BULLS & BEARS: Nation’s hefty trade deficit puts value of dollar at risk

Whenever anyone starts talking about foreign currencies and the U.S. dollar, you can usually see eyes-including mine-glazing over.

Nevertheless, now may be a particularly useful time for investors to gain awareness on this topic. Currently, a number of wise investment thinkers share a growing concern that the U.S. trade deficit, currently running at an unprecedented 7 percent of GDP (the country’s output of goods and services), will eventually trigger a dollar decline.

At Berkshire Hathaway’s annual meeting a couple of weeks ago, Warren Buffett reiterated his strong belief that our trade imbalance will lead to a weaker U.S. dollar. He originally outlined this view in a 2003 Fortune article writing, “In effect, our country has been behaving like an extraordinarily rich family that possesses an immense farm. In order to consume 4 percent [now 7 percent] more than we produce-that’s the trade deficit-we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.”

Mohammed El-Erian, the former Pimco emerging-market bond specialist and now president of Harvard Management Co. (the university’s endowment), calls the current market environment a “stable disequilibrium.”

In a Fortune article this month, he notes that poor countries are running trade surpluses and financing the rich countries. What he finds surprising is that this disequilibrium has been stable, so risk premiums have shrunk and volatility has almost disappeared. El-Erian says this stable disequilibrium may end in a crisis soon, or it may persist for a decade.

Pimco’s Bill Gross, also known as the Bond King, holds similar views on the dollar and is buying European and Asian fixed-income securities.

Currency prices are reached via a combination of relative country growth rates, interest rate differentials, central bank reserves, politics, and trade and capital flows, to name a few. Occasionally, this mix falls out of equilibrium and there is a volatile “adjustment.” The last major dislocation in the currency markets came in the fall of 1998, when the Russian ruble and Asian currencies collapsed. That crisis triggered the implosion of the hedge fund Long Term Capital Management and nearly brought the financial system to its knees.

Of course, what no one can predict is the timing of the next event that could upset the apple cart. But what are some things investors can do to protect their portfolios from a declining dollar? Buffett has recently said he would prefer to gain exposure to nondollar investments by purchasing stocks and businesses whose prices are denominated in foreign currencies and earn a large part of their profits internationally. Berkshire just announced the purchase of Iscar, an Israelibased company, for $5 billion.

El-Erian has Harvard’s endowment well diversified in stocks, bonds, real estate, commodities, and alternative investments, like timber. Only 15 percent of Harvard’s portfolio is invested in U.S. equities.

The average investor can also gain exposure to foreign currencies via the large U.S.-based multinationals whose overseas subsidiaries earn income in currency other than the U.S. dollar. In addition, a number of foreign company stocks are traded on the New York Stock Exchange in the form of ADR, or American Depository Receipts. The irrational course of action would be to panic, sell everything and buy gold.