Dollar DifficultiesJanuary 31, 2010
Recently, we have fielded a number of questions from clients concerned about the U.S. dollar: “Given the massive budget deficit last year and the huge projected budget deficits for years to come, won’t the dollar continue to lose ground?” “What about our trade deficits and the Federal Reserve’s decision to keep rates at extremely low levels?” “Aren’t they printing too much moneywhich will lead to currency debasement?” The dollar’s gyrations are at the forefront of investors’ minds. Certainly we are asking these and many other questions as we look to chart a course for our investment portf olios. And there are many legitimate reasons the U.S. dollar could continue to weaken. However, there are other factors that could cause the dollar to strengthen versus other major currencies. Then, investors must ask the critical next question in either scenario (lower dollar or higher dollar): What, if anything, can I prudently do with my forecast? In this article we address the affects of dollar movements as well as some of the many complex factors that cause the dollar to go up or down. Next we will focus on investment decision-making and strategies to consider based on our views of the dollar. Finally, we give historical perspecti ves on the U.S. dollar and its transition from the gold standard to the current fiat system.
What difference does it make?
We begin by asking, “What difference does it make if the dollar goes up or down versus other currencies?” Many people believe that a declining dollar must be bad for the U.S. economy and stock market. However, over the last thirty-seven years that does not seem to have been the case. Although there have been ups and downs over this period, the overall trend of the dollar has been down (see chart). Yet during this period U.S. stocks and the overall economy have grown at an average annualized rate of 9.6% and 2.8% per year respectively.
This graph depicts how the U.S. dollar has performed over ti me versus other major currencies for the Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia and Sweden. The index was created by the Federal Reserve to analyze changes in the value of the U.S. dollar versus major trading partners and the effects of these changes on the competiti veness of U.S. goods and services. The weight of each currency in the index is based on the trade of that country or area with the U.S. over the previous year.
The dollar experienced its steepest decline during the period between March 1985 and April 1988, when it fell 39% versus a basket of other currencies. It strengthened the most between 1980 and 1985, rising 55%. When we look at the performance of the stock market and the economy during these two periods, the results are surprising. U.S. stocks grew at almost the same very strong rate during both periods - 16% per year. Surprisingly the U.S. economy grew at a faster 3.6% per year pace during the period of the dollar’s sharp decline, while it grew at a weaker 3.3% rate during the period of the dollar’s strong rally.
While it appears a declining dollar is not necessarily bad for the U.S. economy or stock market, it does impact consumers and businesses. For U.S. consumers a declining dollar makes international travel, imported goods, and commodities more expensive. Higher priced imports and commodities can contribute to higher inflation.
For U.S. businesses, a declining dollar makes their products and services less expensive for internati onal consumers and more competitive overseas. The U.S. trade deficit over the first 10 months of 2009 was roughly half of what it was over the same period in 2008. While many factors contributed, the decline in the dollar likely played a part by making U.S. goods more competitive both at home and abroad. A declining dollar also increases the revenue and profits of U.S. multi nati onal companies’ overseas earnings. When those earnings are in a foreign currency that has appreciated, they get translated back into more U.S. dollars. For U.S. investors, a declining dollar increases the value and investment returns of their unhedged foreign stocks and bonds.
What factors impact the exchange rate of the U.S. dollar versus other currencies?
Like other assets, the value of the U.S. dollar (i.e., its exchange rate versus other currencies) is driven by supply and demand. When demand for the dollar increases versus another currency, the exchange rate of the dollar goes up and the other currency’s exchange rate declines. Large trade and budget deficits (like the U.S. incurred this past year) impact the supply/demand equati on and tend to put downward pressure on the U.S. dollar. The Fed’s current policy of keeping the yield on the Fed funds rate at less than 0.25% for an extended period also puts pressure on
the dollar. In general, investors are attracted to government bonds with higher yields and thus also to the currency those bonds are denominated in.
