfurt on November 19th, 2004 said:"Anyone who has not appropriately hedged his position by now is obviously desirous of losing money". He went on to say, "Net claims against residents of the united states cannot continue to increase forever in international portfolios at their recent pace." And in his now famous enigmatic fashion he dropped the bomb, "Continued financing even of today's current account deficits as a percentage of GDP doubtless will, at some future point, increase shares of dollar claims in investor portfolios to levels that imply an unacceptable amount of concentration risk."
A steep drop in the dollar could lead to higher interest rates for the federal government and American private borrowers, as foreign investors demand higher interest rates to compensate them for higher risk.
Legendary investors hedge their bets
Savvy investors from all walks of life are taking this opportunity to diversify their portfolios and hedge their US Dollar bets. According to Forbes Warren Buffet owns 20% of the world's silver, Bill Gates owns 10-20% of Pan American Silver mines, and George Soros also has holdings in gold and silver mines.
What can you do about it?
You've heard the old investment adage, "Don't put all of your eggs in one basket." This is a good time to be reminded that a well-diversified portfolio should be the core of any well-planned investment strategy. And the construction of a well diversified portfolio begins within the framework of Modern Portfolio Theory.
Modern Portfolio Theory is the philosophical opposite of traditional stock picking. It is the creation of two economists William Sharpe and Harry Markowitz who won the 1990 Nobel Prize in economics for their work. Their quest was to try to understand the market as a whole. Investments are described statistically, in terms of their anticipated long-term return rate and their expected short-term volatility. The volatility is equated with "risk", and it measures how much worse than average an investment's bad years are likely to be. The goal is to identify your acceptable level of risk tolerance, and then to design a portfolio with the maximum potential return for that level of risk
Remember, no single type of investment performs best under all economic conditions. A diversified program is capable of weathering varying economic cycles and helps to improve the trade-off between risk of loss and expected return. Of course, diversification helps to reduce risk but cannot entirely eliminate the risk of investment losses.
Most experts recommend analyzing investment portfolios at least once per year. By identifying weaknesses and making adjustments, you can help ensure that your portfolio is performing efficiently.
According to an often-cited and time tested study* held in high regard by many professional investment managers, more than 90% of investment success is due to asset allocation rather than stock selection or any other strategy. This means that investors who carefully allocate their assets among a variety of asset classes (cash, bonds, stocks, etc.) have a greater potential of lowering their overall investment and market risk than those who invest only in one asset class. It is one of the key factors in the investment planning process. (*Source: Brinson, Singer & Beebower Financial Analysts Journal, May-June 1991)
Bottom line is that wise investors don't try to second-guess the financial markets. They take a structured, disciplined approach to investing that recognizes that market declines inevitably will occur. The overall strategic composition of a portfolio will not change unless the investor's situation changes substantially. However, you can use the periodic portfolio reviews to make tactical adjustments depending on prevailing economic conditions. One of the best ways to prepare for economic uncertainty is to have a well diversified portfolio in place and a plan to ensure that it maintains a high probability of helping you reach your goals.
Christopher T. Lawson, financial planner, is a registered representative of Lincoln Financial Advisors Corp., a broker/dealer. Investment advisory services offered through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor, 31111 Agoura Road Suite 200 Westlake Village, CA 91361 (818)-540-6916.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results.
Mr. Lawson has over 11 years experience providing sound financial advice to Corporate pension plans and affluent families. He is a financial Planner with Sagemark Consulting and has presented at regional and national conferences for the following companies: Linsco/Private Ledger, American Express Financial Advisors, Associated Securities, TD Waterhouse Securities, and World Marketing Alliance. He has also worked with Merrill Lynch, UBS PaineWebber, Salomon Smith Barney (CitiGroup), and American Skandia (a Prudential Company).
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