Eurozone Crisis To Help Dollar, Not Risky Asset Classes

Includes: IFAS, LQD, UUP
by: Disruptive Investor

The crisis in the eurozone has the potential to be a prolonged and painful one. To add to this, as new issues surface, there is increasing evidence of political friction among the countries in the eurozone.

This scenario is certainly not good for the global economy struggling to get back to normal growth and activity. However, the events in the eurozone can be considered as a blessing in disguise for the dollar. At the same time, it contributes to increased volatility across asset classes globally. This article discusses these two perspectives and the investment strategy appropriate for the current scenario.

There was a time when euro was being touted as the next global reserve currency. Countries like Iran, were tempted to trade oil only in euros. Many analysts called for the death of the dollar. Currently, the dollar looks strong (relatively) to continue as a global reserve currency for longer than most of us expected.

The euro crisis, which might still be at its early stages, has crowned the dollar as the undisputed global reserve currency. As mentioned earlier, the crisis promises to be a prolonged one. This, in turn, means that dollar has a prolonged advantage over the euro.

It has to be understood that I am not suggesting that the problems for the United States are over. However, the country and its currency are relatively much better off as compared with the euro.

What more evidence do we need (at least in the very near term), than the fact that U.S. Treasury bond yields have still remained relatively lower (even after U.S. rating downgrade and continued sluggish economic growth).

Further, the dollar index has held up pretty well even when the government sector in the United States has piled on debt on its books after the recent recession and crisis.

However, my concern at this point of time is – What might be good for one asset class or currency might be disaster or bad for several other asset classes.

What I am talking about here is the simple relation between the dollar and asset classes such as equities and commodities. A strong dollar is an indication of tightening global liquidity and generally leads to a sell-off in risky asset classes. Post the Lehmann collapse, the dollar index surged to a high of 89 in March 2009. This also coincided with lows for equity markets.

Therefore, if we are expecting the dollar to remain strong, we should ideally see weak equity and commodity markets.

Also, if we are expecting continued relapse in the eurozone crisis, we should ideally see very volatile equity and commodity markets.

Both these scenarios are not great for investors. Volatility can be exciting for traders; however, it might lead to some very painful outcomes.

Just to prove my point, the dollar index was at 75 levels in November 2009. It then surged to levels of 87 by June 2010. Amidst volatility, it again trended down to 73 by April 2011. After moving higher again (close to 79) by October 2011, the index is currently at around 77.

This kind of volatility in the currency market can make investment decisions much more complex and would need greater active monitoring than passive investing. It also changes the definition of long-term and short-term investing.

Therefore, based on the observations above, I draw the following important conclusions, which will help me arrive at a investment decision suiting the current environment:

  1. The prolonged eurozone crisis will help dollar remain as a favored currency
  2. Dollar would be a more favorable currency on a relative basis, not because of its inherent strength, but because of euro weakness
  3. Continued sluggish growth in the U.S. economy will lead to volatility across asset classes closely related to dollar weakness and strength

In line with these conclusions, I would like to have meaningful exposure to:

  1. High quality corporate bonds in U.S. and in emerging Asia
  2. Land or real estate in tier two and tier three cities in emerging Asia (through REITs)

I would also look for equities and commodities as short-term trading opportunities than long-term investment options (at least in the foreseeable future).

There is no doubt that the investment environment has become much more challenging than it was a few years before. Further, with high volatility expected to remain (in my opinion); investors need to be very cautious in investment decision making. Having said this, there is no other option than investing in relatively risky asset classes in order to avoid losing out on purchasing power.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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