Currency War

The concept of a currency war may sound odd, but such a war can have serious consequences and, in fact, we are currently in the midst of one. Therefore, it is worth while examining the nature of this conflict and its potential impact on the U.S. currency, economy, and stock and bond markets. While currencies can be some of the hardest financial instruments to analyze, we believe that the evidence points to a strengthening of the dollar, which would likely be associated with a very positive environment for U.S. investments.

What We Mean by “Currency War”

It used to be that the value of most currencies was based on the gold standard, wherein governments stood ready to exchange a fixed amount of gold for a fixed amount of currency. The practice of tying currencies to gold was widespread for hundreds of years, but was abandoned temporarily by many countries in the 1930s and by the U.S., for good, in 1971. Now, absent the linkage to the yellow metal, there are simply “fiat” currencies, which are valued based on the perceived reliability of the issuing governments. Today, exchange rates fluctuate as a result of myriad factors, including trade balances, levels of government indebtedness, inflation, and interest rates.

In a world of floating exchange rates, currency is a potential tool to help governments spur economic activity. For example, a weaker currency makes a given country’s exported goods relatively less expensive and its imported goods relatively more expensive, providing a boost to domestic industries, which in turn can create jobs. The downside, of course, is that a weaker currency also leads to inflation, which lessens the value of debt and angers lenders and savers alike. So, any decision to engage in an effort to weaken a country’s currency by some combination of cutting interest rates, buying outstanding financial assets such as government bonds (i.e.“quantitative easing”), buying foreign currency, or restricting the flow of capital is not to be taken lightly, but rather is a necessary evil born of difficult circumstances. To the extent this is done aggressively, and to the detriment of trading partners and competitors, currency devaluation becomes a weapon.

The Combatant Nations

One could argue that the Federal Reserve Board’s decision to lower short-term interest rates effectively to zero in the wake of the banking crisis of 2008 constituted the beginning of the current currency war. The dollar of course did weaken, but we don’t believe that was the primary objective. Rather, the focus of the Fed’s effort was to kick-start a floundering economy, not necessarily to boost exports through a weakening currency. After all, the U.S. is a major net importer. Two thirds of our total world trade is with Canada, Europe,China, Mexico, and Japan, and in each case we import more than we export; in the case of China, massively so.

At the moment, the race to the bottom in currency devaluation is taking place mostly within Asia, home not only to some of the most important developing countries (e.g. China, Korea,and Indonesia) but also one of the most developed nations (Japan). Japan is currently suffering through a generation-long period of deflation and economic stagnation stemming from the bursting of its real estate and stock market bubbles in the late 1980s, and also from the effects of a wealthy but rapidly aging population. Not surprisingly, Japan is desperate for economic growth, and if there was a real trigger to today’s currency war, it was the Japanese decision to embrace quantitative easing wholeheartedly.

On April 4, 2013, the new head of the Japanese Central Bank announced that it would increase its purchases of government bonds (very similar to our own Fed’s program) to a level of 5-6 trillion yen per month. While accommodative policies were announced by Japan’s new prime minister in late 2012, the magnitude of this latest move was a surprise.The proposed bond purchases will double the size of Japan’s monetary base in two years, a faster pace than the Federal Reserve’s own quantitative easing program. As a Deutsche Bank analyst noted, relative to the size of Japan’s economy, “it is quantitative easing on steroids.” One of the desired effects of this program is a sharp decline in the value of the yen, thereby enhancing the global competitiveness of Japanese exporters.

This was an aggressive move, to say the least, and Japan’s new policy puts its exporting competitors China and Korea at a real disadvantage. Historically speaking, getting these three into any kind of a brawl should be cause for concern. Korea has since cut its interest rates and China has purchased foreign currencies aggressively, both countries in an effort to weaken their own currencies. In China’s case, a more effective policy might be to lift restrictions on the capital outflows of its citizens.

Investment Implications

We have often said of the current investment environment that the U.S. is the best house in a troubled neighborhood. Economic prospects are still iffy in many parts of the world. Yet while growth here is still only modest, it is definitely improving. And there is ample reason to think that the U.S. has put the Great Recession behind it. Fed Chairman Bernanke’s comment in May on “tapering” the pace of quantitative easing was probably a first trial balloon in what is likely to become a slow but steady reduction in the Fed’s efforts to exert downward pressure on U.S. interest rates and, by extension, the dollar.

