Think Inflation Is All About Interest Rates? Think Again.

If you haven’t vacationed abroad recently, you might be unaware of the U.S. dollar’s sharp decline against many of the world’s major currencies. Most Americans don’t look at the value of the dollar everyday, as they do the stock and bond markets. It’s typically only when you travel to a foreign country that you realize how much the greenback’s global purchasing power has shrunk lately.

Battered by a number of factors, including continuing trade deficits and turmoil in the credit markets, the dollar has dropped sharply over the past year against such currencies as the British pound, the euro and the Canadian dollar, not to mention the Indian rupe and the Brazilian real. More specifically, the dollar’s slump has left it at a 26-year low against the pound, a 30-year low versus the Canadian dollar and, more significantly, at a record low against the euro.

That’s not good because a weakened dollar increases the cost of the imported goods Americans have grown addicted to as well as exerting upward pressure on interest rates. And that’s not even factoring in inflation, which has averaged 2.75% annually over the past seven years. Over that period of time (Aug.1, 2000 to Aug. 1, 2007), the dollar has declined more than 47% [from $0.92 to $1.36] against the euro, with nearly a quarter of that slippage occurring over the past 12 months. So now you know why it really feels like inflation is higher than the official data would suggest.

Government actions can affect the official Consumer Price Index (CPI) numbers and, of course, our government wants us to feel that inflation is under control. But, in fact, the current administration has embraced a set of policies that has led to a sharp slide in the value of the dollar. That situation is unlikely to change any time soon due to a host of factors, not least the very high levels of debt now burdening the nation at almost every level, including international, federal, state and consumer. The main exception is the corporate sector, which has diverted a large portion of its healthy profits to stock buybacks. Until recently, that helped to keep the equity markets bubbling despite an otherwise slowing economy.

My guess is that our government has made a conscious decision to let the dollar fall to make it easier to repay (or at least service) the huge deficit we have accumulated in recent years. So when the dollar drops 30% to 40%, foreign creditors will be paid back in U.S. dollars that are worth commensurately less.

It’s a bit of economic slight-of-hand that benefits the country in the short run, although it carries the very real risk that it will undermine the dollar’s pre-eminence in the global currency markets. There are signs this is already taking place. At the end of last year the value of euro notes in circulation exceeded that of dollars for the first time, and for the second successive year the euro has displaced the dollar as the primary currency of the international bond markets.

So how should you respond to these developments? If you believe the dollar will continue to weaken, you should have significant exposure to foreign stocks, multi-national U.S. stocks, natural resources and foreign bonds. Most Americans do not have enough exposure to foreign equities and bonds. While it’s true that you can get a useful measure of foreign exposure through U.S. multinational corporations that dominate the S&P 500 stock index, consider that:

  • Foreign markets matter more now, reflecting the expansion of the global economy. Whereas American equity markets represented about 70% of global equity capitalization in the 1970s and 80s, now it’s less than 50%.
  • Many foreign economies – China and India, for example – are growing faster than that of the U.S.
  • According to the most recent Forbes magazine ranking of the world’s largest public companies, 16 of the top 30 were based outside the U.S.

If you would like to work with an advisor who has the experience and expertise to develop a strategy to position your portfolio for global economic matters, please give us a call and ask to have information about our firm and services sent to you.

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