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It's not a dollar world anymore--your portfolio needs a currency strategy and here's how to build one
02/28/2012 8:30 am EST
How much? Well, look at this calculation from the Financial Times. In simple non-adjusted U.S. dollar terms world stocks, as measured by the FTSE All-World Index, are just 7.5% below their post-Lehman crisis high set in the spring of 2011 and just 22% below their all time high. Seems like we’re on the road to recovery in global equities although this rally still has substantial headroom.
But look at the index—tracked by the Vanguard Total World Stock ETF (VT)—in other currencies and the picture looks very, very different. In Swiss francs, not U.S. dollars, the index is still 40% below its all-time high. In Japanese yen the index is still 47% below that high. Measured against the price of gold, the index is down 65% from its all-time peak.
Why does this matter to you right now? Well, we all live in a world where what counts most isn’t nominal dollar values of stocks but the real buying power of our portfolios. Gasoline, to take just the most obvious example, climbs in price when the dollar sinks. So too does the price of copper and iron ore and all other globally traded commodities—and the stuff that’s made out of these raw materials.
In the short-term—let’s say for the remainder of 2012—thanks to the off-again/on-again Greek debt crisis investors are in for some heavy-duty currency volatility.
In the long-term—lets say beginning in 2013—I think investors can “look forward” to steady downward pressure on the dollar (unless you believe our politicians magically turn into adults after the election and come up with a credible program to deal with the U.S. budget deficit.)
All investors should be thinking now about strategies and timing for maximizing their real (instead of dollar-denominated) profits during this period. Your strategy as an investor needs to take both the short-term and the long-term picture into account.
Here’s how I see the short-term volatility for 2012.
If the current Greek debt deal holds together—and I think it will—until the next report from the inspectors at the International Monetary Fund, the European Central Bank, and the European Commission (known as the troika) in June results in a new set of demands that Greece can’t or won’t meet, then the euro will rally and the dollar and yen will fall. Not heavily, mind you (and not every day—the yen fell on Monday, February 27, for example), because the euro still isn’t a healthy currency and even after the Greek debt deal investors see it as a risky currency. But the need for currency safe havens will diminish and that will mean selling of the safe-haven dollar and yen. The trend for those two currencies will be downward.
And we know what that means, right? We’ve seen this before during 2011.
First, a falling dollar is good for the prices of commodities and commodity stocks. We can expect oil, copper, and gold, to take just three commodities, to trend upwards. That will push the price of commodity stocks upward as well providing some more upward momentum for stocks in general.
Commodities and commodity stocks won’t be the only winners. U.S. and Japanese exporters will see the price of their goods fall for customers who buy in euros (even if a recession in the EuroZone reduces buying from that economy) and that will lead to sales increases for companies such as Toray Industries (TRYIY) and Komatsu (KMTUY) in Japan, and Caterpillar (CAT) and Cummins (CMI) in the United States.
Currency effects don’t end with the Big Three developed economies either. Other safe-haven currencies such as the Swedish krona and the Norwegian krone will also retreat—that will be a relief to exporters such as Sweden’s SKF that have been in danger of losing sales as their currencies appreciated. Risk-off currencies such as the Mexican and Colombian peso and the Brazilian real will appreciate. In dollar terms stock prices in those countries will climb even as exporters feel the pinch of currency appreciation.
Exactly how big an effect any of this will have on share prices depends to a very large degree on the macroeconomic climate as we close out the first quarter and advance into the second. If the U.S. economy continues to hold to an annual growth rate near 3% (the U.S. economy grew by 2.8% in the fourth quarter of 2011) in spite of fears and predictions of a recession, then I think you’ll see analysts up their estimates for sales and earnings from U.S. and Japanese exporters and for revenue and earnings from big U.S. companies with big exposure to overseas markets. A weak dollar means higher dollar-denominated sales when companies such as McDonald’s (MCD) and IBM (IBM) translate euros and other rising currencies back into dollars for quarterly reporting.
The current over-bought state of the U.S. stock market makes positioning a portfolio for this period very tricky. I don’t think you want to add a lot of risk to your portfolio here, but you can certainly keep the risk of your portfolio at a steady level and still position yourself to take advantage of any potential out-performance from exporters and U.S.-based multinationals by shifting out of high beta stock into the shares of companies such as McDonald’s (Beta 0.44), or IBM (Beta 0.66). (A stock with a beta of 1 moves up and down as much as the market. A stock with a beta of less than one is less volatile than the market as a whole. But it may outperform the market if something special about the stock (called alpha), not related to direction of the market as a whole, gives it a boost.) Or try adding a Japanese exporter or two such as Komatsu or Toray Industries. Japanese stocks don’t have much correlation with the U.S. stock market at the moment and are likely to dance to the tune of the yen rather than follow any other factor.
