The U.S. stock market has enjoyed a strong rally since the early spring, but while the economy has shown improvement, it still faces major headwinds. So it may be best to hedge against the U.S. dollar, which is likely to experience a significant decline over the next few months.
There are a lot of uncertainties permeating the market right now, not the least of which is healthcare reform. Will that reform entail a public option that could add $1 trillion to the deficit? How is reform going to be financed? And is it going to mean higher costs for employers across the board, or just the healthcare insurers?
Investing is made infinitely more difficult when 18% of U.S. gross domestic product (GDP) is hanging in the balance.
And you still have to consider:
- That unemployment is likely to keep rising, perhaps over 10%.
- That the U.S. Federal Reserve's policy of quantitative easing is slowing down.
- That there is almost certainly a second wave of home foreclosures on top of the current commercial real estate epidemic.
- And that retail sales are still a long way from recovery.
There is also reason to believe that the U.S. dollar will continue to be weak, though it probably won't sell off precipitously.
The, having fallen 0.8% Friday. Technically speaking the chart shows a traditional "cup and handle" formation that could lead to an acceleration of the dollar's downward trend. Gold prices, up about 13% Friday, confirm this trend and could soon break through the $1000/oz resistance.
Fundamentally, if the economy – encumbered by high unemployment and a relapse of the housing market – does not pick up the dollar could be further imperiled.
Weakness in the dollar will also be affected by the Fed's withdrawal of liquidity, which is likely to proceed at a gradual pace.
Finally, diversification away from the dollar among the world's central banks is taking place, albeit at a slower pace than many analysts have suggested, and that too, is weakening the dollar.
Let's concede that there is no currency that could supplant the dollar as the world's major reserve currency. So, it's unlikely that the world's central banks will simply abandon the dollar anytime soon. However, we must also acknowledge that a reduction in the weightings of the U.S. dollar within central bank reserves is already underway.
An Aug. 14 article by BNP Paribas currency strategist Ian Stannard in Euromoney recently described this gradual shift in currency reserves. The article noted that only 62.5% of global currency reserves are in U.S. dollars, down from about 66% in 2005.
So I do not anticipate a sudden shift in central bank reserves, but rather a continuation of the measured restructuring we've seen so far. Thus, the slow weakening trend in the U.S. dollar is likely to continue.
So, in this very uncertain investment scenario, I prefer to go for more secure returns in bonds. And we can achieve great diversification at a cheap cost with the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD).
For starters, its weighted average coupon of 6.26% offers a current yield slightly north of 6% at today's prices. Investors are assuming interest rate risk, which means that if interest rates climb, the value of the bond has to come down. But in the short term, there is no immediate threat of inflation.
Looking at the major holdings of the fund – which has no single position that accounts for more than 1.26% of its total holdings – I see some names that have demonstrated continued stability and others that have shown recent signs of improvement, such as American Express Co. (NYSE: AXP). So I do not expect any major credit spread hiccup here. I certainly do not see any hiccup that a 6.26% coupon would not compensate for.
For an additional hedge against dollar weakness, I suggest you revisit my June 8 recommendation of the iShares SPDR Gold Trust ETF (NYSE: GLD). You may also consider buying a bit of the PowerShares DB US Dollar Index Bearish (NYSE: UDN) fund. Do not go overboard. Err on being light, rather than heavy on hedging, since timing currency moves is very difficult.
Recommendation: buy iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD) at market. Consider hedging part of the US dollar risk by buying the iShares SPDR Gold Trust ETF (NYSE: GLD) and PowerShares DB US Dollar Index Bearish (NYSE: UDN). Both funds should account for a fraction of your position. Have a 5% stop loss on UDN (**).
(**) – Special Note of Disclosure: Horacio Marquez holds no interest in the the iShares iBoxx $ Investment Grade Corporate Bond Fund, the iShares SPDR Gold Trust ETF, or the PowerShares DB US Dollar Index Bearish fund.
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