So, if a currency war involves countries trying to weaken their currencies more or faster than their competitors, primarily in order to gain a trade advantage, do we as U.S. investors need to be concerned about a dollar that seems likely to strengthen over time? Our answer is “no.” A weak currency is a boon if you are a major exporting nation, but as noted above,the U.S. is a major importer. Should our currency strengthen vis-à-vis those of our trading partners, both input costs to businesses and final costs to consumers would fall. This is clearly a positive. While the pressure on U.S. exporters (such as large technology companies that derive more than half their revenues from the international markets) would increase, we believe this is already reflected in investor growth expectations.

Are we attracted to the Japanese stock market? There, our answer is “mostly no.” The Japanese government is in debt up to its eyeballs, and its population is both aging and shrinking, making any kind of longer-term economic growth difficult to come by. The Japanese stock market has been booming since Prime Minister Abe’s election in late 2012,and it reacted very positively to the Bank of Japan’s most recent move. A weakening yen definitely helps its export sector, but a Citigroup study on periods of notable currency weakness since 1990 concludes that in most cases, dollar-based investors lose more on currency translation than they gain from rising foreign stock prices.

If not Japan, what about China? In emerging markets, a strengthening currency has usually been good for both local and dollar-based equity investors. China is an important emerging market, and its currency has been getting stronger against the dollar in recent years, not to mention against the yen and the currencies of the other Asian “tigers” as well. Unfortunately, as an exporting nation, this strengthening is a problem for China. Since 2005, the renminbi has risen 4% per year against the dollar, and Chinese unit labor costshave risen 11% per year. That combination has reduced Chinese price competitiveness and forced price cutting to maintain export growth, in turn hurting profits, and thereby lessening the appeal of investment in China.

Another investment implication of a stronger dollar is that commodities priced in dollars are likely to see continued weakness. As the value of the dollar increases, the cost of such commodities to non-dollar-based purchasers also increases, thus causing demand (and hence price) to decline. Perhaps the most obvious example is gold. In addition, gold is considered a safe haven in times of distress, and as a hedge against inflation. While most central banks have been actively trying to reflate their economies, they haven’t really succeeded. Thus, generalized global inflation still seems a long way off. Oil is another commodity likely to see some weakness, not only from a strengthening dollar, but also because of the supply shock currently being generated right here in the U.S. We are watching our exposure to both commodities very closely.

On the home front, we believe there is pent-up demand for U.S. assets as a safe haven and in the dollar as a store of value. The U.S. also has the best economic growth prospects in the developed world. And with Asian central banks buying dollars in an attempt to weaken their own currencies, demand for dollar-based assets, both stocks and bonds, should remain strong. This should dampen the rise of interest rates, even when the Fed does begin to taper its monthly bond purchases. Meanwhile, Chinese annual savings are more than twice U.S.savings, so if capital were to be allowed to flow freely out of China, as is currently being hinted, it would lead to meaningfully increased demand for U.S. assets.

Conclusion

A currency war may not involve bullets, but the stakes are nonetheless high. Protectionism and currency manipulation were aspects of the Great Depression of the 1930s. Trade allows growth, because it enables people and countries to focus on what they can produce most cost effectively and swap the results for those things that they don’t have or can’t make as efficiently. The problem is that devaluing a floating currency can give certain countries an artificial advantage. If this is viewed as unfair, things can quickly escalate into a broader economic conflict that could lead to protectionism and declining world trade. We will keep a close eye on that risk. For now, we maintain our long-held focus on the U.S.equities market, which in so many ways seems well-positioned to benefit from the current situation.

Stock Market Comment

In the weeks since Fed Chairman Bernanke’s May 22 tapering comments to Congress,interest rates on the ten-year Treasury note have risen from 1.9% to 2.6% and the stock market has ceased its relentless advance. Investors are concerned. If excess liquidity was a major factor in the stock market’s rise to date, what will happen when the Fed removes the punch bowl?

It is natural for investors to fear the unknown. It is also natural for bull markets to correct from time to time. Could the onset of Fed tapering cause a continuing stock market correction? Sure, since some sort of pullback seems well overdue. But, could the onset of Fed tapering bring the current bull market to an end? We think not, particularly because such action is likely to be gradual and a result of the Fed’s belief that U.S. economic growth has become self-sustaining.

Stock market valuations are not currently expensive, and equity returns from here will largely be a function of continued earnings and dividend growth. By its rhetoric, the Fed is telling us that conditions favorable to that growth are in place today and should remain so in the future. In our view, a continuing stock market correction would provide an excellent opportunity to invest in quality, growing, dividend-paying companies at more favorable valuations.

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