Protect Now Against Dollar Crisis
- In a mad dash to buy U.S. stocks, currency allocation has been forgotten by investors.
- U.S. fiscal and monetary stimulus is unconscionable and will lead to inflation and a certain negative impact on the U.S. dollar.
- Exposure to foreign currencies provides diversification, upside potential, and protection against a dollar crisis.
- This idea was discussed in more depth with members of my private investing community, WMA Investments & Monitors. Learn More »
Do Not Overlook Currency Allocation
The final week of April saw U.S. equities essentially unchanged, while overall the S&P 500 was up over +5% for April. Earnings and revenue were particularly strong among the big cap tech stocks, including Apple (AAPL), Amazon (AMZN), Google (GOOG) (GOOGL), Facebook (FB), and Microsoft (MSFT), among others. Interestingly, this past week only Facebook and Google finished the week with stock prices above their pre-announcement level. This could be a red flag, as fully-priced stocks are not able to rally further on blow-out numbers that largely beat consensus forecasts. Add to this the blow-out numbers in the week's strong economic data and Biden's proposed additional $4 trillion in stimulus, the 1-point gain in the S&P 500 is very indicative of the exhaustion in the markets.
This past week the Federal Reserve also told us that QE will not end, despite the stronger economic data. Clearly, the Fed is concerned that ending QE will send a signal that the first interest rate hike is nearer than expected. And the Fed wants us to believe that rates won't rise until 2024. Hence, the Fed will make a major policy error, encouraging the asset price bubble to continue to levels that ensure great investor pain when markets recognize inflation and/or some exogenous event hits markets.
One fallout from this misguided Fed policy of letting inflation get out of control before reacting is the impact on the U.S. dollar. We all know the quality of currencies in high inflation countries, and it's never pretty (buenos dias, Argentina). Recall that the gold standard ended in the 1974, and the only thing backing fiat currencies is the belief by the public in the credibility of the central bank that issues the notes. And it does not take a degree in economics or finance to understand that a country whose central bank just prints money out of thin air is, in effect, just debasing its currency for ephemeral short-term gains. Below is a weekly chart of the Dollar Index (the dollar against a basket of euros, yen, pound sterling, Swiss francs).
It may be surprising for some readers to see that the dollar is still well above lows of the past decade. But then again, Japan and the Eurozone have also resorted heavily to QE. If the dollar is not as weak as one would expect (given the Fed's largess), it is likely due to strong investment inflows into the U.S., as foreign investors still see the U.S. (and its stock market) as the best destination for their money. The problem, assuming the Fed is wrong and inflation is not transitory, is that the U.S. will become a less attractive destination for capital inflows. Remember, inflation erodes the value of assets and will reduce demand for U.S. dollars.
We can make the same argument for the Eurozone and Japan, where central bankers are also drinking the QE Kool-Aid. While the U.S. dollar may continue to look stable versus other eroding currencies like the EUR and JPY, we expect to see fiscally strong countries with disciplined central banks to have appreciating currencies.
Another weight on the dollar is that, as the world's reserve currency, economic theory suggests that the dollar should depreciate over the long term. The reason is that the U.S. monetary authorities must keep the world awash in dollars, as the greenback is used to settle transactions around the world (think of all the commodity contracts denominated in USD).
The Dollar And Your Portfolio
The message in this week's commentary is that the advice of stock diversification that we hear all the time ALSO applies to currencies. Maybe the dollar is really a safe haven currency or maybe the dollar will depreciate over many years to come. Should you continue to ignore diversification and hold only USD assets? If we say that maybe the FAANG stocks will go to the moon or maybe FAANG stocks are in a similar position as tech was in 2000, most investors would react by diversifying their portfolios, such that they would manage risk, not holding over 50% in FAANG-type stocks.
Even if U.S. stocks outperform global stocks for another 12 years (highly unlikely), there are still benefits from holding stocks with different underlying currencies. And this is beyond any consideration of a dollar crisis stemming from:
- chronic U.S. deficit spending,
- Biden's multi-trillion spending plans (that will curiously be financed by only 500,000 Americans),
- the ballooning U.S. debt level, or
- the Federal Reserve governors who like to experiment with non-traditional monetary policy.
One major benefit from maintaining exposure to foreign currencies is the decorrelation of asset returns in U.S. dollar terms. A simple example: holding Toyota's stock that trades on New York (TM) affords an underlying currency exposure long JPY, even if your position is still denominated in U.S. dollars. If a global crisis hits (Covid-21, for example), the Japanese yen, traditionally a safe haven currency, will likely appreciate as all stock prices fall. Your holding in TM will reduce the downside volatility in your portfolio, thanks to your underlying exposure to JPY. While we are not recommending Toyota specifically, the idea is to be more sophisticated in your portfolio construction such that your effective currency exposure (even if you don't buy outright foreign currencies) remains diversified… just as your sector allocation to stocks.