Economic growth and inflation rates also impact the dollar. However, the U.S. dollar does not operate in a vacuum. Exchange rates are between two currencies. So if the dollar is supposed to fall, the question is relative to what other currency? It is important to also consider the situati ons of the countries behind the other major currencies such as the Yen, Pound, and Euro. While the U.S. is running large budget defi cits, so are Japan, Great Britain, and many European countries. Japan’s government debt is significantly larger than the U.S.’s relative to each country’s economy. Fitch ratings recently cut the credit rating of Greece, one of the European Union countries, while Moody’s has said Great Britain’s credit rating is at risk if it does not lower its budget deficit. While the Federal Reserve has lowered the Fed funds rate in the U.S., central banks in Japan, England, and Europe have done so as well. Japan has a trade surplus, but Great Britain and many European countries run trade deficits. While these factors do not eliminate our concern over the U.S. dollar, they seem likely to mitigate some of the pressure on the dollar versus the yen, pound, and euro.
While other developed economies face many of the same issues as the U.S., many emerging market countries (i.e. Brazil and China) are in a different position. Emerging countries often run trade surpluses rather than deficits, have large currency reserves, and enjoy higher expected growth rates than the U.S., Europe, and Japan. Over the next decade we believe they will continue to appreciate versus developed country currencies.
What factors could cause the dollar to rise versus other currencies?
Despite what you don’t hear in the news, there are important reasons the dollar might actually go up versus other currencies. One reason is that most countries arguably need a strong dollar more than we do. Exports to the U.S. are a signifi cant part of all world trade. Foreign countries depend on these exports to protect their manufacturing industries and jobs. A weaker dollar makes their exports more expensive, and therefore less competitive, in global markets. These countries do not want to see their currencies appreciate and the dollar weaken further. Some central banks are “talking up” the dollar. Others have begun to intervene in the exchange markets actually buying U.S. dollars to try to prevent their currencies from appreciating further versus the dollar. Countries like China and Japan have an additional reason for not wanting the dollar to fall further. These countries hold massive reserves in U.S. dollars. A significant decline of the dollar would result in sharp capital losses for them.
There are other reasons the dollar could appreciate versus other major currencies as well. In the second half of 2008 and the first two months of 2009 the dollar rose sharply as a result of the financial crisis and the resultant fl ight to quality by investors worldwide. If another proverbial shoe drops we could see that happen again. Conversely, if the U.S. economy recovers more quickly than expected, the Federal Reserve could begin raising the Fed funds rate sooner than expected. This too would be a positive for the U.S. dollar over ti me.
Another factor is the shaky long-term foundation of the Euro currency, which is made of many different countries, each with their own agenda. A severe crack in the European Union over conflicting monetary policy would likely cause the dollar to rise. And yet another factor that would increase demand for the dollar would be a geo-political crisis—like major terrorism, war in the Middle East, etc. At this point in time, there is simply no other global reserve currency other than the U.S. dollar.
Several months ago reports that the dollar was in permanent decline seemed to be everywhere in the media. Concerns about the U.S. budget deficit, trade deficit, the Fed’s monetary policy, and other issues led many to conclude that the dollar would only conti nue to fall versus other currencies. Now, a few months later, the once ubiquitous reports on the certain demise of the dollar are nowhere to be found. The strategy of betting against the dollar that was once thought to be bulletproof no longer seems to be in vogue either. The dollar has rebounded against the euro, the yen, and the pound (see graph). While the issues facing the U.S. haven’t noticeably improved, some of the issues facing other countries have gained more attention mincluding Greece’s difficulties and the impact on the euro. As Dave Rosenberg, Chief Economist and Strategist for Gluskin Sheff said, “All of a sudden the U.S. dollar looks like the one-eyed man in the land of the blind.” When almost everyone believed it could only go lower, the dollar rallied significantly against all the major currencies. Given the multitude of complex factors that impact currencies, savvy investors should not be surprised that it is extremely diffi cult to predict currency movements. and cultures. We noted that conflict within the European Union over monetary policy could weaken the euro versus the dollar. The point was not to make a contrarian call on the dollar but rather to highlight a few reasons the dollar might not be in a state of perpetual decline.
