Richard Graham's  Instablog

The Dollar: Past and Future

There has been much talk about the dollar recently. As I write this article, the Euro has crossed the USD 1.50 threshold, and no relief is in sight for the dollar’s precipitous decline off of its recent high. This extreme movement begs the question, “How did we get here, and where are we going?” Hopefully, I can explain my thoughts on this question.

Past

The dollar’s decline began roughly at the same time that the US economy began to recover from the 2000 recession. The recession, arguably, caused a flight to quality that strengthened the dollar. The dollar’s strength, however, was short lived. As soon the economy recovered, it began it’s current downward trend (see figure 1). I believe there are three reasons for this long-term downward trend, which will continue to weigh on the dollar in the future.

 

 

1. Preference for Other Assets

 This is probably the most important reason for the dollar’s decline. Over the last ten years foreign non-dollar asset classes have handily outperformed dollar denominated asset classes (While commodities are priced in dollars they should be considered here because their price movement is generally inverse to the dollar). Even after the current precipitous economic catastrophe, commodities have returned roughly 250%, emerging markets 200%, Chinese stocks 150%, and Hong Kong shares 100%. Compare these triple digit gains to the measly returns of the S&P 500 and the US dollar, and you can see why people were so willing and continue to be willing to sell their dollars for other assets (see figure 2).

 This phenomenon is the result of nothing more than global economic development. Traditionally risky markets like China and other emerging markets became safer as they became politically stable (a prerequisite for any foreign investment), increased investment (which created massive commodity demand), and began export driven economic growth. By gathering large amounts of wealth through a steady stream of exports these countries made their assets extremely attractive. While the global recession has damaged the export model, emerging markets (if they should be called that anymore) will be able to develop a consumption based model that is based less on exports but still creates economic growth.

 
2. National Debt and Current Account Balance

These two macro-economic factors have had contributed to the dollar’s decline. As we see in figure 3, US national debt has substantially increased over the past decade. Debt as a percentage of GDP has also increased. Extreme Congressional action to balance the budget not withstanding, we can expect these two numbers to continue to increase over the next decade. As a result, increasing national debt will continue to weigh down on the value of the dollar. This effect, however, is relatively over-hyped. The US debt to GDP ratio is still relatively low when compared to other countries, and this recent article by Bespoke shows that the US default risk is also low when compared to other countries. National debt, however, is a factor that should be considered when valuing a currency.

 

 A much more important marco-economic variable that has weighed down the dollar is the US’ negative current account balance (see figure 4). Over the past decade the US has run a very large current account deficit even though it has had a positive current account on services. This excess consumption of goods was financed via the growth of credit (which has now stopped). Basic economic theory dictates that in a floating exchange rate system when a country runs a current-account deficit, its currency devalues to correct the imbalance. We have seen this effect in action for the last 8 years and it will continue to weigh on the dollar in the future.

 

 

3. Decline of American Power

One very overlooked factor that influences the value of a currency is the military and economic strength of the issuing country. Before the 2000 recession and September 11, 2001 terrorist attacks, the United States was at the apex of its power militarily and economically.  The aforementioned events along with the following US debacles in Iraq and Afghanistan, however, have substantially damaged this image. As we watch the world in 2009 we see a world that was very different from how it was in 2000. The world has become multi-polar: countries like China, Russia, Iran, North Korea, and Brazil are beginning to more heavily assert themselves on the international stage be it through economic or military policy. While the United States may have the largest conventional military force and nuclear arsenal, it certainly does not project that image, which has allowed multi-polarity to take over world affairs. In a nutshell, the decline of American unipolar power and the rise of a multipolar world is not only a slap in the face to America, but also a threat to her currency.

 

Future

So what is the future direction of the dollar? In the short term, it appears that the dollar should rally regardless of the direction the economy takes. Take these two contrasting scenarios for the economy. First, the economy begins the second half of its “W” recovery and growth slows. This would send jitters throughout world markets and create a flight to quality to the US dollar. Second scenario, the US economy continues to grow. This would elicit an interest rate hike from the Federal Reserve which would strengthen the dollar. These two scenarios, however, are short-term scenarios and buck the long-term trend.

