Is a Dollar Crisis Looming?
Axel Merk"It's the 70's, stupid!" was a headline on CNBC on Wednesday, October 5, 2005 - a day when the dollar dropped sharply against major currencies. The 1970s was known for stagflation, a period of sluggish economic growth combined with high inflation. The 1970's is associated with a breakdown of the gold standard, high inflation, price controls, bad equity and bond markets, as well as a major bull market for commodities ranging from oil to precious metals.
Why do these concerns make the headlines now? Are these concerns justified? What does and can the Federal Reserve Bank do about them? What are the implications for the stock, bond and housing markets, as well as for gold and the dollar? How can you seek protection? Let us address these one at a time.
We have been warning for a long time that both monetary and fiscal policy are steering us towards stagflation; yet very few had been warning even about inflation a few weeks ago. In a country that is deeply divided into "red" and "blue" states, anyone critical of any policy was dismissed as simply not liking the administration. It took a federal spending blitz to authorize in excess of $60 billion (and to contemplate over $200 billion) to help in the reconstruction of the Gulf Coast after the hurricanes to wake up fiscal conservatives. A cynical rumor was spreading that President Bush may really be a radical liberal with a mission to ensure that no Republican will ever be elected again. Republican Representatives are not amused and indeed concerned that they may not be re-elected if spending is not brought under control.
Are the concerns justified?
The dangers of stagflation have been long in the making: if you drive an economy to maximum efficiency (or productivity) by encouraging consumers (through low interest rates) to finance their spending on credit, you get a consumer highly sensitive to increases in interest rates (and home valuations, a source in recent years to finance consumer spending). Add to that global overproduction (fostered by low US interest rates, low US taxes, and Asia subsidizing its exports through low exchange rates), and you foster low consumer prices on anything you can import from Asia and high commodity prices. US corporations have their margins squeezed and are unlikely to create as many jobs as would be typical at this stage in the economic cycle. US wage growth and job security are unsatisfactory due to the pressures of globalization. Driving this environment to extremes by responding with an economic stimulus to every crisis, we have an economy that is no longer resilient to shocks. The clearest sign that we are at an extreme is that US car manufacturers had to apply "employee discounts" to empty their inventories - this should not happen with the GDP growth we have.
To prevent the consumer from slowing down, ever greater stimuli are constructed. The problem is that they are less effective and foster inflation: we had a very tight energy supply situation before the hurricane, and may be adding over $200 billion as a further economic stimulus. While inflation has been contained so far because much of what we consume is imported from Asia, we cannot fully rely on Asia saving the US economy. Not only do we have significant inflation in oil and other raw materials, anything we cannot import from Asia, from healthcare to education has seen significant price increases over the past couple of years.
What does and can the Federal Reserve Bank (Fed) do about these concerns?
Fed Chairman Greenspan was quoted to have said that the US had lost control of its budget (not surprisingly, Treasury Department officials said that his comments were misinterpreted). In the past couple of days, numerous Fed officials warned about inflation, and how the Fed will be vigilant. The Fed these days puts a higher priority at expectations management than at managing fundamentals. In our view, this is the greatest mistake a central bank can do - it is supposed to set policy, to lead, not to react to perception. Until a few weeks ago, perception was that there was nothing to worry about in the markets - well, it wasn't. The Fed should have reigned in consumer spending a few years ago; indeed, much of corporate America cleaned up their balance sheets after the tech bubble burst. But consumers became victims of the temptation to load up on debt, to weaken their balance sheets.
