Over the last several months, the U.S. dollar has generally declined in value against other currencies, raising concerns that the dollar may depreciate further. (A discussion of factors impacting exchange rates can be found here). There is also the threat of future inflation. Both of these can impact investment portfolios. How can investors protect themselves?

In this article, I’ll discuss how a portfolio can be structured to offset the potential negative impacts of dollar depreciation or rising inflation. We will then review how three portfolios – a Merriman suggested worldwide equity portfolio, the S&P 500 and our recommended bond portfolio – each performed during times that the dollar depreciated or inflation increased.

The conclusion is that a well diversified portfolio can provide reasonable shelter against these economic tempests, and can also outperform the S&P 500.

Dollar depreciation

Portfolio structure and the dollar
We have purposely structured our client portfolios to withstand various economic scenarios, including dollar depreciation.  The equity component is equally divided between U.S. and international funds. Any decline in the U.S. dollar will increase the value of foreign currencies, which could increase the dollar value of foreign securities.  A client with a 60/40 stock/bond account has 30 percent of assets denominated in foreign currencies.  That offers significant protection against a dollar decline.

Periods of dollar decline
Figure 1 shows the value of the dollar compared with a broad group of currencies, as compiled by the Federal Reserve, from January 1973 through September 2009. 

Figure 1 – Dollar index

The arrows and numbers show four periods when the dollar was generally depreciating relative to other currencies.

Portfolio returns when dollar declines
How have our recommended portfolios done when the dollar declined? To answer this question, we will focus on the 100 percent worldwide equity portfolio we use in our fine tuning tables. This is a portfolio which has similar characteristics to, but is not exactly the same as, the portfolio we use for our clients. This worldwide equity portfolio is comprised of Dimensional Fund Advisors (DFA) mutual funds or their underlying indices. The portfolio has 40 percent U.S stocks, 10 percent U.S. real estate investment trusts (REITs), 40 percent international developed country stocks and 10 percent emerging market stocks. The portfolio has a value and small cap tilt. The recommended bond portfolio includes short term Treasuries, intermediate term government bonds and Treasury Inflation-Protected Securities (TIPS).

Figure 2 shows the returns of the worldwide equity portfolio, S&P 500, and our recommended bond portfolio during the four periods in Figure 1 when the dollar was falling. The numbers in the first column correspond to the numbers in the graph above.

Figure 2 – Portfolio returns during periods of dollar depreciation

During each of these periods, which varied from five months to over 10 years, the dollar declined at an annual rate of at least 4 percent. The three portfolios each had positive returns during the four periods of dollar decline. During each of these periods, the worldwide equity portfolio increased by over 10 percent annualized, and also beat the S&P 500. Our recommended bond portfolio (all U.S. dollar denominated) also had positive returns in each period.

Each of the three portfolios had positive returns during these periods of dollar declines.

Rising inflation

Portfolio structure and inflation
Our portfolios also have safeguards to protect against rising inflation. Their allocation to emerging markets should benefit from increases in commodity prices. REITs also provide long-term protection against inflation. Asset classes such as small cap value and small cap have also generally performed well during periods of high inflation.

Our bond allocation includes TIPS whose principal increases with the U.S. Consumer Price Index (CPI). We also include short-term Treasuries, whose interest rates will reset at higher levels in an inflationary environment as the underlying bonds mature.

Other articles at FundAdvice.com exploring these topics include “Inflation: Will your investments protect you?” and “Treasury yields and fixed-income investing”.

Periods of rising inflation
Figure 3 shows the rolling 12-month change in U.S. CPI, with numbers one through eight corresponding to periods of generally rising inflation.

Figure 3 – CPI: 12-month change

Portfolio returns when inflation increases
Given the worrisome increase in the projected U.S. budget deficit, and the possible resulting impact of increasing inflation, how have the portfolios done during periods of increasing inflation?

Figure 4 shows how the portfolios performed during these eight periods of increasing inflation. The numbers in the first column correspond to these periods. The next four columns show the month that 12-month inflation was at a low, the month that inflation peaked and the associated 12-month inflation rates. The next three columns show the annualized returns for the three portfolios during each period. The last column shows the difference in returns between the worldwide equity portfolio and the S&P 500.

Figure 4 – Portfolio returns during periods of rising inflation   

The worldwide equity portfolio had five periods of positive performance, and outperformed the S&P 500 in six of the eight periods.

While there were periods of negative performance, the worldwide equity portfolio, on average, generated positive returns during periods of rising inflation.

Conclusion
In economics and finance there is much uncertainty between potential cause and ultimate effect. Deficit spending may run out of control or politicians may successfully rein in the spending. Inflation may or may not increase as a result. Often, but not always, rising inflation leads to dollar depreciation. Portfolio returns can be positive or negative during periods of dollar depreciation or increasing inflation.

We believe the best solution for the long term investor is to structure a diversified portfolio which can withstand many (note that we are not saying all!) of the potential economic scenarios which may be encountered over time. While past results are no guarantee of future performance, the appropriate portfolio structure and asset allocation have been used in the past to mitigate the impacts of a falling dollar or rising inflation.

Larry Katz is director of research at Merriman.

This document contains hypothetical results. Although we have done our best to present this information fairly, hypothetical performance is still potentially misleading. Hypothetical data does not represent actual performance and should not be interpreted as an indication of actual performance. This data is based on transactions that were not made. Instead, the trades were simulated, based on knowledge that was available only after the fact and thus with the benefit of hindsight. Results do not include the impact of taxes, if any. Past returns are not indicative of future results. The content in this article is intended for educational and informational purposes only and not as investment advice or an offer or recommendation to buy or sell an investment product.  Any investment decision made carries risk including the risk of financial loss and is ultimately the responsibility of the individual who should consult beforehand with a financial advisor.