Since the Bretton Woods agreement broke down in 1971, and the US was effectively freed from the gold standard constraint, it started printing large volumes of dollars, injected into the banking credit system. Inflation in the 1970's saw the advert of high interest rates in the Volcker era, as he started the squeeze on inflation. The 1980's saw the US government move into high fiscal deficits under President Reagan's big spending plans. The mid 1980's also saw the US push the dollar lower after the Plaza Accord in September 1985 to keep the economy moving.
After coming out of the 1990/1991 recession, the US started adopting a strong dollar policy in principle. The fact was that the dollar was boosted largely by the biggest equity boom of all time (mostly over the 8 years to 2000), as capital inflows helped push the dollar firmer and firmer, even as the underlying trade position of the US deteriorated.
The dollar rose substantially in this period as the US became the main engine of growth for the whole world. US consumers drove this process, mostly because of the greater and greater volume of cheap credit that they were able to access. The rest of the world, especially Asia geared up to sell their goods to the insatiable US consumer.
The simple process involved - products are manufactured in cheap producing countries and sold to the US, while dollars flow from the US to Asia and to Europe as payment. The strengthening dollar made for cheaper and cheaper imports, which helped keep inflation moving lower and lower, and interest rates low. This in turn boosted spending, and hence drove up imports - a vicious circle.
The accumulating dollars held by countries outside of the US, found their way back into the US by way of outside investment into shares, bonds, property etc. Because less US goods are purchased by countries outside of the US (there is no reason to buy expensively produced US goods), a growing trade imbalance arouse.
While the growing trade imbalance has been a concern for many years, its impact has not really been felt, until more recently that is.
The trade imbalance has increased steadily over many years, and is now running at a rate of around $500 billion a year - around $2 billion each working day. These funds must come from somewhere and while the US and its citizens have no saved capital, they have been fortunate enough in that foreign countries have been happy to pump capital in, buying bonds and equities.
As a fact this disequilibrium position has been ongoing for many years, and while capital flows more than offset the increasing trade deficit, there is nothing to stop even a $10 billion/ day trade deficit, as long as other nations are happy to continue to invest capital, and therefore provide the funds to the US for them to continue trading in an overdraft type situation.
What is certain however is that the trade deficit and capital offset flows are cumulative, so that when the reversal comes, it has behind it the full weight of cumulative imbalance that has been built up over many years.
Up until recently, there has been little pressure on the US dollar, helped also by the large volumes of foreign reserves held in dollars. Now as it gets more and more difficult to continue to attract foreign funds to the weaker investment environment, capital flows start to slow. This in turn has and will continue to weaken the dollar, which in turn makes for a weaker investing environment. The effect is a self-perpetuating reversal of the process that we have seen over the last 10 years.
As this happens, then the existing trade imbalance needs to decline dramatically, or the floating rate at which outside goods are purchased (i.e. the exchange rate of the dollar), must continue to slide, making it more and more expensive to import goods, in order to balance out the slowing capital inflows.
The likely prognosis is a combination of the two. By most accounts, the US consumer has less and less ability to continue spending, with high debt levels, and job security on the line. Combined with higher imported prices, as the dollar slides, we must see the start of the slowdown in the large US trade imbalance.
It is doubtful whether this can happen quickly enough for the impact on the dollar to be minimized. Also remember that foreigners will make some decisions on their cumulative capital invested into the US, where the dollar slide affects returns. Remember that with interest rates on both short term and longer term debt instruments at extremely low levels, this is quickly wiped out by exchange rate losses for foreign investors - South Africa's invested in the US have experienced this painful scenario and so the decision to repatriate is very real.
At the same time foreign countries cannot actually afford a weak dollar, and they have been, and will continue to do everything in their power to try and keep the level of the dollar up. This is one of the main reasons, why it could be a slow process down.
Why do I say this? The world's main economies, whether they like it or not are largely geared to export to the US. This is especially true of Asia. The Japanese government has always been a very big player in the currency markets, selling yen and buying dollars to keep the yen competitive for its exporting companies.
The US has no choice but to continue to try and stimulate the US economy
The US government is adopting a massive economic stimulus package to keep the US economy moving ahead. Time will only tell if it will work. It looks like they are only buying time, with:
» Monetary easing on an unprecedented scale, with interest rates at 40 year lows;
» Large-scale fiscal stimulus in the form of lower taxes and bigger spending, resulting in budget deficits of at least $2 trillion over the next 10 years.
» And statements by the Treasury Secretary as to their effective indifference to a strong dollar. It has been taken as the start of a "weak dollar policy".
