For perspective, the global economy is experiencing two powerful secular forces that will continue for years if not decades. The first is the deleveraging of most developed economies after more than 20 years of easy money and excessive indebtedness. The second is the rapid industrialization of the emerging economies that is creating dynamic shifts in the demand for the necessities required to support their rapid growth. The result of these forces has been the massive transfer of wealth from West to East, as we have written about previously. The efforts to stimulate the global economy after the financial crisis have accelerated these divergences. We believe that consistent focus on these enduring trends will enable serious investors to position their portfolios in the attractive companies that are beneficiaries of these dynamic periods while avoiding those companies that will be negatively impacted. This Outlook will focus on the impact of continuing currency creation by central banks against a backdrop of an unprecedented global financial environment.
GDP Growth, Fiat Currency and Reserve Currency Defined
A reserve currency, or anchor currency, is a currency which is held in significant quantities by governments and institutions as part of their foreign exchange holdings because of its perceived importance, stability and liquidity. It also is the international pricing currency for products traded on global markets such as oil, gold, non-ferrous metals, grains and other commodities. The U.S. dollar has enjoyed the status of being the world’s reserve currency since the Bretton Woods agreements of July 1944. From that time and continuing up to the mid-1980’s, the U.S. was the largest creditor nation and the fastest-growing economy in the world. This contrasts sharply with its current position as the largest debtor nation with the largest deficits and sub-par growth.
The Challenge for the Developed Economies
Central banks and governments continue to face difficult choices in dealing with increased social, economic and political challenges. The recent efforts to implement austerity programs by European governments are undermining the social order. High unemployment rates, worker strikes and political backlash against incumbent leaders continue to dominate the headlines, particularly with respect to France, Greece, Poland, Spain and Portugal. Consequently, opposition to further fiscal stimulus initiatives leaves countries more dependent on export growth. To achieve this, these developed countries’ currencies must be devalued. Japan, which is export-driven, recently took steps to weaken the yen to protect the competitiveness of its exports. However, Japan’s efforts to weaken the yen are being hindered by the specter of further QE by the U.S. Federal Reserve (Fed), which is widely expected to be implemented at the next FOMC meeting in November (dubbed “QE2” by the financial press). This prospect is weakening the U.S. dollar versus the yen. Japan’s experience highlights the interconnectivity of the global economy and foreshadows the risks of a currency war as other countries continue to take steps to devalue their currencies or implement capital controls. Brazil and Thailand recently introduced tax increases to slow the flow of capital into their economies for fear of overheating and making their exports more expensive. Capital inflows have the effect of pushing up the value of a currency making exports more expensive and less competitive.
In the U.S., the headwinds from high unemployment levels, low interest rates and the need to bring state and local budgets into balance leave this economy in a state of disequilibrium. The U.S. can no longer count on an over-leveraged consumer to drive GDP growth, and in light of this the current administration has made doubling exports over the next five years a priority. This makes a cheaper U.S. dollar a necessity. Unfortunately for the world’s central bankers, currency moves do not occur in isolation. Further complicating the global currency picture is China’s currency policy. China is a leading exporter, the largest creditor to the U.S., the owner of the largest currency reserve and one of the fastest growing economies that has pegged its currency to the dollar. So a weakening U.S. dollar pulls down the Chinese yuan (or renminbi) putting further pressure on other nations’ exports as their currencies effectively appreciate against the yuan. Consequently those countries risk losing market share to the Chinese until they devalue their own currencies.
We are in a period of competitive currency devaluations as nations are forced to act and react to one another’s policies. Attempts to manage currencies in this fashion are short-term oriented and merely postpone the hard decisions ultimately required for structural change. At some point, coordinated action by governments will be required.
The Fed Dilemma
The Fed is faced with a difficult choice. The Fed may continue and accelerate its efforts to stimulate the economy or let the economy deflate which would certainly lead to a deep recession. Both choices have a cost. The Fed has come out in favor of further quantitative easing to attempt to stimulate the economy. This could devalue the dollar and benefit exports but at the expense of potentially generating high inflation in the future and lowering the U.S. standard of living. If the Fed does not act it would be out of compliance with its mandate, and the economy would likely decline further unless the government embarked on well-targeted stimulus programs. After recent comments by several Fed officials, the Fed appears likely to move ahead with QE after the November 2nd mid-term elections, although the amount and timing of implementation are less certain. The scale of central bank monetary creation and intervention that is reportedly being considered is without precedent. We would not be surprised if the total amount of QE ultimately viewed to be required over the next few years is in excess of $2 trillion or approximately twice the size of the Federal Reserve’s balance sheet.
Implications of an Extended Low Rate Environment
Importantly, low rates have benefited many corporations by allowing them to strengthen their balance sheets, increase share repurchases, fund mergers and acquisitions and raise dividends. Many companies’ shares yield more than the interest they pay on their bonds. This valuation disparity cannot endure and we expect it to be reconciled through the continuing flow of capital into high-quality equities with attractive and growing dividends.
The Role of the U.S. Dollar as a Store of Value
This trend is leading to a shift in demand from fiat currencies toward hard assets, as reflected by the actions in recent years of various countries with surplus foreign reserves. Countries such as Russia, China, India, among others have been diversifying their foreign reserves into developing market currencies, as well as fixed and strategic assets and commodities, including oil and gas companies and projects, iron ore and copper mines as well as gold, among others.
In addition, in the environment of low interest rates that we expect to persist for some time, those companies with secure and rising dividends will continue to attract interest as investors seek higher returns. Leading pharmaceutical, consumer staples and even technology companies currently offer attractive and growing dividend yields and should be among the primary beneficiaries. These companies also enjoy strong balance sheets and significant revenue growth from the developing markets.
Fixed income security selection is focused on relative-value income opportunities with a short to intermediate duration. With regard to credit selection, we favor companies whose balance sheets are stable or strengthening. With the severe budget constraints facing states and municipalities, we are particularly cautious with regard to the municipal bond market. Given continuing economic and sovereign debt challenges, there is a high probability that demand for U.S. Treasury debt will remain strong keeping the rate structure at low levels.
Consistent with our 40 year history, ARS continues to focus on select undervalued businesses that are positioned to benefit from important secular trends. While investors continue to express concerns about investing in the broad market, ARS believes that this remains a time for opportunistic and thoughtful security selection as we continue to expect to see separation and outperformance for those companies that are well-positioned to benefit from the global divergences and imbalances described above.