We created some interesting charts that reflect the impact of currency choice on stock returns. The first chart looks at the S&P 500 versus the MSCI All-World ex-U.S. Index denominated in various developed market currencies. We started the charts just before the Financial Crisis to see the full secular bull market. We hedged the ex-U.S. index with euros (EUR), yen (JPY), Aussi dollar (AUD), and Swiss francs (CHF), which gives the total return for an American investor having bought the ex-U.S. index in these currencies. Some key points:
- The S&P 500 stocks (+291%) crushed the index of world stocks, measured in U.S. dollars (+76.0%).
- The underlying currency effect is non-negligible. Buying the ex-U.S. index in euros would have yielded +63.8% while buying in francs would have returned +141.5%.
- During crisis periods (2008, 2011, 2020) the yen and franc indexes cushioned the downside of stocks.
- More generally, the secular trend gap in favor of the U.S. is clearly in rare air. In the 2003-2007 bull market, the ex-U.S. index outperformed, but at the maximum, the spread in favor of the ex-U.S. was never more than +100%.
The next chart repeats the process using emerging market currencies: Indian rupee (INR), Singapore dollar (SGD), Brazilian real (BRL), and Turkish lira (TRY).
Our next takeaways:
- Fiscally solid EM countries, like Singapore, offer currencies that provide safety and reduced portfolio volatility. In the event of a dollar crisis (or euro crisis), holding Singapore dollars may be good protection.
- EM assets have massively underperformed in the post-Financial Crisis bull market. We'll explain why in a second.
- For a return-to-the-mean investor, there is lots of potential energy in currencies like the rupee, lira, or real, which could explode higher with strong global economic growth. We'll look at a few high potential currencies in the next section.
The reason why EM currencies and stocks have done so poorly is due to several factors. First, EM and ex-U.S. stocks tend to alternatively out/underperform U.S. stocks in successive secular bull markets. We've seen this alternance since the 1980s. So it is not a surprise that EM has underperformed, although the magnitude is impressive. Second, developed country central banks have gone over-board with the monetary policy stimulus. It should again not be a surprise that developed country assets have outperformed in conditions of excessive liquidity. Third, global growth has been anemic since 2009. While EM countries have higher potential growth rates, most countries have been running under their historic GDP growth rates. In relative terms, this hurts, for example, the U.S. less than a BRIC country. Finally, EM current account balances as a percent of GDP deteriorated post-Financial Crisis and have been slow to recover, as shown in the next chart.
Some Underlying Currencies To Consider In A USD Portfolio
At WMA, when we buy foreign companies, we always look at the potential underlying currencies headwind or tailwind. Right now, we like EM assets in general. The underlying currencies that we find most attractive today are the Russian ruble, Brazilian real, Turkish lira, and Indian rupee. Again, a key point is that U.S. dollar portfolios don't need to physically hold these "exotic" currencies, but rather just hold dollar-denominated securities with underlying assets in these currencies, such as an ADR or an ETF.
The Russian ruble prices in lots of bad news for the Russian economy (geopolitics, weak economy, last year's collapse in oil prices). If the economic situation improves in Russia, the currency could more than double to return to the pre-2013 mean. We are not predicting a ruble back to 2007 or even 2010 levels, as the collapse in oil prices has likely permanently impaired the ruble. But just a move back to RUB 50/USD (2016 levels) from the current RUB 75/USD would be an enormous tailwind for investors in, for example, the Russia ETF (RSX). Note that our charts are inverted and rescaled, to show, in this case, a ruble appreciation with a rising line.
The real is probably the most exciting opportunity for U.S. investors, given the upside potential of the currency, the economic potential of the Brazilian economy, and the wide choice of solid companies to choose from in Brazil. Look for the real to come down from its current BRL 5.3/USD to its historical range against the dollar of around BRL 3.0.
The Turkish lira looks like a train wreck. This is what happens when a central bank loses its independence and creditability. Erdoğan essentially controls the nation's central bank, which explains why the lira is so weak relative to Turkey's economy (which is not that bad). Again, we are not making a timing call, just pointing out that the undervalued lira could appreciate rapidly whenever the situation changes.
India is another BRIC nation that has been forgotten over the past decade. But just based on demographics, the country's potential GDP growth is enormous. Buying Indian stocks or the tracker (INDA) gives exposure to rupee near its cheapest price in a generation. Unless you believe that the Indian economy is going to collapse and never recover, buying/holding assets in rupee will be a slam dunk winning investment.
Investors are overwhelmingly focused on U.S stocks. The reasons are compelling, even if the valuations are not. The notion of diversifying underlying currency holdings has been forgotten or just ignored by investors. While everyone is piling into big cap U.S. stocks, it would seem to be a good idea today to follow the crowd a bit less. Attention to currency holdings is one way to diversify your portfolio and protect against a dollar crisis or more generally an end to U.S. stock outperformance.
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