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One result of the euro debt crisis: the U.S. dollar gets another 10 year term as the best global currency
06/19/2012 8:30 am EST
But in spite of the euro’s rally after the Greek vote, if I had to pick the best global currency for the next 10 years my choice would still be the U.S. dollar.
Not because U.S political and financial leaders are smarter, more virtuous or more disciplined than their counterparts elsewhere in the world. (It may come as shock, but they’re not.) But because the kind of self-interested, shortsighted muddling through that these leaders are likely to produce should be enough to keep the dollar ahead of the pack for another decade. If only because U.S. self-interest is reasonably well aligned with the interests of the global economy.
Before you go all ballistic on me—How can you pick the dollar? Don’t you know how fouled up the U.S. government budget is and how over-extended the Federal Reserve is?—parse my statement in detail.
First, I’m not saying the U.S. dollar will be the best currency in the world over the next decade—only that it will be the best global currency. To win that contest it doesn’t have to beat the Canadian loonie or the Colombian peso, but just the yen, the euro, and the yuan. There simply aren’t that many currencies with enough trading volume and enough market depth to be viable global currencies. (For the record, over the next ten years I’d much prefer to put my money in stronger local currencies. For more on that preference and a dividend-income strategy based on it see my posts http://jubakpicks.com/2012/06/05/use-the-fear-trade-to-your-profit-by-buying-overseas-stocks-with-over-valued-dollars/ and http://jubakpicks.com/2012/05/25/10-high-dividend-stocks-that-pay-in-currencies-stronger-than-the-dollar/ )
Second, as I’ve said repeatedly, the U.S. dollar doesn’t have to be a good currency; it only has to be better than the competition.
And third, being the “best global currency” doesn’t mean that the U.S. dollar will be a good store of value over the next decade or that assets such as gold or commodities or real estate won’t hold their value better. If you’re looking to protect your wealth against inflation or currency depreciation, I think you can do better than the dollar.
But nonetheless, if the U.S. dollar gets another decade at the top of the global currency heap, it does have profound significance for the U.S. and global economies—and for the returns investors can expect from stocks, bonds, and other assets.
Here’s my argument for the continued global reign of the dollar.
Look at the competition.
The euro has looked like it was coming on, but the current crisis has damaged it so severely that it will take years to put its reputation back together. Consider the Greek bond haircut where the European Central Bank played a key role in orchestrating a deal that rewrote the terms of existing bonds to the detriment of current bondholders and then refused to write down its own holdings of Greek bonds. Care to put your trust in that system? And there’s more. Contingency plans on dealing with a run on Greek banks have envisioned a situation where Greece is still in the euro, but where no one in Greece can take euros out of the country. That, to me, looks like two currencies with one name. Or finally consider the failure of the European Central Bank to assume the role of the lender of last resort for the euro. This has exposed a key weakness in the euro system—the European Central Bank is, for better or worse (and it’s been for worse in this crisis), not a central bank with all the powers of the Federal Reserve. It’s reasonable to ask now, who stands behind the euro? Asking that question at all shows exactly how much faith has been stripped away from the euro. And, of course, the Greek vote doesn't actually solve any of the euro’s problems.
The yen? Are you kidding me? Japan’s public debt was 231% of GDP at the end of 2011, a level that makes every other country in the world look the picture of fiscal health. I know that it has become popular to point out that Japan has managed to survive—and the yen to appreciate—even as debt has soared to these levels. But that doesn’t mean that no level of debt is significant. And it doesn’t mean that investors should discount the way that Japan’s rapidly aging population creates another demand on the nation’s huge savings pool. Or that the slide of the country’s trade balance into negative territory in 2011 isn’t worrying. Japan can’t continue to age and create retirement liabilities AND continue to spend money it doesn’t have. (The 2012 budget deficit again looks like 10%).
Which leaves China’s renminbi. China is clearly moving to loosen controls over its currency. At some point on the current trajectory that would turn the renminbi into a freely traded global currency. And at that point investors should think about the renminbi as a true competitor to the U.S. dollar. But China’s pace on the path toward a freely traded renminbi has been slow and it’s not clear that China is fully committed to reaching that end point. A freely traded renminbi would expose China’s very stressed banking sector to even more stress. And it’s not clear to me that China will decide to take that risk—or that it can afford to. My best estimate now is that the renminbi won’t be ready for a full global role within my 10-year time frame.
What about all the problems facing the U.S. dollar? The budget deficit for fiscal 2011 (the fiscal year that ended in September 2011) came to 8.7% of GDP. The Federal Reserve’s balance sheet hit $2.85 trillion in the week ended on June 13 including $1.66 trillion in U.S. Treasuries. Eventually, the thinking goes, the Fed will have to sell some of what it bought to stimulate the economy back to the financial markets—or pay the price in higher interest rates and a falling dollar. The U.S. public debt is more than 100% of GDP and is certain to go higher.
This isn’t exactly the profile for a strong currency.
