December 2004
As we enter the holiday season, the falling U.S. dollar seems to be on everybody's mind. We venture to guess that if you read the newspaper or listen to the radio, you've likely heard about the weakening dollar. Really, it's been pretty hard to avoid. We've written this piece as an aid in understanding the discussion and to give you a sense of how we have incorporated it into our investment strategy.
Despite the fact that the U.S. dollar has been declining in value against the European and Japanese currencies for three years, it failed to get much mainstream attention. That is, until a few weeks ago when it broke through a trading range that was mistakenly thought to have been a bottom. It is now down anywhere from 25% to 55% from its peak against the Canadian dollar, the British pound, the Japanese yen, and the euro. The dollar would have also weakened against the Chinese currency (called the yuan for those of you who want to appear very well-read at holiday parties) if it was freely set by the currency markets. Instead, as a matter of Chinese policy to remain ultra competitive, it is unfairly pegged to the dollar.
A Weakened Dollar Personified
How does a weakening currency actually affect you and how might it affect investment portfolios? In a very practical sense, if you were planning a trip to London, Paris or even Toronto for next year you could expect to pay a lot more for hotels and meals than you would have two years ago. For example, one euro now costs Americans $1.35 compared to only $0.87 three years ago. That's a 55% increase in cost that Americans have to pay for goods or services priced in much of Europe. It shouldn't be surprising to soon see higher prices on new foreign made cars, like a BMW or a Lexus, to make up for some of the currency related losses these companies have suffered over the past three years. Besides the real life, albeit marginally negative, affect of international vacations costing more, American manufacturers could very well try to take advantage of the higher prices on their foreign competitor's goods by raising their own prices. Overall, a weakening dollar tends to feed an inflationary environment.
There are a number of reasons that the dollar is declining. The primary reason is that Americans purchase more things from other countries than they buy from us. Opening China to free trade was originally billed as a wonderful way to gain access to a huge consumer market for our products. To this point, this free trade has largely resulted in us exporting US factory jobs and importing cheap products. By buying more goods than we sell, we are basically sending more dollars overseas than come back to us. As foreign governments are flooded with these dollars they could obviously sell them and buy other currencies. But this would only further weaken the dollar and effectively raise the price on their own goods that they need us to buy. Not a great option. Another avenue is to take their dollars and invest in dollar-based assets. The safest and easiest place for foreigners to invest their dollars is in U.S. Treasuries and they have done just that in a big, big way.
They have invested hundreds of billions of dollars a year in US government's securities. In recent years, it hasn't been unusual for foreign governments to have purchased the majority of our newly issued government securities. Rather than out of the kindness of their hearts, they've been doing so for very self-serving reasons. They've wanted to help keep the dollar strong enough to help us keep buying what they are selling. As an added benefit, foreign investors have been largely responsible for keeping US interest rates lower than they should be. This, in turn, has fed our credit culture via low mortgage rates, rising home prices and growing sense of wealth. At least on paper. In a way, this looks like a massive incentive financing effort to keep the US consumer in the consuming game. And so far they have accomplished their goal. Interestingly, keeping the US consumer consuming has been a shared goal with Alan Greenspan and our politicians.
Many foreign economies like China, Japan, and Germany depend on exporting their products to America to keep their economies growing. But today they are engaged in a precarious balancing act that is looking rather out of balance. In the last three months or so it has become clear that foreign investors and governments have been much less aggressive in bidding for US government bonds. They are instead beginning to diversify into other currencies, like the euro - much to the dismay of European manufacturers! It seems like nobody likes a strong currency in today's competitive global economy.
The Foreign Central Bank Catch-22
It also seems that the currency losses on their massive holdings of U.S. government securities are beginning to take their toll. So, in a classic catch-22 scenario, some foreign central banks are facing a tough decision. Should they abandon their support of their manufacturers by letting the US dollar weaken? Or should they keep investing gobs of cash in our weakening currency? We may be getting an early glimpse of their decision. Their recent action to limit their support of the dollar may be partly based on the growing expectation of ever-expanding US trade deficits and our substantial budget deficits. In other words, our lenders are beginning to show some worry about our country's financial health.
To be fair to our foreign counterparts, we could argue that our own business and political leaders aren't sending optimistic signals to potential investors. Despite the fact that companies in this country have been generating record profits over the last two years, they have been very cautious to invest that cash in equipment and in people. These are the things that drive an economy forward. In a normal recovery, businesses begin to use their excess cash flow to invest in new products and start to expand their production capacity to meet future demand growth. In a normal recovery, businesses begin to hire new employees. But businesses are behaving a bit differently this time around. The recent employment report for November showed once again that hiring trends remain far below normal. Many U.S. companies have chosen to sit on their piles of cash. No doubt part of their reluctance is due to their giddy over-investment in the late nineties and to the very aggressive fiscal and monetary policies adopted after the bubble burst. To sum it up, odd recessions tend to produce odd recoveries.
Our Worries and Our Actions
As money managers, an important element of our job is to think about problematic scenarios and then make proactive decisions to protect against them. This is a somewhat gloomy process by nature but it serves an optimistic purpose. In a nutshell, a weakening dollar in a moderate sense isn't all that bad. Currencies have fluctuated in the past and over long stretches they've done so in large ways. Now, fluctuations over short stretches pose difficult issues in financial markets. If the US dollar weakens quickly and violently (for whatever reason) and capital flees to safer currencies like the euro or the yen, then interest rates here at home will rise quickly and violently. Not at all good for longer term bonds or for stocks. On the other hand, if the dollar weakens at a slower and more moderated pace - and this is our government's preferred method - then we worry about a growing inflationary environment coupled with rising long term interest rates. This was once called stagflation and, yes, this too is not good for longer term bonds or for stocks for that matter. It all sounds pretty dark, but it certainly isn't a hopeless situation devoid of opportunistic action. In many ways, with the right approach, these scenarios still produce great opportunities for harder to earn profits.
Our concerns about the dollar have been incorporated into our managed portfolios. We have chosen to own shorter term, high quality bonds that are designed to protect a portfolio from higher inflation and rising interest rates. And on the stock side, our approach remains fundamental. Our strategy will continue to focus on downside protection by making sure the price is right and our allocation to stocks will be largely driven by the opportunities the market gives us. We continue to believe that any money manager worth his salt (or fees) understands the real value of cash in a down market. We are looking forward to 2005 - believe it or not.
John W. Gudritz, CFA
john@frontstreet.com