Depression Investing - Which Currencies to Hide in?
The world's a mess and in our eyes policy makers are inadvertently doing their best to worsen a bad situation. Let's assume you've had it and want to hide somewhere safe to ride out the storm. Unfortunately there appears to be no such thing as a safe asset anymore. Therefore you may want to consider taking a diversified approach to something as mundane as cash. Sure, U.S. Treasury Bills are the one "safe" asset - at least by regulation. But will Treasury Bills retain their purchasing power as the U.S. government raises almost $3 trillion in the debt markets this year? As the debt to be raised is going to be in the range of 12% - 15% of GDP (some estimates the Treasury Department take seriously go as high as 18% of GDP), increased U.S. savings simply won't be enough to fund the shortfall.
Let's consider the potential outcomes:
- Those loaning money to the U.S. could be rewarded by higher interest rates, but this would mean long-term interest rates would need to rise; - something the Federal Reserve (Fed) does not want because of the negative impact on growth.
- The Federal Reserve could print the money and buy up Treasury Bonds. This may keep the cost of borrowing low, but likely weaken the U.S. dollar substantially. In our view, this is the Fed's preferred scenario; in his testimony to Congress, Fed Chairman Bernanke reiterated his view that the most important steps to get out of the Great Depression were guarantees on bank deposits and the devaluation of the dollar. The banking system has been guaranteed this time around, but the dollar has not yet devalued.
- A crowding out of private sector investments may also allow the financing of all the debt that needs to be issued. Basically, the $3 trillion to be raised is money not available to the corporate sector - or the states - or municipalities - or other sovereign countries. It is very difficult for anyone but the government to raise money. Indeed, Warren Buffett in his annual letter to shareholders, points out that the cost of borrowing for his AAA rated enterprise is higher than for broken businesses that have received government support through implicit or explicit government guarantees. The government with all its well-intended efforts is destroying healthy companies, substituting rather than encouraging private sector participation.
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You would think that gold is the place to hide with so much money being printed. Yet despite the immense amounts being "thrown at the system", the inefficiency of the policies themselves makes little of the money stick. The administration's spending package includes bailouts for some homeowners, yet a reduction in the tax deductibility for others. Does the government want higher or lower home prices? Similarly, the government is pulling the rug from under Sallie-Mae, the agency in charge of providing student loans, presumably because the system is to be replaced with a different, grant-based system; is that new system up and running or are we simply taking away a source of funding for students? This isn't about arguing which of these programs are good or bad, but to highlight that it is extremely difficult to make investment decisions when you don't know what the policy is.
There are many other conflicting ideas in the spending program; in the end, there is only one clear message: if you make a lot of money, your taxes will go up. Importantly, there are no investment incentives for businesses; or other policies for that matter that encourage more prudent financial decision-making by individuals. On that note, with the shambolic state of the banking system, you would think the government would do what it is required to do by law - the FDIC improvement act of '91 (FDICIA) requires prompt and decisive action to address insolvent institutions, requiring the government to choose the least expensive option for taxpayers. Instead, policy makers continue to apply (very expensive) Band-aids. For the time being, investors are running for the hills as a result and gold is retreating from its recent highs. In our assessment, the inefficiency of the programs will delay any recovery and make it very, very expensive. Eventually, we believe some of that money will stick, economic growth may resume and all the money in the system will prove inflationary. Indeed, because the policies do not encourage consumers to reduce their debt levels, we believe that if and when inflation breaks out the Fed may be unable to contain it - we simply don't think it is realistic that the economy would be strong enough to institute Volcker-style policies (Volcker was the Fed Chairman from 1979 to 1987 and drove the Federal Funds rate to 20% in 1981 to weed out inflation).
While we believe that inflation will ultimately haunt the U.S., we are presently in a phase of inefficient government policy with the threat of deflation outweighing the threat of inflation. Moreover, we are in a period where a depression, if not a long and drawn-out recession, is a very realistic probability. So where should investors hide? Investors may want to consider adding a diversified selection of currencies to their portfolios. To this end we have some thoughts on currency investing within a depression scenario:
The euro. If, as we believe, the euro zone will not follow in the U.S. footsteps to try to devalue their currency, growth may lag, but the currency could be strong even in face of a serious recession or depression. However, the solvency of the banking system in Europe raises some serious issues. For more details, please see our recent discussion on whether there are any hard currencies left.
