Why U.S. Stocks Are Going to Kill Your Portfolio

Does this year's $1.6 trillion deficit scare you? What about the multitrillion-dollar overspending of next year and the year after that? Are you worried that the Federal Reserve's "teaser" rates to banks will come back to bite us?

The U.S. government has attempted drastic fiscal and monetary solutions to generate inflation -- any ol' inflation will do -- to get the economy moving again. For the moment, those efforts have propped up ailing financials such as American Express (NYSE:AXP) and JPMorgan Chase (NYSE:JPM).

But what happens when inflation does come back? The government's printing presses have been working nonstop for months, and when economic growth does return, inflation is going to kill your returns.

If they're too exposed to the dollar
Now, to be sure, many economists, including Nobel laureate Paul Krugman, still believe the more immediate concern is deflation. And it's true that as long as the Fed can't generate inflation with interest rates near 0%, deflation will be a real prospect. But as economic growth picks up, inflation will become an increasing concern.

Why does it matter for your returns? Researchers have found that stock returns are negatively correlated to expected and unexpected inflation. And no less an investing luminary than Warren Buffett has explained how inflation robs the equity investor.

Now, sure, Fed chairman Ben Bernanke is well aware of the dangers of inflation and has promised to drain liquidity from the system quickly once inflationary pressures present themselves. He has even warned Congress about spending too much. But monetary policy is notoriously slow to take effect, and the legislature is about as loath to cut spending as a contestant in an all-expenses-paid spree.

We're already seeing the effects. Oil prices are increasing, swallowing much of the stimulus money that is being doled out weekly in dribs and drabs and threatening the nascent recovery. Interest rates are starting to creep up, an ominous sign for millions of underwater mortgage owners. Until things are definitively clear, the government will be backing easy money, and Wall Street will push both the government and the Fed to continue expansionary policies until the economy clearly emerges from its doldrums.

But with savings rates skyrocketing and Americans reluctant to spend, that definitive recovery could be years off -- and in the meantime, inflation will eat away at your returns.

But all this is happening in dollar-land
If you're as concerned about inflation as I am, it makes sense to invest in something besides dollar-denominated assets. Prudent purchases of high-quality, high-growth foreign companies can be just the thing to diversify against the risk of dollar inflation.

Here are just a few of the compelling investment opportunities around the globe:

As of Nov. 9, 2009. Data provided by Capital IQ and Yahoo! Finance. TTM = trailing 12 months.

Notice that these companies operate in a variety of countries. Just as you want to diversify your portfolio away from the dollar, your portfolio should also have exposure to a variety of currencies to hedge against the prospect of unsound fiscal and monetary management in any one of them.

For example, as the Chinese yuan appreciates against the U.S. dollar, owners of China Mobile will capture foreign-exchange gains in addition to the swift growth that the company is realizing. In the case of China Mobile, you'll capture 100% of those currency gains, because the company does no business in the U.S. or elsewhere.

However, if you'd like more balanced exposure to a variety of currencies, then you might select Unilever, which derives about one-third of its revenue from the Americas, one-third in Europe, and the last third in Asia and Africa. This balanced business offers you a natural hedge against major currencies and has some of the most globally recognized consumer brands to boot.

In other words, as dollar inflation heats up, you'll be protected by your foreign-based investments.

Go further west
And this is a perfect time to buy, because global equities have experienced a temporary downturn. At Motley Fool Global Gains, advisors Tim Hanson and Nathan Parmelee have recommended rock-solid companies across the globe that can profit even when inflation hits the U.S. -- and it surely will. You can read all about them by clicking here to join Global Gains free for 30 days.

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This article was originally published on Sept. 11, 2009. It has been updated.

Fool contributor Jim Royal does not own shares of any company listed in this article. Petrobras and Turkcell are Income Investor recommendations. Turkcell is a Global Gains pick. NetEase.com is a Rule Breakers selection. American Express is an Inside Value recommendation. The Fool has a disclosure policy.