This summer, Brad Pitt will star in a new film called "World War Z", an action-horror film about a post-zombie apocalypse Earth, hence the "Z" in the title. Zombie films are not our cup of tea at Neosho (we thought the genre was dead), so it is debatable whether we will see this film, but one thing is clear to us, we are perched on the precipice of "World War C", where "C" stands for "currency".
And that is just not our assertion: the heads of the British, Japanese, German, and Brazilian central banks have publicly argued that we are, in fact, in the midst of a currency war. In its simplest terms, a currency war is a race between nations to see who can end up with the lowest relative currency value against the others. The prize, in theory, is more exports, which should mean more jobs, which should result in greater societal happiness, or at least some plutocrats getting to keep their jobs a little longer.
We believe that while we have witnessed skirmishes on the currency front, we have yet to enter a full-fledged war because the European Central Bank (ECB) and Bank of England (BOE) are not (yet) engaged in purposeful currency devaluation. Rather, since 2009, each has been pre-occupied with either saving their currency (the ECB) or saving their banking system (the BoE). The relative value of their respective currencies has not featured high on their list of priorities over the past four years.
Not so, however, for the U.S. Federal Reserve, the Swiss National Bank, the Bank of Japan, the Central Bank of Brazil, and the People's Bank of China, all of whom have been very interested in the relative valuation of their currencies. And this is a list that matters because three of the top five global currencies are represented on that list and all of them have been engaged in competitive devaluations of their currency in order to promote their own exports.
This form of international contest should strike those with a sense of history as similar to the trade and tariff wars of the Depression Era 1930's: "beggaring thy neighbor" in order to extract one's own country from economic straits. In the 1930's, the "beggaring" took the form of either abandoning the gold standard, literally blocking the importation of foreign goods, or imposing tariffs so high that imports were effectively blocked. This time around, there are no gold standards to abandon and international trade rules have become too ingrained, both economically and legally, for onerous tariffs or outright bans to be practical or legal. Thus, the only economic weapon left is that of currency devaluation.
Tensions were ratcheted up a couple notches with the recent election of Shinzo Abe as Japan's Prime Minister this past December. As a candidate, Abe explicitly and repeatedly promised to double Japan's inflation rate target from 1% to 2% via increased central government money printing, borrowing, and spending. And while the Bank of Japan has pushed back against Mr. Abe's proposals, we have still seen the Yen depreciate 25% against the Euro and 10% against the US Dollar since last July. In short, Japan is "all in" on making the Yen weaker and, thus, boosting Japan's exporting companies. Can they succeed? That is to be determined, but as exchange rates show of late, the markets are taking the Abe seriously.
Meanwhile, over the past four years the ECB has been focused on propping up Greece, Spain, Italy, and Portugal in an attempt to preserve the Euro as a viable global currency. It is impossible to simultaneously prop up and devalue a currency: the monetary presses are either "on" or "off", despite all the sophisticated instruments and acronyms of late. Further hampering the ECB's ability to mimic the Federal Reserve and Bank of Japan's currency devaluations is Germany's insistence that the ECB's monetary efforts be "sterilized", i.e. that no new net money is injected into the system. As such, the Euro has tended to rise and fall as the chances of Greek default or further European contagion wax and wane, rather than through the perception of a deliberate weakening of the basis of the Euro.
But how long can the Frankfurt-based ECB resist the imperative to battle generally high unemployment rates and shrinking GDP, or more to the point, how long can Germany hold fast to its inflation-phobic outlook? A great North-South Divergence is occurring in Europe: Spanish unemployment rates now match those of Greece in the 25% range and France has crossed the 10% unemployment rate threshold, while German unemployment is 4.5%. The French continue to struggle to bring their fiscal deficit below 3%, while the Germans ran a budget surplus last year. French President Hollande has warned that the Eurozone's economy could be "destroyed by the rising euro" and that the Eurozone leadership needed to set a "medium term exchange rate target" for the Euro. Though this suggestion was quickly quashed by German President Merkel, it's real purpose may have been to prod the ECB to knock down the rising Euro. We also note that Merkel is up for re-election this Fall, so the last impediment to the ECB's full engagement in currency devaluation may be gone within months.