The Swiss franc. The Swiss franc has benefited from its reputation as a safe haven. Don't take our word for it, but the market's: since last fall, the Swiss National Bank (SNB) has been issuing Swiss franc denominated Treasury bills at par. Investors are willing to lend the Swiss government money at 0% (the return is negative after commission). In the U.S., yields were near zero or dipped negative at the height of the credit crisis, but in Switzerland, this has become the norm. Initially, the SNB was reluctant to issue debt at 0%, but has since opened the floodgates and accepts anyone looking for these bills. One of the criticisms of gold has always been that it doesn't pay interest; but is the Swiss franc as good as gold?
The Swiss National Bank is working hard to dilute its status as a safe haven. A few weeks ago, the SNB started issuing U.S. dollar denominated Swiss Treasury bills; the yields are a tad higher than Treasury bills issued in the U.S.; for the SNB it is an inexpensive way to fund the dollar denominated guarantees extended to the Swiss bank UBS. However, it does create dollar denominated liabilities, a potential vulnerability.
Switzerland is affected by Eastern Europe's affection with low interest rates: many Eastern Europeans financed their homes with Swiss franc mortgages; as the currencies in Eastern Europe have plunged, there has been a scramble to obtain Swiss francs. This challenge is not limited to Switzerland (Japan, Sweden and the euro zone face the same challenge), but the Swiss have been particularly proactive in providing temporary credit facilities to Eastern Europe. This, too, may come back to haunt Switzerland, but is perceived the lesser of the evils as it helps prop up Swiss banks (most affected are Austrian banks as they not only extended loans, but were leaders in buying Eastern European banks).
Then there is the issue of whether some of the financial institutions are "too big to bail". Sweden is suffering from this challenge as their banking system does not enjoy the safe haven status, but has extensive exposure to Eastern Europe in particular. Switzerland, for now, is enjoying its safe haven status. However, the SNB's active efforts to talk down the Swiss franc is troubling to us; we are less excited about the Swiss franc than we once were.
The Norwegian krone. Norway may replace Switzerland as the place to take refuge in Europe. Norway is a surplus country, an enviable position to be in should we face an extended depression. Norway can afford to get through this crisis; Norway can fix any problems in its economy or banking system. The Norwegian krone is not particularly sexy; indeed it is highly correlated with the euro and Swiss franc; and if the markets recover, risk friendly money may move towards other currencies again. However, in our assessment, the Norwegian krone may be the most appropriate depression trade. If one expects a cascading effect of trouble with further challenges in the banking sector or trouble in giants like General Electric, then investors may want to consider adding Norwegian krone denominated government debt.
The Japanese yen. We consider the Japanese yen the "panic trade" currency. It is noteworthy that the Japanese banking system is one of the healthiest in the world right now; as a result, when there is fear of an implosion of the global financial system, the yen may benefit. However, this benefit requires that there is no intervention by the Bank of Japan. The current composition of the BOJ has not intervened in the markets. Indeed, the finance minister recently resigned when he appeared to be drunk at a G7 meeting in Italy; as long as the leadership in Japan is weak, there may be little intervention. However, the Japanese economy is deeply in depression mode with industrial production down 42.5% from peak levels (in comparison, industrial production fell 55% during the Great Depression in the U.S.); exports are down around 50% to the U.S., Europe and Asia.
There is one area we are in agreement with Fed Chairman Bernanke: those countries that devalue their currency may recover more quickly from a depression. Rather naturally so: if the purchasing power of your savings is slashed, you have a great incentive to work again. Because of high savings levels, the Japanese have so far been able to absorb the implosion, however painful. This is, by the way, our reason for being more optimistic about the euro than many: unless you have a severe current account deficit like the U.S., you don't necessarily need to have growth to have a strong currency.
We do believe that the "panic trade" is fading out. That's because policy makers throughout the world have provided guarantees to the banking system and shown they are willing to do anything - including sacrificing their currencies - to protect the financial system. That sharply reduces a disorderly adjustment of the financial system. Instead, we are now faced with either pursuing an orderly adjustment, i.e. a deep recession or depression; or whether we reflate the system. As these forces play out, the panic scenario may move to the background. In a global depression, surplus countries such as Norway may be the ones losing the least; there is really no winner in a depression, but Norway is better positioned than most.
There may be another depression trade - the Chinese yuan. To learn why and be informed as we discuss further currencies, including currencies that may benefit as the world tries to reflate, subscribe to our newsletter at www.merkfund.com/newsletter. We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively.
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