All this could do a 180-degree change in direction if the Greek debt deal starts to come apart again this summer. If, as now looks likely, the Greek and EuroZone economies slow significantly this summer—and contract more than is now projected—then Greece will miss the targets it just agreed to when the troika issues its report in June or July. I think the impatience that countries like Germany, the Netherlands, and Finland showed in the days before the finance ministers agreed on the current deal mean there’s very little inclination to cut Greece any more slack.
So in June or July, it’s back to euro debt crisis time. Which, of course, means a reversal of the current trends of the previous period: The euro sinks, the yen and the dollar rally, and emerging markets currencies…
Well, what would happen to emerging market currencies?
On the one hand, emerging market currencies could continue their risk off connection to the euro and a decline in the euro on renewed worries about the Greek debt crisis could send the real, the peso and other emerging market currencies sliding downward. And that, in turn, could lead to a resumption of the bear market in emerging market stocks that has only recently ended.
On the other hand, emerging market currencies could break that relationship and climb while the euro stumbled. Emerging market stocks could even rally while European markets fell. How could this happen? If China’s economy put in a bottom that signified a clear end to the possibility of a hard landing, and if the People’s Bank of China moved to an actual interest rate cut, then growth prospects in emerging economies would likely be strong enough to lift those currencies and those equities even if Europe slid back into crisis again.
All this is part of the short-term currency picture. Here’s how I see long-term currency volatility for 2013.
If we get a dollar (and yen) rally on a renewal of the euro debt crisis, I think investors should treat it as an opportunity to trade on a strong dollar to pick up currencies such as the Canadian, Australian, and Singapore dollars; the Swedish krona and the Norwegian krone; and the Chilean peso—and the equities valued in those currencies. Gold and commodities—and commodity stocks--would be a good pick up in any strong dollar period that followed a renewal of the Greek debt crisis.
And that’s because 2013 doesn’t look good for the dollar. No matter who wins the November election, U.S. politicians won’t be able to dodge the U.S. budget crisis much longer. Washington is facing brutal battles over the Bush tax cuts, about the run-away cost of healthcare entitlements, and about under investment in critical infrastructure. It’s hard to imagine real progress on these issues without a full-fledged crisis putting a gun to the heads of our political leaders. And with Standard & Poor’s having cut the U.S. AAA rating to AA already, the threat of another downgrade will hang over U.S. politics and U.S. financial markets.
How bad the damage to the dollar will be depends on three things.
First, on how dysfunctional the EuroZone and Japan are in 2013. Remember, the United States doesn’t need to run a good currency, just one that’s not as bad as the alternatives. If the risk to the euro from Europe’s disunity and the risk to the yen from Japan’s huge national debt seem larger than the risk to the dollar, the dollar might fall very little even if the U.S. is thrown again into budgetary deadlock. Remember the dollar rallied after the S&P downgrade because the euro was such an unattractive alternative.
Second, on how quickly China has moved to turning the renminbi into a plausible global alternative to the dollar. Although China’s leadership has outlined steps to liberalize trading in the country’s currency, the end result is still well short of the kind of full convertibility that would create an alternative to the dollar. And I frankly don’t see China’s very conservative—and new--collective leadership speeding up the timetable significantly in 2013.
Third, on the new mechanics of the price of oil. The U.S. trade deficit climbed in 2011 to $558 billion in 2011 from $500 billion in 2010. That puts pressure on the dollar: Investors have to wonder how long the world is going to keep funding the United States to spend more than it takes in. But the 2011 figure, and probably the 2012 figure as well, are distorted by the relative health of the U.S. economy in comparison to that of its trading partners. If the U.S. economy is growing—even if its only from a 1.8% annual growth rate in the third quarter to a 2.8% growth rate in the fourth quarter—while the economies of Europe are slipping into recession and the economies of China and Brazil are slowing, the U.S. trade deficit should be rising. That’s especially the case if the price of oil is climbing. In reporting the annual trade deficit, the U.S. Census Bureau cited the high price of oil as a major reason for the increase in the trade deficit.
But high oil prices are likely to have a strange net effect on the U.S. trade deficit in 2013. High oil prices are likely to slow the U.S. economy—and that would decrease U.S. imports. However, now that the U.S. has become a net exporter of refined petroleum products—thanks to the production coming out of U.S. oil shales—to the tune of about 1 million barrels of refined petroleum products a day high oil prices don’t operate exactly the way they used to on the U.S. trade balance. If a combination of slowing growth (but not too slow) and rising exports of refined petroleum products can shrink the trade deficit, then the dollar might wind up stronger than expected in 2013.
At the moment that's a chance I’d be willing to risk. If we get a replay of the Greek debt crisis in the second half of 2012, and the safe-haven effect pushes up the price of the dollar again, I’d look to gradually build positions in temporarily depressed currencies with strong long-term prospects such as the krona, krone, Loonie, and Aussie dollar. I think those positions would pay off in real terms when the U.S. dollar starts to slide again in 2013. And they’d pay off even more if the U.S. can’t get its act together in 2013 and goes stumbling off into an ever more uncertain budgetary future.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Cummins and Toray Industries as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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