How Should Currency Movements Impact the Management of an Investment Portfolio?
Given the diffi culty of predicti ng short-term currency moves, well-diversified portfolios should include non-dollar investments as an important part of their long-term asset allocation. Brightworth does not overlay a macro currency view on our clients’ portfolios. Instead the individual investment managers use their bottom-up fundamental view of currency issues in the management of their specific strategies. Although some of our managers invest in currencies directly, the primary currency exposure in Brightworth portf olios comes through our managers’ international stock and bond investments. As economies outside of the U.S. become a larger share of the world economy, investing in international companies becomes even more important. While international stocks and bonds are impacted by the dollar strengthening or weakening, the underlying returns of the stocks and bonds often account for the bulk of the return for U.S. investors.
Our portfolios also have exposure to other currencies through their investments in large multinational U.S. companies. Many of these companies generate significant portions of their earnings and revenues overseas and may benefit if the dollar declines. In 2008 nearly half the sales of the companies making up the S&P 500 Index came from outside the U.S. and that number has been rising in recent years. For some companies it is even higher. For example, over 75% of The Coca-Cola Company’s 2008 case volume sales were outside the U.S. stocks can be good investments over ti me regardless of how the dollar moves versus other currencies. Brightworth currently (and historically) has invested a significant part of the equity portion of the portfolios we manage in the stocks of U.S. multi national companies. We believe well-run international and U.S. multinational stocks can be good investments over time regardless of how the dollar moves versus other currencies.
Direct currency investments can be used for prudent off ensive purposes in a portfolio when experienced investment managers want to make money buying long the currencies of countries in a risk-controlled fashion based on the factors that help drive a stronger currency. These factors include consistent economic growth, political stability, low taxes, low inflation, reasonable government regulati on, increasing exports, and budget surpluses, etc. Currency investments can also be used for prudent defensive purposes as part of a portfolio when experienced investment managers use other currencies to diversify exposure away from the U.S. dollar. Brightworth has used investment managers over a number of years who make small, risk-controlled currency investments as a part of their overall strategy.
Over the last 235 years the United States has grown from a rag tag collection of British colonies to the world’s sole economic and military superpower. During its colonial days our country lacked a standard medium of exchange, then progressed through a series of different monetary standards to the current system in which the U.S. dollar functions as the primary global reserve and trading currency. In this third and final article in the series on the dollar, we will briefly examine the history of the U.S. dollar and its remarkable journey over the last two and one-third centuries.
One of the first orders of business of the newly formed United States was to improve trade and commerce by deciding on a currency system. At the time, many leading countries were on a bimetallic standard in which both gold and silver coins were legal tender. Following the recommendation of Thomas Jefferson and Alexander Hamilton, the U.S. Congress passed the Coinage Act of 1792 authorizing the U.S. Mint to create gold ($10 eagle, $5 half eagle, and $2.50 quarter eagle) silver (dollar, half dollar, and quarter) and copper (penny and half penny) coins.1 Over the course of the next 100 years the bimetallic standard would result in growing discord for the young country. One of the pitfalls of a bimetallic standard is expressed by Gresham’s law that states “bad money drives out good.” It predicts that if two types of money (e.g., gold and silver coins) circulate simultaneously and the market value of the two deviate from the official standard, the money with the higher market value will be hoarded, withdrawn from circulation, and melted down.2 This happened several times in the U.S. until 1900 when the Gold Standard Act officially took the U.S. off the bimetallic standard and onto the gold standard.3 Paper currency was backed by gold alone and set to a fixed exchange rate of $20.67 per ounce of gold.4 Most other countries had already moved to the gold standard as it further facilitated international trade.
