A New Downgrade? All Assets Are at Risk

11/22/2011 3:30 pm EST

Focus: MARKETS

Axel Merk

President and Chief Investment Officer, Merk Investments, LLC

As Congress appears to be fumbling its way toward a new US debt downgrade, it shows us that even the US dollar and Treasuries are not immune to the possibility of a major crash. That’s Axel Merk’s opinion, and he advises holding a basket of currencies to mitigate the risks of any one currency.

The US dollar has certainly seen its share of problems over the last few years. Do you think it’s going to remain the reserve currency of the world?

The US dollar had become the reserve currency because of prudent policies pursued over the decades. These days, that position is being abused, in our view, in order to impose US policies on the rest of the world.

The reason the US dollar continues to be the reserve currency is because of liquidity. Because when you have billions, like the Chinese have, there is really no good second place to go. It is not the quality—it is the liquidity.

Having said that, as countries like China gain operational experience in other regions—the Eurozone, Japan, Australia, Canada, or directly investing in resources in other places in the world—on the margins, that status will change.

It’s not going to happen overnight. The risk, of course, is that something more drastic may happen overnight…but the most likely scenario is that, over time, investments will be spread.

Having said that, it doesn’t mean everything is well for the dollar, because in the US we have a current account deficit. That means even marginal changes in our locations by foreigners will have an impact on the US dollar, and as such, the risk of a continuous dollar decline is there. And it’s elevated. given that the Federal Reserve, in our view, wants to have a weaker dollar.

Now there are arguments made that having a weaker dollar benefits our economy. Do you agree with that?

Not at all. An advanced economy cannot depreciate itself into prosperity. You have to compete on value, not on price.

A Vietnam engages in competitive devaluation because they can only compete on price. Any advanced economy shoots itself in the foot by doing so.

We’ve seen it at the price at the gas pump, we see it in real wages not going anywhere. It will boost the corporate earnings for the next quarter, but long-term it is rather unhealthy to try to grow through currency debasement.

And what impact does the quagmire that’s going on in Congress in the United States have upon the dollar?

The reason we haven’t come to any agreement on long-term fiscal issues, which are urgently necessary, is because the bond market in the US is behaving. The only language policymakers understand is that of the bond market.

We see that play out in Europe. In Europe the bond market is forcing countries to engage in serious reform, so as long as the bond market will behave, I don’t think we will have the political will to engage in reform.

The key difference, though, is that in the US we have a current account deficit. We’re dependent on foreigners to support the currency. In Europe, that is not the case. In Europe, even though the economic growth may not be there, the currency does not need to be weak.

In the US, however, in the absence of economic growth, foreigners will be inclined to invest elsewhere. As a result, the US dollar is far more vulnerable if and when the bond market starts to act up.

How does the investor use this to their benefit?

Well, investors may want to start diversifying beyond the US dollar. Also, with regard to the bond market, they may want to be very careful how much exposure they have to the long end of the yield curve—to long-term interest rates.

Obviously it can happen that those yields go down, but one of the trends we have seen is that investors are yield chasing. Interest rates are so low, investors are choosing again less creditworthy companies or governments, and also longer-dated securities. The volatility in that market can be very high.

So, we encourage investors to start looking at anything as a risky asset, including US dollar cash. Diversify internationally to cash, just like the Chinese government does it. Have a managed basket of currencies as part of your portfolio to mitigate the risk of any one currency.

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