Even if the ECB remains a non-combatant in the currency wars, with Britain about to enter its third official recession since 2007, a cheaper Pound will help expand British export volumes and thus the British economy. The BoE Governor-designate, Mark Carney, due to take up his post in July, has already hinted at a more "flexible" approach to U.K. inflation than his predecessor, floating the idea that he will target nominal GDP growth, rather than inflation, as the primary factor in determining BoE monetary policy.
We believe it likely that the ECB will shift from preserving the Euro to "optimizing" it's value for the benefit of EU outbound trade and that the BoE would likely follow suit. At that point, there is no argument that this will be a full-fledged currency war. Given the relatively mild effects to date from currency skirmishes, many might be lulled into a false sense of indifference as to this state of affairs. However, as von Moltke once said, "No plan survives first contact with the enemy", a point re-iterated later in Mike Tyson's "Everyone has a plan until they get punched in the mouth." Just how would a true currency war end, we do not know
How does this affect our investing thought processes?
First, it represents a continuation of the dominance of macro-factors over company fundamentals as the largest driver of equity valuations. This is not to say that company fundamentals will not, in the long run, be the prime determinant of the value of a stock, but, rather, that companies will find themselves unexpectedly pushing against currency headwinds at one moment, only to find a quarter later that the winds have shifted in their operational favor. For example, if the Federal Reserve decides to stop purchasing mortgage bonds and US Treasuries tomorrow, they would still have to unwind their current portfolio to the tune of about $3 trillion or more. That in and of itself will distort the supply and demand for securities and currencies across the spectrum, both in the U.S. and abroad. Add three or more additional central banks doing more or less the same thing and how can macro-economic policy not impact stock and currency valuations? Never underestimate the power of several trillion dollars to move markets.
Second, if the ECB and/or the Bank of England enter the currency fray and we do escalate to large-scale intensive currency devaluation, we doubt there will be a "winner" via open market action alone. Those longer in the tooth will recall that even the last great resetting of exchange rates in 1986 was as a result of the so-called "Plaza Accord" and not open market currency battles between the United States and Japan. As such, we are not predicting a winner in this war. At best, the participants will exhaust themselves and any plausible estimation of their reserves, only to find themselves roughly in the same relative positions vis-à-vis their currency exchange rates, and all delivered in a bumpy ride. At the periphery, you may see countries like Australia, Canada, or South Africa benefit as their own currencies appreciate.
Third, with an eye towards currency volatility, we continue to think it wise and ultimately profitable, to focus on companies that have multi-currency exposures in their sales efforts. Sales across a number of the major currencies provides a natural hedge, on top of which, such multi-currency companies tend to hedge some of the currency risk themselves. This does not mean that such companies are invulnerable to currency swings, but rather that have greater flexibility in positioning their sales and sourcing efforts with currency movements in mind. For investors, higher rates of local inflation means two things: one, the necessity of higher nominal hurdle rates of return in order to generate real return, and, second, greater uncertainty over future rates of devaluation/inflation.
Fourth, and perhaps most importantly, currency devaluation results in inflation at the consumer and investor levels, regardless if there are winners, losers, or simply a tie in World War C. Why is this so? Because although relative currency exchange rate levels may not change dramatically as a result of a currency war, internal rates of inflation for consumers within each of the World War C countries will rise. Compounding this problem will be the fact that, as far as US consumers are concerned, real world consumer inflation is being under-reported by the Consumer Price Index (CPI), the official and most frequently cited US inflation statistic. According to both Shadow Statistics and Euro Pacific Advisors using separate methodologies, CPI only captures half of the real world rate of consumer price inflation.
In other words, US consumers have experienced TWICE the rate of inflation that CPI reports. So, real inflation today, rather than being at the historically low rate of 2%, is running more akin to 4%, a historically average rate. So, far from there being room for further money creation before we hit even normal inflation, we are in fact at our historic norm and any further money-printing/monetary accommodation will result in abnormally high rates of real inflation. Regardless of what the US government reports, US consumers are already experiencing the effects of currency devaluation, whether a true "World War C" comes to pass or not.
Thus, we continue to believe that exposure to not just equities, but the right equities at the right prices offers the simplest hedge against further increases in the real world inflation rate. We believe the shares of companies which have a multi-currency footprint, whether domiciled in the United States, Europe, South America, Africa, or Asia, as well as pricing power and relatively unlevered balance sheets remain the right place to be as far as equity exposure.