For long-term investors, the dollar’s descent raises fundamental questions about the wise allocation of assets. In the short run, weak currencies boost an economy. Local goods become cheaper in the world marketplace, which boosts exports, growth and jobs. Weighted by America’s volume of trade with industrial and developing countries, the dollar was weaker in 1992 than it is today, ““and we thought that was fine because it made us more competitive,’’ says Irwin Kellner, chief economist for Chemical Bank in New York.
The weak dollar, by the way, needn’t cause more inflation by raising the price of imported goods. The buck is down against the yen, the Deutsche mark and a few other European currencies. But it’s rising against the currencies of two major American trading partners, Canada and Mexico – so their goods will be cheaper here. Prices will stay level for imports from places where currencies roughly track the dollar, like much of South America and Southeast Asia. Even goods from Germany and Japan might not rise in price as much as you think. Japanese products, for example, are often made in lower-cost countries like China and Taiwan.
But the weak dollar has a downside, too. Every year, the government has to finance the U.S. debt by selling hundreds of billions of dollars in Treasury securities – and buyers are getting harder to find. The dollar remains the world’s leading monetary unit. But holders – foreign and domestic – don’t like it when dollars depreciate. To attract enough buyers for the debt, U.S. interest rates have to stay high. Adjusted for inflation, real short-term rates today are 3 percentage points higher than their historical average, Kellner says, while long-term rates are one point higher. If weakness persists, and the Treasury still has big annual deficits to finance, real interest rates can’t fall far. That would change the long-term investment climate. Bonds and certificates of deposit would look relatively better. Stock- market returns might disappoint. The implications:
Near term, the Mexican mayhem might help put interest rates down and bond prices up. Market analyst Larry Jeddeloh, of The Institutional Strategist in Minneapolis, says the Federal Reserve has historically met any threat to America’s banking system – like the Mexican collapse – with lower interest rates, not substantially higher ones. The cycle of rising rates should be over, or nearly so. As rates ease, bond mutual funds rise in price.
But then what? As long as America’s No. 1 industry is the fabrication of debt, real rates will stay relatively high. If Congress cuts taxes and doesn’t cut enough spending, the next rising-rate cycle might be closer than anyone thinks. The classic defense against this risk is to allocate more money to medium-term bonds or bond mutual funds, with maturities in the three- to five-year range. They yield reasonable returns when interest rates fall and won’t lose as much value as long-term funds do should interest rates increase again.
U.S. stocks should rise when interest rates ease – but not necessarily right away. Investors are unsure of how deep the coming business slowdown will be – and under that question, crevasses lurk. We’ve entered the longest period on record without a major market correction. Market strategist Steven Leuthold of The Leuthold Group in Minneapolis expects a far-reaching decline; he’s mushing his troops away from stock markets around the world, and into the safety of cash and medium-term Treasuries. Steady-as-you-go investors, however, will keep to their asset allocations – especially funds in the United States. The third year of a presidential election cycle often is terrific for stocks. Nicholas Sargen, a managing director at J.P. Morgan in New York, says the winners will be the big U.S.-based multinationals that both export and do business abroad. When you buy their stocks, you share in foreign growth without taking any direct currency risk. These companies cluster in the leading stock-market indexes, like the Standard & Poor’s 500. That helps explain the top performance this year of ““index’’ mutual funds invested solely in S&P stocks. Sargen’s favorite sector is capital goods because of the worldwide demand for more business investment. Jeddeloh favors smaller growth stocks, which he thinks will start to outperform the larger firms. But note that if a slipping dollar translates into chronic higher interest rates, stock performance will stall. You may have to increase your savings to raise the money you will need to retire on.
There’s still a good story for long-term investment abroad. Key European countries just put interest rates up to defend their currencies and pre-empt inflation fears. That put their stock and bond markets down. But the business expansion in Europe is broadening, which suggests good investment returns once the currency flap subsides. Investors may also reconsider the shattered emerging-markets funds. The key to foreign investing is diversification. Funds that buy stocks all over the world suffer less during currency scares than funds spotted on one narrow area.
Most American investing, however, is done in the United States, where gains depend, more than you realize, on sounder budget policies. With little progress on deficits, says Sung Won Sohn, chief economist for Norwest Corp., the dollar will gradually slip lower, real rates will stay high and growth in America’s standard of living will stall even more. American thinking has made progress: we support the idea of lower deficits. But we haven’t yet taken the next step: that lower deficits mean less federal entitlement spending on us.