This leads us to the question of what the Fed can do. The Fed has painted itself into a corner: to stop inflation from taking over, it would need to put a serious dampener on consumer credit. Because of a much greater sensitivity the consumer has towards interest rates now than in the past (because of the high debt load), such medication would not only throw the country into recession, but could easily lead to a depression. If the Fed was truly vigilant and raise interest rates sufficiently to stave off inflation, we would destroy the over-extended housing market. The problem is that the housing market may already be past its peak, and while interest rates have been climbing, monetary policy continues to be accommodating. Add to the equation that Bush will appoint a successor to Greenspan in the coming months; he is likely to favor someone close to him, someone favoring growth over fighting inflation. Morgan Stanley's chief economist Stephen Roach points out that there is a "curse of the Fed" - each of the past 3 Fed transitions at the top of the Fed over the past 27 years lead to jolts in the markets. This time around, we have a current account deficit of over 6% of GDP, a much weaker position than in the past to weather any storm. The recent outspoken comments by various Fed officials are a reflection of their nervousness. We have been predicting for some time that Bush will appoint former Fed governor and current chief economic advisor Ben Bernanke. Bernanke is best known for his opinion that throwing money out of helicopters is an acceptable monetary policy should there be the need; he is also a key driver behind managing monetary policy through perception management rather than managing fundamentals. One of the frustrations of the Fed has always been that they do not have full control over longer-dated debt securities (the Fed sets short-term rates), and other aspects of the financial markets. Ben Bernanke is a supporter of managing the entire yield curve (short- and long-term debt securities) through market intervention; he must have strongly endorsed handing out $2000 debit cards to Katrina victims (the victims certainly deserve help - we just point out the type of micro-management that we are likely to see more of in the future). Given the choice of beating the inflation that is in the pipeline and managing an inflationary economy, we believe the Fed will opt for an inflationary route, while giving lip service to how serious they are about fighting inflation; some action will be taken, and we may see a recession with higher interest rates and high inflation. Stagflation.
What are the implications for the stock, bond and housing markets, as well as for gold and the dollar?
Take an economy that is 70% dependent on consumer spending, and we are not very optimistic about any equities that are dependent on the US consumer. The US automotive sector is clearest victim of the policies, as the industry cannot adjust quickly enough to cope with the transformations that would be necessary to survive in this environment. But we are also negative on the financial sector as we believe the unwinding of the credit bubble will leave its scars. It is possible that we are postponing the unwinding of the credit bubble for a bit longer; but even then, a flattening and potentially inverted yield curve is a bad omen for the sector (an inverted yield curve refers to long term interest rates being lower than short term rates - typically this happens when the Fed applies the brakes to economic growth). There will be companies that thrive in this environment, but not enough in our view, to make up for the losses elsewhere. The bond market has been focusing more on an economic downturn than inflation. It is difficult to predict whether and when this will change; especially if the Fed was to get into more active management of the entire yield curve, it will be difficult to say how the bond market will evolve. We believe the risks are to the downside in the bond markets, and that if the Fed were to manipulate the yield curve, we are asking for more trouble in other areas of the financial markets. The markets need fair interest rates, not low interest rates. And even if our central bankers believe they can master our monetary system, free market forces will prevail and find an avenue to act as a valve.
We are very bearish on the outlook of the US housing market - home prices are in no relation to the rental income they could generate. The New York Times and other reputable newspapers recently quoted Greenspan as saying that homeowners need not to worry about the housing market as even in a decline, homeowners still have some equity in their homes. To consider it good that homeowners are, on average, not yet "maxed out" is a good sign - if reputable papers interpret Greenspan this way, we are in a bubble? If you buy a stock on margin, you are not allowed to borrow more than 50% of the money to pay for it; you get what is called a "margin call" to contribute more cash if the portion of borrowed money versus the value of the stock rises too high. In the mortgage industry, where investments are much larger and usually not diversified (a home is more expensive than the average stock purchased and most do not purchase a portfolio of homes), many homeowners opt for 80% to 100% debt financing; sometimes even more than 100% debt financing - after all, the homeowner may also need to buy furniture and renovate the place. If home prices go up over 10% in a year, they can also fall over 10% in a year. The problem is that the leverage in the housing market is so much greater than in the stock market; and because houses cannot be sold overnight, the period to adjust to lower housing prices is likely to be painfully long. To say we do not need to worry as long as there is still a tiny buffer should home prices fall are the words of a fool.