The long-term trend is the same as it previously has been, except accelerated. One critical factor that has been slowing the dollar’s decline is Asian central banks’ ability and willingness to keep their currencies undervalued against the dollar. This policy has allowed Asian countries, particularly China, to rack up very large current-account surpluses (see figure 5). Post-financial crisis, however, this currency strategy will be untenable because of the lack of credit and the decline of wealth in the United States. Because it is no longer extremely easy for Americans to refinance their homes and most household wealth has been hit by the stock market decline, Americans will no longer exorbitantly consume. This means less exports and a reliance on increased consumption in Asian countries, which will appreciate Asian currencies and depreciate the dollar.

 

Another example of this phenomenon is Brazil. Brazil recently introduced a tax on capital inflows in order to stabilize the Real. This tax, however, has had a minimal effect, and the market expects the Real to continue to appreciate. Once again, central banks are unable to keep their currencies undervalued against the dollar.

Additionally, as mentioned earlier, the economics of a floating exchange rate system and the current account balance will depreciate the dollar. Because the United States has such a large current account deficit, its currency will depreciate to stimulate exports to correct the deficit. Because emerging market central banks are unwilling or unable to keep their currencies low, this trend will accelerate, and emerging market currencies will appreciate to correct their current account surplus by encouraging imports.

In the long run, it seems that the only direction the dollar can go is down.

  

 

This rally has been interesting. Some say it is an example of efficient markets pricing in the fact that economic doomsday has passed. Others say it is nothing more than an example of “irrational exuberance.” Unfortunately, both are right. The “green shoots” and “less bad” economic data will eventually bear fruit, which will give the market a real reason to rally. Furthermore, firms will continue to beat low earnings estimates, which will provide the market the momentum it needs to continue its upward march.

The Green Shoots will Turn into Plants

The main driver of this rally has been the so-called “green shoots,” or bright spots of economic data that have been released since the market’s March bottom. The market has taken data like the increasing unemployment rate or increasing jobless claims and rallied on it, basing its claim to rally on the fact that the data beats its estimates. This reaction is certainly irrational. Q2 GDP data shows that consumption is declining, and banks continue increase write-downs on commercial real estate and consumer credit card loans. These economic indicators, however, do not phase the market; it continues to march on.

Eventually, though, the green shoots will turn into plants. And, that is what we will see in Q3: GDP growth is almost universally projected to be positive. That coupled with corporate earnings “beats” along with more “less bad” economic data should propel the market upward through Q3.

Corporate Earnings and Bank Stocks

Another recent driver of this rally has been corporate earnings. During this earnings season, 74% of companies have beaten earnings estimates. The reason for this is simple. Firms along with analysts gave ridiculously low earnings and revenue estimates. Firms’ cost cutting measures easily allowed them to beat these lowball estimates, which propelled the market higher and gave it confidence.

Additionally, in a recent WSJ editorial, Zachary Karabell raises a good point about the source of US corporate earnings. He points out that most firms are not solely reliant on US economic growth. Even if the US continues sluggish growth, firms will reach outside the US to generate the growth and revenues necessary to keep up with earnings expectations. It seems that fate of the stock market and the US economy has begun to diverge.

One check against the market’s exuberant joy during earnings season should have been bank stocks. These firms still hold a large amount of deteriorating commercial real estate and consumer credit card loans. Additionally, they still possess a large amount of various illiquid asset backed securities. Banks and Congress, however, prevented these factors from having any real effect by pressuring the change of FASB rule 157. Because banks can now estimate the fair value of their illiquid (and deteriorating) assets instead of relying on market prices, they have successfully finagled their balance sheets into looking healthier than they actually are. That, coupled with large trading profits, easily overshadows any impending problems for banks. Because banks were the main cause of this crisis, their recovery is crucial to market confidence. And, because their profitability and health does not seem to be threatened, banks will continue to infuse the market with confidence.

Sluggish Recovery

One argument most bears levy against bulls is that economic recovery will be sluggish. It will be marked by high unemployment, low consumer spending, increased savings, and even high inflation. These claims are true, however, the market has already priced them into share prices. When the front cover of Newsweek says that recovery will be sluggish, it is safe to say that everyone knows the recovery will be sluggish, that includes the stock market. Additionally, as the sluggish recovery continues, firms and analysts will continue to produce low earnings estimates that will continue to be beaten.

