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Hedging the Dollar: An Ounce of Prevention

By Roger Conrad on September 28, 2012

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There’s still more than a month to go in the 2012 presidential race. But with the president apparently pulling ahead in national polls, rhetoric is ratcheting up that a day of reckoning is approaching for the US dollar–spurred by the Federal Reserve’s latest round of quantitative easing as well as the prospect of four more years of deficit spending.

At the core of that worry is the belief that the easy money we’ve seen since 2008 can only have one result in the long run: rapid inflation, if not hyperinflation. And that, in turn, means the debasement of the US dollar, as well as any asset tied to it, including stocks.

There are certainly plenty of examples throughout world history of aggressive monetary and fiscal policy leading to currency collapse. In fact, only one form of money has successfully held its value through millennia: gold.

When President Clinton left office in January 2001, the US government budget was in surplus and the value of the US dollar was surging globally. But the price of gold was languishing in the $200 per ounce to $300 per ounce range, a fraction of the highs it had reached 20 years earlier.

As Uncle Sam piled up ever greater levels of debt over the past 12 years, however, the yellow metal has steadily moved higher. And the Fed’s unprecedented monetary easing since the 2008 crash has accelerated gold’s ascent. This year, the metal hit over $1,800 an ounce before backing off over the summer, but now it’s quickly approaching that earlier high again.

Interestingly, when adjusted for inflation, gold’s 1980 high of about $800 an ounce equates to a level higher than $3,000 an ounce. That argues for a much higher gold price–and lower US dollar–if inflation does get out of control again like it did in the 1970s.

The two key questions are whether the risk has grown enough under current circumstances for investors to do something to protect themselves now, and if so what measures are best.

Inflation vs. Credit

Most income-oriented investors know there are basically two major dangers to returns: credit concerns that can threaten your payment streams, and inflation risk that can erode the value of any cash flow.

Being a yield investor means you have to stick around long enough to collect your dividends and interest. Frequent buying and selling is punished in the tax code, and you lose the benefit of a rising stream of dividends as well, which also supports a higher stock price over time.

Successful income investing means balancing credit and inflation risk against prospective returns. When I started in the investment advisory business in the mid-1980s, inflation was definitely a bigger worry than credit risk. Even the hint of higher interest rates or a weakening dollar would send many investors scurrying out of dividend-paying stocks, bonds or anything else with a value tied to yield.

By contrast, credit risk has trumped all since the 2008 crash. And any rumor that a company’s debt burden poses a risk to its dividend tends to trigger the greatest volatility. Inflation worries have had relatively minimal impact on share prices. In fact, inflation has been basically nonexistent.

Natural resource prices have rebounded strongly from the lows in early 2009. But their impact, ironically, has probably been to dampen inflation by impairing economic growth. Mainly, rising raw materials prices have taken money out of the pockets of consumers and businesses, which limits spending and hiring. That’s resulted in an anemic economic recovery that’s prevented the kind of wage-push that fed the inflation of the 1970s.

The 1970s stagflation was characterized by rising prices of goods and services amid a slumping economy, and it could well happen again. Fortunately, the economy is not yet at that point. Instead, most of the current inflation is largely on the raw materials side.

As for the US dollar, at Investing Daily’s Wealth Summit earlier this year, EverBank’s Chuck Butler aptly described the greenback as being in an “ugly contest” with the other major currencies. While the US dollar certainly has problems, so do its major rivals.

For example, although Europe has managed to hold its currency together thus far, the Continent’s most troubled countries still face enormous stresses ranging from high unemployment to growing political unrest. It seems all but inevitable that eurozone creditor nations such as Germany will have to provide further easing in order to save the euro and preserve the huge advantage they have in European trade. And that’s not necessarily a plus for the euro’s value.

In autumn 2011, many economists were shocked to see investors flee to the perceived safety of dollar-denominated investments, mainly US Treasury bonds, shortly after Standard & Poor’s downgraded Uncle Sam’s credit rating to AA+ from AAA. And since then, they’ve likely been just as flummoxed when anxious investors have sought sanctuary in the US dollar each time global economic woes came to the fore, including this week.

The US dollar, represented by US Treasury paper, is still the only market big enough to absorb all the cash seeking a safe haven on a day when panic is in the air. Bottom line: It’s still winning the ugly contest. And as long as that’s the case, the buck won’t decline in a straight line against other paper money around the world.

That said, the US dollar does lose ground against other currencies rather consistently once global credit risk appears to diminish. That’s particularly true against currencies considered to be more attractive when global growth is picking up, such as currencies in nations that have resource-backed economies, including Australia and Canada.

The US dollar probably won’t suffer a genuine collapse amid a crashing global economy and stock market. Rather, the primary worry is that it will experience a more gradual but relentless loss of purchasing power when the global economy is growing, and the value of assets is rising.

What to Do Now

Political views generally don’t mix well with a sound investing strategy. But regardless of your hopes for the election’s outcome, it’s prudent to hedge your exposure to the US dollar in your portfolio.

To achieve that end, there are a wide range of options, some of which will work much better than others. A “hedge” position is essentially an investment you own because it will buck a downtrend in the rest of your portfolio.

In the case of the US dollar, gold is often cited as the best hedge, as its value is not tied to any paper currency. If the Europeans, Japanese, Chinese and other major nations join the US in pursuing easy-money policies, their currencies will probably stay in a range against the dollar. Gold, however, will gain value against all of them. And its gains will offset any loss of value due to a declining currency in the rest of your holdings.

I’m a believer in holding gold, even after the big gains made over the past decade. Most investors, however, are going to be better off holding their US dollar hedges in more productive assets. My top choice: dividend-paying stocks of healthy and growing companies based in countries with “hard” currencies.

In this environment, a hard currency is from a nation known for its production of natural resources and is backed by a government with a healthy fiscal position. The two currencies that best fit that description now are the Canadian dollar and the Australian dollar.

Canada and Australia are both major exporters of dozens of key raw materials, from grains to base metals and energy. These resources are mostly priced globally in US dollars, but those prices rise with both demand and US dollar inflation.

Both currencies were huge winners the last time inflation rocked the world, back in the 1970s. They’ve gained ground over the past decade, however, for a somewhat different reason. Mainly, massive demand for their commodity exports to Asia, which is now the world’s primary source of demand growth for everything from oil to copper.

That’s helped boost the value of these currencies even with global inflation mostly nonexistent. And those gains would be much, much larger if inflation should stir.

To get that currency advantage, you don’t have to buy stock in a resource-producing company. Rather, all you have to do is buy a company that’s investing in its business and growing its dividend, whether that business is generating hydroelectric power under long-term contracts, running fee-for-service pipelines, or operating a railroad.

Your gains come in two ways. Canadian stocks, for example, are priced and pay dividends in Canadian dollars. When the Canadian dollar’s value rises, so does the US dollar price of every Canadian stock. And a rising Canadian dollar will also push up the US dollar value of the dividends paid on that stock.

If there are no forthcoming currency gains, you’ll still own productive assets because the underlying business is growing so its stock will gain value over time. And if you choose companies that earn money from fees, you’ll still make money even if natural resource prices don’t rise.

That’s the ideal way to protect your portfolio regardless of what happens to the US dollar in coming years. And an ounce of prevention is always worth at least a pound of cure, just in case.

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