U.S. Dollar – Grave Concerns Remain
by Axel Merk and Kieran Osborne. April 15, 2010Print
We continue to see risks ahead for the U.S. economy, and in particular, the U.S. dollar. Significant global imbalances remain – indeed; the recent global financial crisis has served to exaggerate many of these imbalances. Of grave concern is the unsustainable Federal budget deficit, which may have morphed out of control, with no signs of government constraint over the near-term. The U.S. current account deficit remains at a high level, and will likely weigh on the dollar for years to come. Add to this the inflationary pressures brought about by the Federal Reserve Bank’s (Fed) substantial balance sheet expansion – the balance sheet has grown nearly threefold since the beginning of the crisis – which may cause a further devaluation of the U.S. dollar. Despite political rhetoric to the contrary, in our assessment, policies are clearly working against a strong U.S. dollar. Moreover, we are yet to see evidence of a strong, sustainable economic turnaround in the U.S.
We were never in the “V” shaped recovery camp, and our analysis of the data thus far doesn’t support such a thesis. Businesses appear unwilling to hire, with the unemployment rate remaining at historically high levels. House prices have yet to revert to long-run affordability measures, despite historically low interest rates. Banks are not lending despite a plethora of available funds - whether this is predominantly driven by continued bank risk aversion, a lack of demand for loans, or a combination thereof does not portend a strong economic rebound. Debt levels remain high and what debt is not being driven by private sector demand is more than made up for through insatiable government debt growth. Alcoholics do not drink themselves sober; likewise piling more and more debt onto the system does not rectify a country’s debt-fueled problems. Until we see fiscal and monetary restraint in action rather than words, we consider the medium and long-term risks remain to the downside for the U.S. dollar.
Given current dynamics, we consider there to be many attractive currency investment opportunities. Of particular interest is the Asian region and those countries well placed to benefit from ongoing Asian demand. Despite a global economic downturn, Asian behemoths China and India continued to post healthy economic growth, albeit down from their lofty highs. Both countries realize they can no longer rely on exports to the West, and the U.S. in particular, to drive economic growth given the weak consumer spending outlook here. Rather, China and India have increasingly focused on developing their own domestic economies and respective middle classes. Such focus will require substantial ongoing spending on infrastructure, which is reliant on hard commodities and natural resources. As such, we favor the currencies of countries that are rich in such resources and have central banks that have followed more prudent monetary policies, like Australia, Canada and Norway.
In our opinion, rapid Asian domestic economic growth will create increasing inflationary pressures. Indeed, China has recently clamped down on bank lending and India has raised interest rates in response to such pressures. We believe the Chinese approach to containing inflation is highly ineffective, and that currency appreciation may be a much better solution to tame domestic inflationary pressures. China presently focuses on curtailing bank lending via required reserve rules and direct government mandates. In our opinion, a more effective, less costly response would be to allow the currency to appreciate. While this is unlikely to happen overnight, we have seen China move in this direction, allowing numerous bi-lateral swap agreements across a range of currencies, increasing the number of currencies with which the Chinese renminbi can be readily converted, and carrying out stress tests on the business implications of a stronger renminbi.
An Asian currency we are not currently in favor of, however, is the Japanese yen (JPY). We harbor concerns over the long-term viability of the country’s ability to service its enormous levels of debt in light of unfavorable demographics – specifically, an aging, shrinking population. Moreover, recent initiatives have us concerned that the Bank of Japan (BoJ) may now reignite its quantitative easing policies, which had lain dormant throughout much of the credit crisis (ostensibly through weak leadership). Such policies may significantly devalue the currency. In our view, the recently elected Democratic Party of Japan has compromised the independence of the BoJ, telling the Bank in not-so-subtle ways that it needs to do everything in its power to stave off deflation (read: print money). Indeed, the BoJ has succumbed to this pressure, recently announcing an expanded quantitative easing program. We consider these steps may undermine the value of the JPY going forward.
Lastly, there has been a lot of concern surrounding Greece’s woes and the spillover effects on the rest of Europe and the euro (EUR). Unlike many other market participants, we see considerable value in the EUR on a long-term view. It is welcome relief to see that market dynamics are bringing Greece to account, penalizing the country for its lack of fiscal discipline. We believe that Greece will ultimately be seen for what it is: a low single digit percentage of eurozone GDP. In our eyes, the EUR will not only survive, but may offer significant upside potential. Structurally, in our analysis, the eurozone is simply not as effective at printing and spending money as the U.S. is. Given the spluttering economic recovery outlined above, we consider the Fed may expand its balance sheet once more in the next economic downturn, devaluing the U.S. dollar, while the European Central Bank (ECB) is likely to continue to follow much more prudent monetary policies. Therefore, while the eurozone may experience weaker economic growth, it is likely to be on the backdrop of a stronger currency. It is important to note that when a country doesn’t have a large current account deficit, as the eurozone does not, it doesn’t necessarily need strong economic growth to have a strong currency – one only needs to look to the Japanese yen over recent years as an example. Relative to the U.S. dollar, the EUR may retain significant value.
With so many global dynamics playing out, we believe there may be many attractive currency investment opportunities. In particular, we consider the significant risks to U.S. dollar weakness will remain for some time to come, given recent policy initiatives and massive global imbalances.
© 2010 Axel Merk