“Water, water, everywhere, but not a drop to drink.” In 1789, English poet Samuel Taylor Coleridge penned this famous line in The Rime of the Ancient Mariner, a poem that describes the deathly journey of a mariner’s ship. After being cursed for shooting an albatross, the mariner sees his crew slowly die of dehydration, only to be redeemed at the end of the poem for realizing the sins he has committed. China, interestingly enough, is in this same precarious situation: it has been inadvertently cursed by the fruits of quick economic growth and urbanization. As a result of its explosive growth and recent droughts, China’s water supply is increasingly in danger. This threatens to choke China’s industrial and population growth. It also provides a valuable investment opportunity. As China’s water problem deepens, it will be forced to invest in new water treatment and irrigation technologies, unlocking a 1 trillion RMB market with plenty of opportunity.

China’s Water Crisis

China is home to 270,550 sq km of water. Unfortunately, this water is heavily polluted, threatened by drought, or being overused. According to a March 2009 study by China Research and Intelligence, over 70% of Chinese rivers, lakes, and seashores, and 90% of its underground water supply in urban areas are polluted. The main cause of this pollution is China’s unbridled economic growth. Much like during the United States’ own industrial revolution, Chinese firms dump their waste products into the water without regard for the environment, which makes the water unusable. Additionally, spills and accidents like the one at the Jilin chemical plant in 2005 exacerbate this cycle.

Another threat to the Chinese water supply is drought. In early February this year, China declared a drought emergency in the Hebei, Shanxi, Anhui, Jiangsu, Henan, Shandong, Shaanxi and Gansu provinces, which are provinces in central and northern China, China’s breadbasket region. For the past few years, the water table in northern China has been falling roughly five feet a year. These droughts, currently, show no signs of abating and are exerting extreme pressure on China’s water supply.

The final major threat to China’s water supply is overuse. China is an agricultural powerhouse, which poses a particular threat to its water supply due to excess irrigation. According to a Swiss Re focus report on water availability, between 1850 and 1980, China lost 543 medium to large sized lakes from irrigation. Today, as the result of excess irrigation, the Yellow river no longer reaches the sea. Moreover, demographic changes will increase China’s water use to unsustainable levels. China’s population is projected to rise from roughly 1.3 billion today to 8.5 billion by 2025. Assuming current water use per-capita remains constant, China’s withdrawal of freshwater supplies will increase from 549.76 cu km/yr to 3527 cu km/yr, a 541% increase. Additionally, China’s changing diet will pressure water supplies even more. The Chinese consume a primarily vegetarian diet; however, westernization has shifted her diet from being vegetable based to meat based. To put this into perspective, it takes roughly 1000 liters of water to grow a bushel wheat, but 15,000 liters of water to produce a kg of beef. Clearly, this trend will pressure China’s already dwindling water supplies even more.

Investment Opportunities in the Crisis

The Chinese government has recognized this water crisis. In its 11th five-year plan, the government allocated 1 trillion RMB for investments in the water sector. These projects range from a series of canals connecting the water rich Yangtze River of the south and the water deprived Yellow River of the north to desalinization and water reclamation projects. While projects like the Yangtze River-Yellow River canals are ambitious, they are not the future. Merely moving water around China will not be able to supply her with the water she needs in the future, the future for water in China is water reclamation, water treatment, and desalinization.

There are multiple firms that are well positioned to take advantage of this future trend. The first, and the best positioned, is Hyflux (SIN:600). Hyflux is a Singaporean company that specializes in water purification, treatment, and desalinization. They possess a proprietary membrane technology that can be applied on large scales in municipal settings. With fifteen wastewater treatment plants already constructed in China, the company  has strong China exposure. Because of its advanced and unique technology, Hyflux is the leading firm to take advantage of this crisis.

A second well-positioned firm is Duoyuan Global Water (NYSE:DGW). Duoyuan Global Water has heavy China exposure and provides water treatment, purification, and wastewater treatment services. It has over 80 distributors in 28 provinces, with a quarter of those distributors in the drought-ridden north. While Duoyuan does not possess the same membrane technology as Hyflux, it provides the same range of services as Hyflux and has larger China exposure. For an American investor, Duoyuan could be a better choice if they cannot trade Singaporean stocks.

Other firms that are positioned to profit are Veolia Environment (NYSE:VE), China Water Affairs Group (HKG:0855), and Insituform Technologies (NASDAQ:INSU). These firms deal more in water transportation and infrastructure, and less in water purification and treatment. They do, however, have China exposure and should benefit from Beijing’s attempts to bring cleaner water throughout China.

Disclosure: No Positions.