The gold standard was largely abandoned by many nations during World War I under the pressures of wartime spending and again during the Great Depression in an effort to improve economic demand and flight delation. In 1933 the United States left the gold standard, and a year later devalued the U.S. dollar to $35 per ounce of gold.5 During the Great Depression, the U.S. and global economies contracted severely. The stock market crashed, thousands of banks failed, companies went out of business, unemployment soared, and governments around the world adopted protectionist policies such as import tariffs that drastically weakened world trade.6 Although there were many factors that contributed to the Great Depression, many financial historians believe America’s reluctance to leave the gold standard limited the Federal Reserve’s monetary options and exacerbated the situation.7 Demand for labor and supplies from World War II helped to bring the depression to an end. As the war raged on, the U.S. and Great Britain began planning for a post-war international monetary system. The goal was to create a more regulated, stable structure that would prevent countries from engaging in the “beggar thy neighbor” strategies of the depression by devaluing their currencies to try to increase exports and boost their economies. The efforts culminated in the summer of 1944 with 730 delegates from all 44 allied nations gathering together in a small ski village, Bretton Woods, New Hampshire, to develop the postwar monetary and financial system.8 By this point in the war, Europe and the UK were financially destitute and their infrastructures were devastated. In contrast, the U.S. had entered the war later, and with the exception of Pearl Harbor, the battles had not been fought on U.S. soil, and the U.S. economy had strengthened dramatically, allowing it to more or less dictate the rules at Bretton Woods.9
Under the new system, countries agreed to regulate their currencies to stay within a 1% trading band to the U.S. dollar with the ability to adjust their exchange rate by international agreement if needed. The U.S. committed to maintain a fixed relationship between the dollar and gold ($35 per ounce).10 The U.S. dollar became the global trading and reserve currency. To manage this system, the International Monetary Fund and the International Bank for Reconstruction and Development (part of the World Bank today) were created.
In the beginning of the Bretton Woods system, the U.S. was running huge trade surpluses, and its enormous reserves continued to grow. This resulted in an international dollar shortage and a lack of global liquidity. For the system to work the U.S. needed to run trade deficits so dollars would flow out of the U.S. In the late 1940s and 1950s the U.S. implemented economic policies to deliberately run current account deficits.11 The U.S. also implemented the Marshall plan and other economic aid programs that provided significant financial aid to help improve Europe and Asia’s productivity and global competitiveness. Over time the Bretton Woods System became strained and eventually collapsed for a number of reasons. As Europe and Asia rebuilt their economies, the U.S. was no longer as economically dominant. Another strain on the system was described as “Triffin’s dilemma”: Growing world trade and the need to provide liquidity to the global system required the U.S. to run large current account deficits for other countries to hold dollars as part of their foreign exchange reserves. Maintaining the dollar’s peg to gold at $35 per ounce became more and more difficult as the supply of dollars increased. Ultimately President Nixon ended the convertibility of the dollar to gold in 1971.12
The “Nixon Shock” marked the end of the Bretton Woods System, and the price of gold began to float at market levels. Over time most countries removed their peg to the U.S. dollar allowing their currencies to float as well. The U.S. dollar became a fiat currency no longer backed by gold or silver. Today the dollar’s value versus other currencies floats based on supply and demand.
Recently there have been calls for a new Bretton Woods System to replace the U.S. dollar as the primary global reserve currency. However, there are no viable alternatives to the U.S. dollar, at least in the short term. Over time that will probably change, but that is not necessarily a cause for concern. During the last 235 years, the U.S. has survived and even thrived despite the numerous changes to the monetary system and we expect it will continue to do well regardless of the modifications that may take place to the monetary system in the future.
1 “The Money of the Constitution,” The New York Times, July 19, 1896
2 Craig Calhoun “Gresham’s Law,” Dictionary of the Social Sciences, January 1, 2002
3 Gold Standard (Issue) Gale Encyclopedia of U.S. Economic History, January 1, 1999
4 Donald Kemmerer, “Gold Standard,” Dictionary of American History, January 1, 2003
6 George Friedman, Peter Zeihan, “The United States, Europe and Bretton Woods II,” October 20, 2008
7 Gene Smiley, “The Great Depression” The Concise Encyclopedia of Economics
8 Benjamin Cohen, “Bretton Woods System,” Routledge Encyclopedia of International Political Economy
9 Friedman, Zeihan