Riding with the currency: when the dollar loses value in the world markets, there are pitfalls to watch out for. Here's how to benefit whether it is weak or strong.

Harlan Brandon knows shoes. After 15 years of designing them for companies such as Nautica and Fila, the 50-year-old New York City native stepped out on his own two years ago and launched HBF Collection, his premier line of shoes. But his extensive knowledge of shoes was not enough to ward off a threat to his budding business. The designer-turned-entrepreneur would soon get a crash course in currency valuations.

His introductory line of shoes was manufactured in Italy, then imported to the U.S. so that major department stores could review his designs. The shoes are priced between $90 and $110, but soon after opening shop, Brandon realized he wouldn't be able to turn a profit. "When I started out, I was just making it," Brandon explains, "then the euro got stronger and stronger.... I just couldn't continue."

During Brandon's first year, the dollar weakened progressively against the euro, and a weakening dollar buys less units of a foreign currency. In August 2002, when Brandon began purchasing Italian components, it cost 98 cents to buy one euro. By August 2003, it cost $1.16. Brandon saw his costs increase by 18 cents, and his profit margin virtually disappeared. Instead of raising the price of his shoes, Brandon moved manufacturing to India, where the dollar is still strong. His experience is one example of how currency fluctuations and a weak dollar can directly impact business owners. When the dollar is weak business owners face higher costs, which potentially trickle down to consumers in the form of higher prices.

WHAT DRIVERS THE COST OF MONEY?

The pricing of money occurs on the foreign exchange market, also known as forex. It is the largest financial market in the world. More than $1 trillion is traded daily--U.S. dollars for euros, euros for yen, etc. Just as the value of a U.S. company is set by the U.S. stock market, a country's currency, when left to free market dynamics, is determined by forex.

During the last two years of the Bush administration, the U.S. dollar has plunged in value against the world's major foreign currencies, more than 22% since early 2002. Some experts point to the increasing federal deficit as a primary reason. The Congressional Budget Office projects the deficit will hit $422 billion this year. According to Joseph Davis, an investment analyst and economist with the Vanguard Group, two factors have played a key role. One is the record-low, short-term interest rates, which have recently begun to rise through the actions of the Federal Reserve. The other is that the U.S. trade-deficit-to-GDP ratio is roughly 5%, a level many economists say is unsustainable.

WHEN THE DOLLAR IS WEAK

A weak dollar not only affects business owners with international operations like Brandon, it also influences whether Americans can afford a trip overseas and how much they spend in a foreign country. Pete Anderson, for example, a 36-year-old newlywed, understood how a weak dollar could affect his honeymoon with wife Lisa. While traveling to Indonesia several years earlier as part of an M.B.A. program, he became keenly aware of the effect currency values had on his wallet.

"When I was in Jakarta in 1999, they were in the midst of their currency crisis. So the rupiah [Indonesian currency] was cheap to buy. As a tourist, I could buy almost anything I wanted. I could live like a king," Anderson says. For example, he stayed at a five-star hotel for $45 a night, hired a chauffeur several times during his stay at $15 per day, and purchased a custom-made suit for about $400. "So when I began thinking about going to Europe for my honeymoon, I didn't want the reverse to happen to me," Anderson says. "I didn't want the euro to suck me dry."

When Anderson began researching his trip in the summer of 2002, the dollar had been on a steady decline against the euro. In May 2002, investors paid 89 cents per euro. Three months later, one euro costs $1.02--a 12% drop. Anderson, who pays close attention to the news and economic reports, became concerned about exceeding his budget and took action. "I said, wait a minute. If I have a $5,000 budget and the dollar drops another 10% against the euro, that's an extra $500 it'll cost me. So I wanted to lock in my costs as soon as [I] could."

In February 2003, six months before his trip, Anderson paid for hotels, car rentals, and travel packages. By that time, the dollar bad fallen an additional 4.9%. Anderson was wise to buy sooner versus later. Given the rapid rate of the dollar's decline, what would have cost $89 in May 2002 would have been $119 by June 2003. By purchasing early, he saved more than 34% on the cost of the trip.

But a weak dollar isn't bad news for everyone. It's a boost to American industries since it makes American products cheaper abroad. This increases demand for those products and can potentially lower the trade deficit. It can also mean strong returns for U.S. investors with international assets. According to Morningstar, the one-year average return for international stock funds for the week ending Sept. 10, 2004, was 17.85% compared to an average return of 11% for domestic stock funds.

George Stein, an analyst at the Chicago Mercantile Exchange, says investors should move money into foreign bonds or stocks when the dollar is weak because there is the possibility of receiving a "double punch." Stein explains, "On Sept. 1, 2003, a U.S. investor could have bought euro currency at $1.09 and invested the proceeds in an index of European stocks such as the German DAX. Because the DAX increased in value over the year, by Sept. 1, 2004, a U.S. investor could have sold the index and realized a return of 8.5%." That would be the first punch--equity appreciation.

"Since the dollar continued to decline against the euro during this same time period, the U.S. investor could have converted his euro currency back into dollars at a cost of $1.20. This conversion would have resulted in an additional gain of 10% before transaction costs." This additional gain is the second punch--currency appreciation. With both the equity and the currency increasing over the year, a U.S. investor in this example would have received combined pretax earnings of 18.5%. In other words, a $10,000 investment would have grown to $11,850.

One of the easiest and safest ways to diversify globally is through international mutual funds. In fact, according to AMG Data Services, investors have been pouring money into overseas funds at a much faster rate this year than U.S. equity funds.

WHEN THE DOLLAR IS STRONG

In 2004, the U.S. dollar increased slightly in value against major currencies, but compared to its historical positioning, it is not yet strong. When the dollar is described as strong, it buys more units of a foreign currency than it did before. For U.S. consumers, this translates into lower prices for foreign goods and services. For Brandon of HBF Collection, returning to Italy to expand his shoe product line becomes a viable option. Likewise, Anderson's honeymoon in Europe and other trips abroad would be less expensive. U.S. investors also get a deal on foreign stocks or bonds because prices are relatively lower.

But everyone doesn't benefit in a strong dollar environment. The price of American products overseas goes up when the dollar gets stronger. This makes it more difficult for U.S. exporters to compete in foreign markets. It also dampens tourism in the U.S. since it's more expensive for foreigners to travel and purchase items in the United States.

A weak U.S. dollar works to enhance short-term returns for investors in U.S.-based mutual funds that invest internationally. This situation was reverse during much of the 1990s when the dollar's appreciation gave a boost to returns for Japanese and European investors who put their money in U.S. assets. There is no way for investors to ensure that they are always on the positive side of short-term currency effects, since it can be difficult to predict when the dollar will go up or down in value. For this reason, Davis of Vanguard advises investors to diversify across asset classes as well as between domestic and international instruments. So no matter which way the dollar goes, your total return is more likely to go up.

2004 cost of living comparisons in U.S. dollars

In most cases, the weak dollar makes products more expensive in Europe
and Japan. But, as this chart demonstrates, factors such as labor costs
and consumer demand may make some products less costly despite the
weakness of the American currency.

                                       NEW    BUENOS
                                      YORK     AIRES   LONDON   TOKYO

Monthly rental of a luxury           $3,500     $600   $3,603   $4,501
  two-bedroom apartment
Music CD                              16.23     8.52    23.97    21.19
1 cup of coffee, including service     3.30     1.10     3.23     4.73
Fast-food hamburger meal               5.75     2.43     6.63     5.48

SOURCE: MERCER GLOBAL INFORMATION SERVICES WORLDWIDE COST OF LIVING
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