A New Era of Opportunity
Could it be that the government is now in the driver's seat of the economy, having replaced the private sector? We certainly don't believe it is the engine yet, but increasingly it has moved from being the backseat driver directing instructions intermittently, to taking over the steering wheel. Anytime I watch the financial news networks I'm struck by the fundamental shift away from Wall Street and U.S. business as the source of news-flow impacting the financial markets. It seems these days that government or central bank intervention invariably steals the headlines, pushing markets one way or the other. One could be forgiven for believing the administration envisions becoming the engine, given the massive government growth and policies pushing it in that direction (a scary thought for all of us).
This is just one of the plethora of changes we have witnessed impacting the economic landscape. Some may be more permanent in nature (think banking regulation), some temporary (think "cash for clunkers"). With all that has happened over the past year, now may be a good time to evaluate the fallout and reflect on what has been an unprecedented period in the markets. Above all else, the seismic shifts in the economic environment will impact us all; but where there is change there is opportunity.
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Take the Federal Reserve Bank's (Fed's) interventions. These are creating gigantic amounts of inflexibility on the Fed's balance sheet. The Fed, in recent announcements, has changed its tone to focus on the scaling back of Treasury purchases and the unwinding of many short-term liquidity and credit programs. What is not highlighted, however, is the substantial commitment to purchase longer-dated securities, namely agency mortgage backed securities (MBS), which will have a marked effect on the Fed's balance sheet and ability to counteract inflation; in simplified terms, one can think of the size of the Fed's balance sheet as the money that has been virtually "printed." As short-term program unwinding nears an end, it will no longer offset the increased MBS purchases. In other words, not only is the Fed replacing short-term, more flexible programs, with longer term inflexible ones, but as the short-term program run-off nears an end, continued MBS purchases will likely grow the Fed's balance sheet further.
Presently, there is just over $625 billion in MBS held outright on the Fed's balance sheet, implying the Fed will need to double their purchases to meet the pledged commitment of $1.25 trillion. It wasn't so long ago that the Fed's total balance sheet was around $800 billion; it's presently over $2 trillion, with more to come - no wonder the Fed recently went on a hiring spree. (Which, by the way, may be a further indication that the Fed intends to keep a bloated balance sheet for an extended period of time.) Unlike short-term liquidity and credit programs that can be wound down reasonably easily should inflation break out, these longer-dated securities will be much harder to nullify.
Conversely, many central banks around the world have been more constrained in their approach to non-conventional policy intervention. Aside from the Bank of England (which competes with the Fed for title of most prolific money printers), there are very few central banks that are, in our opinion, acting as irresponsibly as the Fed. Other central banks have focused on providing liquidity to the banking sector, not directly to specific areas of the economy. Moreover, security purchases, if any, have been on a much smaller scale and much shorter time horizon, indicating that most central banks around the world have a better ability to wind down any such programs, and are unlikely to fall into such an inflation inflexibility predicament we believe the Fed is boxing itself into. Given that less money is generally being printed outside of the U.S., most countries may not incur substantial currency devaluation, relative to the U.S. dollar.
Whereas the Fed and U.S. government balance sheets are likely to be in shambles going forward, it is not hard to find examples of nations in much healthier situations. Take Norway, for example, which has twin surpluses and whose central bank has focused squarely on its mandate of price stability throughout the credit crisis by using traditional monetary policies. The Reserve Bank of Australia, too, has been much more conservative in its approach to the credit crisis, taking a relatively hands off approach, as has the Reserve Bank of New Zealand, to name but a few.
Another recent development has been the increased correlations witnessed across asset classes. As we approached the credit crisis all asset classes were moving up in tandem; as we entered the credit crisis all assets moved down together; and now, as we seem to have escaped the worst of the crisis, asset classes are moving in lock-step like never before. This shouldn't be too surprising: as everyone levered up heading into the credit crisis, all asset classes moved up; as everyone de-levered through the credit crisis, all assets declined in value, and; as money was printed prolifically, money flowed back into assets like stocks, bonds, commodities and natural resources. An implication for investors is that it may be increasingly important to add uncorrelated assets to their portfolios.
Given the need for further money printing to support MBS purchases, we may be in for more of the same. The problem the Fed has faced is that despite all this money printing, the money has not flowed into the real economy - commercial and consumer loans continue to decline (after all, who wants to lend to an embattled consumer, or a business with a significantly impaired growth outlook) and consumer spending remains extremely weak. All of which does not bode well for a "V" shaped recovery some are positing.
Lastly, despite significant economic downturns around the world, developing Asian nations, particularly China and India, have continued to post positive economic growth. To be sure, growth has been curtailed somewhat, but massive infrastructure spend locally, combined with continued growth in the domestic markets helped underpin continued positive growth in the high single digits. Going forward, both countries are likely to focus on developing their respective middle classes and domestic economies, with continued focus on up-skilling the workforce, upgrading domestic infrastructure, and developing local financial market capabilities. The most recent example of the latter being the Chinese government's decision to issue yuan denominated sovereign bonds later this month. Asian policy makers seem aware they can no longer rely on a U.S. consumer who needs to de-leverage for an extended period of time.
It is our view these economies will only grow in global importance and prominence over time. Put simply, we believe these developing economies have significantly higher growth potential relative to many developed nations, such as the U.S., as they continue to develop and become more self-sufficient. As such, continued investment inflows are likely to be seen into these regions. The flip side is that inflationary pressures are likely to grow; we believe one way China may address this issue is by easing its pegged currency approach, which should lead to a weaker U.S. dollar. Additionally, countries well placed to gain from ongoing Asian demand in commodities and raw materials should be net beneficiaries.
If the Fed and U.S. government continue down the present road, we believe it is an inevitability that the U.S. dollar will come under increasing pressure going forward. Not only will inflationary pressures conspire to weaken the dollar, but also a continued deterioration in public finances will wear away at the safe haven status the U.S. has held for so long. With higher economic growth likely to be found outside of the U.S., continued monetary and fiscal concerns domestically, and the increased correlation across traditional asset classes, the era of investing solely in U.S. stocks and bonds may be over. In such an environment, we believe investors may want to consider whether an additional asset class, such as currencies, may provide valuable portfolio diversification benefits and upside potential. The currency asset class has traditional exhibited low correlations to traditional asset classes and may provide investors with the opportunity to benefit from appreciating currencies as global dynamics play out.
We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.