A declining dollar is raising alarms among doomsayers predicting hyperinflation or the end of the U.S. dollar as the world’s reserve currency. The passage of multiple trillion-plus dollar stimulus bills, with the possibility of another one coming down the pike, has aggravated fears over the prospects of intensifying inflation and the eventual demise of the dollar. More reasoned observers may have a downbeat near-term outlook for the dollar but don’t see any justification for an outcry of “The dollar is falling! The dollar is falling!” Not only do we agree with the second camp, but we also don’t believe a declining dollar should be a concern, as long as your portfolio is properly diversified.
No Sign of Inflation Surge
First, let’s address inflation concerns. The massive increase in the Fed’s balance sheet over the last year has revived concerns over an upside surge in inflation. However, starting with the early days of quantitative easing, the Fed’s liquidity injections quickly escalated from billions to trillions with no effect on inflation. While the Fed’s recent injections of trillions due to the COVID crisis were unlike any we have seen, the Fed doesn’t appear to be concerned. In January, the Fed stated it is still targeting 2% inflation with no plans to increase rates in the foreseeable future. So, contrary to warnings from inflation alarmists, there appears to be noreason for concern at this time.
Rumors of Dollar’s Demise Are Greatly Exaggerated
According to doomsayers, the same forces that were supposed to trigger an inflation surge were also supposed to drive the U.S. dollar into uncharted depths. However, while it’s true that the dollar has been falling after a decade of strengthening, it’s still near its long-term highs relative to other currencies.
Source: St. Louis Fed
Trade balance data can impact currency exchange rates through supply and demand. While the dollar index (DXY) declined 7% in 2020, the Fed’s trade-weighted indices show a less dramatic decline of 2.5%. That included a 5.5% decline against advanced economies and a 0.5% increase against emerging market economies. Three-quarters of the DXY is derived from euro currencies, which account for just a quarter of U.S. trade. More than half of U.S. trade is with emerging markets.
While current trade balance levels have not been encouraging, they are still in line with the 20-year trend.
Economic growth directly impacts the value of the dollar because it reflects the projected strength of the United States. Current projections by the International Monetary Fund pegs the United States as the strongest among developed economies. That future growth can be expected to raise the floor on further declines in the dollar.
Source: International Monetary Fund, January 2021
Interest rates are also a driver of currency value. Countries with higher rates tend to attract more capital, which supports the value of the currency. Currently, U.S. interest rates are among the highest of developed economies. And, as we all know, the Fed would not be hesitant to raise rates should inflationary pressures increase too quickly.
Source: Bloomberg, March 16, 2021
If you just consider the dollar cycles over the last 50 years, you can see that the cycles—both up and down—last around 10 years. We’ve been in an up cycle for eight years with a ways to go before it nears peak levels from past upswings.
While it’s not definitive, the data seems to indicate that the current trend is not out of line with the dollar’s previous cycles. While we may see some further weakening in 2021, any significant decline doesn’t seem to be in the cards.
You Can Never Say Never
Of course, when it comes to the economy and the possibility of a black swan event or just an unexpected change in direction, we never say never, which is why diversification is critically important. Diversification is the recognition that we really can’t know what will happen in the future. If you are concerned with rising inflation or a declining U.S. dollar, the best way to diversify is with high-quality global stocks.
Even now, as the U.S. dollar declines, the currencies of emerging economies are increasing in value. Companies with significant global exposure in the faster-growing regions are positioned to ride the tailwinds of rising population, per capita income, and GDP to sustainable growth of 5% to 7% per year.
Why We Aren’t Concerned About a Declining Dollar
None of this is to say we shouldn’t be vigilant, always keeping our eyes on the horizon. But nearly all the companies we own generate a majority of their profits from outside the United States. So a declining dollar would benefit our portfolio returns over time. Also, because of the global reach of our companies, we are highly diversified from a currency perspective—another reason why a strategy of investing in only the highest-quality companies across the globe will get us through any environment and protect our capital.