The slowing economy, large fiscal expenditure including defense increases, and recent tax cuts, mean that the US needed to up its debt levels. It has been hitting up against the $6,4 trillion limit since February 2003, but now, in less than a year, President Bush has just signed an increase in the limit by another $1 trillion (actual $984 billion), bringing the total government debt limit to $7,5 trillion.
In addition to this official government debt, when adding in private and corporate debt, the total is estimated at around $30 trillion, which is close to 3 times the gross national product of the US.
The Federal Reserve with a dual mandate on inflation and growth, sits in an invidious position. Having fuelled credit expansion to such a massive extent, it's very difficult to see how it can rein this in, without disastrous consequences.
This is what Stephen Roach from Morgan Stanley said this week.
"Global rebalancing is a conceptual framework that unifies many of the seemingly disparate macro forces at work in the world today. It suggests that the ultimate outcome is not in doubt -- even if reactionary forces win out in the short term and the world goes back to its old ways of US-centric global growth. My key premise is that a US-centric world economy remains on an inherently unstable course. A persistence of secular downward pressures on the dollar is an unavoidable outcome of the chronic imbalances that have arisen. Sooner or later, that will spark a global rebalancing. It's just a question of when -- and on what terms. Sadly, the longer it takes, the more disruptive the endgame."
[my emphasis]
So, what does this all mean?
In a nutshell, the US has been the single engine driving the world economy. This has largely come through its citizen's insatiable appetite for credit purchases. With no internally generated savings, they have gone on a massive spending spree, which the creditors have financed.
Paying back accumulated debt, is not half as much fun, as incurring the debt. For starters paying down debt levels means little is left over for further consumer binges. An added factor is the probable downward effect on values, as assets are liquidated to pay down debt.
Against this backdrop, I believe that:
» The US Federal Reserve is likely to retain interest rates at these very low levels for a long time, while its biggest concern is trying to keep domestic growth moving.
» The low interest rate environment is likely to keep on fuelling the very hot private mortgage environment for house purchases;
» Massive supply of new dollar debt, together with comments about printing to avoid deflation at all costs, will continue to concern the foreign holders of US dollar denominated assets, mostly US Treasury debt.
Interest rates are been kept down artificially. With large increases in the supply of debt brought on by record budget deficits, holders typically demand higher yields as compensation. But the Federal Reserve has commented that it is probably going to have to buy longer dated bonds to hold down yields, and inject liquidity.
In my opinion these artificial methods of keeping interest rates down, while inflating debt levels, has to have some unintended consequences.
The question you should ask is "what should I do about my US dollar based investments?"
In my opinion, it appears that the ongoing risks of being invested in US dollar denominated investments remains very high, especially US equities and also supposedly risk free bonds. I have had a dim view of US equities for a long time now.
While we may have already seen the best part of the rand appreciation against the dollar, the low prospective returns from the underlying asset classes in the US, don't make it an exciting diversification. My recommendation is to seriously question your exposure.
Alternatives - Make sure that your portfolio has exposure to Gold
A decline in the dollar is being matched by gains in bullion. Increasingly I am seeing reports of investors selling out their dollar holdings, moving to euro, Australian dollar, and also gold.
Some of the reasons for holding gold and gold shares include:
» The weak dollar, which in turn may precipitate further financial weaknesses - investors look to move to alternatives;
» Low interest rates mean that the opportunity cost in holding physical gold is very low
» After a protracted bear market, gold and gold shares have performed very well over the last 18 months, and this trend is likely to continue;
» Demand remains in excess of supply, and mine hedges have reduced substantially; and
» Hedge against global financial uncertainty.
My strong recommendation is to allocate at least 10% of your total portfolio to gold shares at this point in time. Even if very little performance is achieved, the result is a very good risk diversifier.
Please e-mail me directly on ian@sharenet.co.za for more information on how you can best allocate a portion of your total portfolio to gold.
Conclusion:
The more the dollar slides, the greater the propensity for foreign holders of US assets to liquidate their positions, which in turn is likely to exacerbate the already weak share and bonds values.
For this reason, I don't believe that it's too late to dramatically reduce offshore equity exposure and bond exposure.
Please contact me if you have an existing offshore exposure, and are looking for specific advice in this regard.
Optimising your investment strategy in challenging times
I provide investment counsel to high net worth clients on their specific investments and investment strategy.
Have a look at www.exsequor.co.za for more information on this service.
If you would like to find out more about how I can remodel your investment planning, then please feel free to contact me.
Sincerely
Ian de Lange CA (SA)
30th May 2003
ian@sharenet.co.za
021 710 5700
This investment newsletter is published for general information. While every effort has been taken in the production of it, Sharenet (Pty) Ltd and/or Ian de Lange bear/s no responsibility for any loss or damage that may be result from any person's reliance on the information contained in the newsletter.
Posted: 2003/05/30 15:47 View Archive