Making the Weak Dollar Work for You
After gradually losing value for the past five years, the dollar has hit a new record low against the euro. It now takes $1.36 to purchase a single euro. By contrast, it took only $1.32 to buy that same euro at the end of last year and less than a buck at the end of 2002.
Still, don't be surprised if the greenback continues to drift even lower this year.
Why is the dollar weakening? Global currency trends are a sort of referendum on the health of a country's economy. And the U.S. economy is expected to grow at a slower pace than the economies of Europe or the emerging markets.
Last week, the dollar hit new record lows shortly after the federal government reported that U.S. gross domestic product, the broadest measure of economic activity, had expanded just 1.3 percent in the first quarter of 2007. Not only was that well below the 2.5 percent U.S. growth rate at the end of last year, but this figure was well below the 1.8 percent growth rate Wall Street was expecting, says Ashraf Laidi, chief currency analyst for CMC Markets U.S.
To be sure, that was just a preliminary estimate of economic growth. But if it holds up, it would represent the slowest rate of U.S. economic growth in four years. And currency traders are clearly worried.
Of course, if the U.S. economy slows down much more, the Federal Reserve Board may be forced to step in and cut interest rates to jump-start economic activity. Laidi says that the Fed could start trimming rates as soon as June.
Yet if the Fed were to do that, it could lead to further dollar weakness. After all, investors are constantly searching for the most lucrative markets in which to park their cash, comparing the interest rates that short-term cash instruments are paying out in various countries.
Many economies are still raising their short-term rates to control inflation. In contrast, the United States looks to be on the verge of trimming rates. And if it does lower rates while Europe is hiking, it would be a no-brainer for investors to take some of the cash that they're stashing in U.S. dollars and transfer it to a higher-yielding market.
So, the dollar is likely to stay weak for the remainder of the year, if not weaken further. Standard & Poor's believes that by the end of 2007, it will take $1.37 to buy a single euro.
What does this mean for U.S. investors?
Foreign investments should continue to outperform.For the past five years, U.S. stock funds have lagged behind the performance of foreign investments in large part because of the so-called currency tail wind. When the dollar is strengthening, the value of foreign shares held by U.S. investors may fall, even if foreign stock prices are on the rise. Conversely, when the greenback is tumbling, Americans investing abroad stand to make money, sometimes even if their foreign stocks don't. With the dollar expected to stay weak, it would seem to make sense to be patient with your foreign equity holdings.
If you are investing in the United States, favor large stocks over shares of small companies. Why? Because large, U.S.-based multinationals derive more of their business overseas than smaller companies do. And when the dollar is weakening, those foreign-derived earnings get a boost from the currency exchange once the profits are repatriated back into U.S. dollars. Since many small companies do most or all of their business in the United States, they don't get this earnings boost. Of course, this isn't the only reason to favor blue-chip stocks. Shares of the largest, industry-leading U.S. companies have struggled for the past five years, and many believe they are trading at cheap enough levels to attract investors back.
Inflation is likely to be an ongoing concern. A weak dollar raises the prices that American consumers pay for imported goods. This means that overall inflationary pressures are likely to rise, despite the slowing economy. So as the dollar weakens, watch for signs of inflation. Keep in mind that inflation is enemy No. 1 for bond investors, because rising prices eat away at fixed-income returns. If you're a stock investor, be sure to stick with companies that dominate their industry. In an inflationary environment, only dominant companies can pass along cost increases to customers and preserve their earnings.