You’ve probably got doubts that U.S. politicians will do anything to fix these problems. And you’ve got a well-founded suspicion that they’ll do things to make the problems worse. I’d say that’s extremely likely.
But I’m not counting on any sudden road to Damascus conversion to fiscal rectitude in my view of the U.S. dollar. Instead I’m assuming that politicians will muddle along, making thing gradually worse, but not doing anything that really disturbs the current pattern of a gradual slide from AAA to AA (in 2011) to A (in 2013 or later.)
But because the interests of global investors are so clearly aligned with the interests of U.S. politicians, I don’t see that slide accelerating or making much difference to the global role of the U.S. dollar over the next ten years.
From the financial market’s point of view, it’s not like there’s an oversupply of AAA- or even AA-rated, liquid debt in the world. (How long to you think it is before even Germany loses its AAA-rating under the pressure of the euro crisis?) As the history of Japan’s public debt illustrates, financial markets will shrug at deficit figures as long as they don’t see any signs that they won’t get paid back on time. (And, so far, the U.S. is good for that.)
From the politicians’ point of view, the best of all solutions will be not to do anything drastically painful to fix U.S. problems since that would cost votes (and require courage that seems in very short supply in Washington) while at the same time doing just enough to keep the situation from getting worse so fast that it’s really noticeable. Remember the recipe for how to cook a frog? Put the frog in a pot of cold water. Put a small flame under the pot. The frog won’t notice the gradual increase in temperature in time to jump out before it is cooked. The hope will be that U.S. voters won’t notice the gradual worsening of U.S. finances until they’re completely cooked. (Warning to politicians: The folklore about how to cook a frog makes an interesting metaphor but it’s not actually true. The frog gets more and more active in trying to escape as the temperature of the water goes up. See this Snopes.com entry: http://www.snopes.com/critters/wild/frogboil.asp )
All this talk about frogs aside, what’s the real world investment effect if the U.S. dollar remains the best global currency for another decade?
There are major advantages to being the world’s reserve currency, it is frequently pointed out. Chief among them, financial cynics say, the United States can print money to pay its increasing debt and pass along the costs, or at least some of the costs, to the rest of the world. For a long but not unlimited period of time. (For more on the advantages of being the global currency and the role of trust in currencies see my post http://jubakpicks.com/2012/06/08/would-the-breakup-of-the-euro-put-us-on-the-path-to-the-end-of-paper-money/ .)
Let’s count some of the advantages to the United States and the costs to the rest of the world from another decade of the U.S. dollar as the global reserve currency.
- U.S. interest rates will rise but more slowly than otherwise. Demand for U.S. dollars created by the world’s need for dollars to conduct trade and financial transactions, and by the use of the U.S. dollar in foreign exchange reserves will keep U.S. interest rates lower than they might have been. It’s still reasonable to project that U.S. interest rates will climb with any modest stabilization in the global economy, but the rate of increase will be relatively slow.
- The U.S. dollar will depreciate over the next decade but more slowly than otherwise. The argument is the same as that for a slow increase in U.S. interest rates.
- Global inflation, especially commodity inflation, will be faster because of falling dollar. If the dollar remains the dominant global currency, then many commodities—oil and grains—for example, will continue to be priced in dollars. As the dollar depreciates, the dollar price of these commodities will rise. Tack that on to whatever price increases you expect from sources such as the rising costs of extraction or the rising cost of inputs such as fertilizer and fuel.
- Low U.S. interest rates will delay the onset of the U.S. fiscal crisis. It makes a huge difference to the U.S. budget deficit whether the government has to pay 2% or 6% to raise 10-year money.
- U.S. companies will be able to raise money at cheaper rates than if the dollar dropped out of the running for top global currency. That will provide inexpensive capital for investment in plants, for share buybacks, for dividend increases, and for acquisitions. Low interest rates on bonds make stocks more attractive investments (all else being equal) and these uses of cheap money will add to that attraction. That’s a good thing since earnings growth in U.S. and other developed economies looks anemic over the next ten years. I’m hoping for a 5% a year return on U.S. equities on average over the next ten years. That would be below the 7.5% annual average long-term return. The advantages the dollar gains from remaining the dominant world currency would sure make attaining that 5% goal more likely.
- And finally, if the U.S. dollar remains the best global currency for the next ten years that would assure that New York and U.S. financial companies remain key players in global markets. The trend may be headed in Asia’s direction but the speed of that shift is important.
My argument for the U.S. dollar remaining the best global currency for another decade isn’t finally especially optimistic. It’s based on the comparative weakness of competitors more than on U.S. strength. And it assumes a continued deterioration in the U.S. financial position and in the value of the dollar—but assumes that it will occur at a slower pace than it would if the U.S. dollar lost its role as the global reserve currency.
It would be better, of course, if the United States actually dug in and intelligently addressed its fiscal problems. I’m just don’t think the odds of that are especially good.
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 not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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