The winner in all of this has been gold. That's because the natural valve is, in our view, the dollar. Gold may be the most sensitive gauge for the value of the dollar; after reaching a 17 year high, the public seems to take notice. The US has most of its debt denominated in US dollars - so why not devalue the currency to address the debt. Social security reform seems unlikely - so why not let a drop in the US dollar erode the purchasing power - politically, this is the easiest approach to reduce benefits to the elderly. Currently, foreigners need to purchase over $2 billion worth of US dollar denominated assets every day just to keep the dollar stable (a direct result of a current account deficit of over 6% of Gross Domestic Product). With the US economy slowing, it would seem likely that foreign investments also decline. Foreign government purchases of US Dollars have already been in decline this year. Notably, the formerly largest buyers Japan and China have reduced their US dollar purchases. Venezuela is the latest country to shift significant portions of its assets out of the US.
How can you seek protection?
In any market environment are opportunities to profit - sometimes it is even easier in turbulent times if the painting is clearly on the wall. We cannot give specific investment advice here, especially as every investor has a different situation. But our analysis above may give you ideas in which way to look. On the equity side, evaluate whether your investments are dependent on the US consumer. Overall, corporate America's balance sheets are in good shape (with notable exceptions). And "new economy" companies may be flexible enough to cope with this environment. For those of you in US equities, one area to look at are large gold producers, be cautioned though as, many factors may affect the market price of gold producers beyond the price of gold. In theory, gold producers are a leveraged play on gold: as the price of gold rises, the production cost is supposed to remain relatively stable: if it costs $300 to produce an ounce of gold and the gold price is rising 10% from $400 to $440 an ounce, profits theoretically rise 40% from $100 to $140 an ounce. In practice, this equation doesn't hold as gold producers are highly energy dependent and many producers have not been able to expand their margins despite a rise in gold; other factors, such as political uncertainty and management skill also affect gold producers. You can of course buy the metal, gold itself, at your local coin dealer. Or the speculator has various tools in the derivatives markets.
You may want to explore international investments. However, again, be cautioned that much of the rest of the world is geared towards selling to US consumers. Just as with any investment, you need to do your homework or find a financial advisor who can assist you.
One approach to seek protection from a falling dollar is to diversify into a basket of hard currencies. Many investors have shied away from currency investments because it has either been considered speculative, or because many retail investors have not had access to it. We do not encourage currency speculation as short-term swings are very difficult to predict. But you may want to consider "exposure", i.e. investing your money into a basket of hard currencies and hold it there. Or if you are shifting out of equities or bonds, why not consider hard currency cash instead of US dollar cash. We have responded pro-actively by putting our own money where our mouth is by establishing a mutual fund this spring, the Merk Hard Currency Fund. The Fund seeks protection from a falling dollar by investing in a basket of hard currencies including gold. The Fund purchases money market instruments in 'hard' currencies. We determine the basket based on our analysis of monetary policies of the respective central banks. We don't speculate by trying to take advantage of perceived opportunities; instead, we allocate the money into the basket and have the basket evolve over time. It was a tool we saw missing in the market and we believe it may provide desirable diversification. Our goal is to protect against a potential decline against the dollar while trying to mitigate other risks. For example, we only invest in highly rated money market instruments with an average remaining duration of 90 days or less; unlike a global bond fund, we try to minimize the interest risk (bond funds can lose value in a rising interest rate environment), and do not purchase equities. Our Fund is not a money market fund as we do not seek a stable net asset value; we specifically seek the currency risk.
We do not know what the future holds, but we ponder about scenarios. Even if you disagree, our analysis may deserve consideration. And if it deserves consideration, a prudent investor may want to consider diversifying his or her portfolio to take it into account.
10 October 2005
Axel Merk is portfolio manager of the Merk Hard Currency Fund.
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