U.S. Dollar and Euro - Review and Outlook
The analysis below is based on our letter to shareholders in the annual report of the Merk Funds*.
The 12-month period ended March 31, 2012 (the "Period") could be described as one of contrasting halves. The first half of the Period was marked by increased pessimism and concern regarding Europe, particularly the periphery nations. In contrast, market sentiment was more optimistic through the second six-months of the Period, and markets exhibited significant strength. During the first six-months ending September 30, 2011, the market - as measured by the S&P 500 Index - returned -13.78%, while the market returned 25.89% during the second six-months ending March 31, 3012.
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News emanating from Europe dominated market gyrations for the majority of the Period. Specifically, the periphery nation sovereign debt crisis and concerns surrounding its global contagion effects - particularly on countries previously considered immune to the fallout, like China - held the market's attention. Concerns appeared more acute through the first half of the Period, where we witnessed heightened levels of market volatility and general selling of perceived risky assets. The VIX index - widely followed as a bellwether for market volatility - reached a high of 48 in August 2011, as concerns mounted regarding the Greek debt situation and focus shifted to the larger European countries, particularly Italy and Spain, where political upheaval only muddied the waters. Policy makers on this side of the Atlantic compounded the problem, with Washington leaving the decision to raise the U.S. Government's debt ceiling to the last minute causing further market distress.
During the second half of the Period, the market appeared to ascribe a more optimistic assessment to the European situation and the global economy. Particularly in the U.S., we saw the release of many economic data points that beat consensus expectations, including notable improvements to the unemployment rate. European policy makers also appeared to alleviate the market's concerns regarding Italy and Spain, where austerity measures were finally agreed to and put in place, while much needed clarity was provided surrounding the Greek situation when bondholders agreed to participate in a debt swap. At the same time, we witnessed a number of central banks following much easier policies through the second half of the Period. The U.S. Federal Reserve (Fed) became evermore dovish in its rhetoric regarding easing measures and extended the calendar date that low rates are anticipated to be kept in effect, moving it out to the end of 2014 from mid-2013 previously. The Bank of England expanded its quantitative easing program by £50 billion pounds and the Bank of Japan also increased its expansionary asset purchases by ¥10 trillion and concurrently set an inflation target. Additionally, the ECB expanded its balance sheet via two long-term refinancing operations (LTRO's), together totaling over €1 trillion. All of which helped alleviate market concerns and underpinned significant strength in equity markets, as indicated above, and a substantial reduction in the VIX index, which fell to a low below 14 in March of 2012.
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Going forward, we consider that central banks around the world are likely to err on the side of further monetary policy easing. Our analysis finds that the composition of voting members on the Fed's Federal Open Market Committee (FOMC) is more dovish in 2012 compared to 2011 and is set to become even more dovish in 20131. We therefore consider it very likely that rates will be kept low for an extended period of time in the U.S. and, should economic fundamentals deteriorate, further easing policies may be put in place. Elsewhere, the Bank of Japan appears committed to generating inflation via easing policies, while the Bank of England appears to be more concerned about deflation despite the existence of what we deem to be elevated inflationary pressures (as measured by the consumer price index). We consider it likely that the Bank of England announces further stimulus measures should economic growth in the United Kingdom disappoint. At the same time, there is renewed pressure on the ECB to purchase periphery nation debt to stave off further fiscal deterioration in the region. While ECB President Draghi appears committed to provide the banking system with unlimited levels of liquidity (through the two three-year LTRO facilities), pressure is mounting to intervene directly through the Securities Market Program (SMP) and buy the likes of Spanish debt. Notwithstanding, the ECB is likely to do everything in its power to stop the financial industry from collapsing, which may mean further liquidity provisions, such as the LTRO's already seen.
All of which should serve to underpin those currencies most correlated with the outlook for economic growth and of countries set to benefit from increases in the price of commodities and precious metals. We believe as central banks continue to follow expansionary, inflationary policies, that those assets exhibiting the greatest monetary sensitivity should benefit - such as commodities, natural resources and precious metals. As such, we favor the currencies of commodity producing nations, such as Australia, Canada and New Zealand. In particular, we do not consider that China will experience too severe a slowdown in economic growth - the recent announcement to expand the trading band of its currency should be seen as a signal that policy makers there believe the risks to the economy have satisfactorily abated. We think Australia and New Zealand are well situated to benefit from ongoing Asian economic strength, while both countries' fiscal positions are in stark contrast to the U.S. and Europe, for all the right reasons. Canada, too, should benefit from ongoing commodity price appreciation, and is well placed should the U.S. economy continue to pick up steam ahead of consensus forecasts.
In Asia, we continue to favor the currencies of nations who are producing more value-added goods and services while concurrently focusing on the development of the domestic economy as a source of long-term sustainable economic growth. China in particular checks these boxes. We consider building inflationary pressures brought about by increases in global commodities and a tightly managed currency, may ultimately force the Chinese into allowing the currency to float more freely2. While there have been recent hiccups regarding China's upcoming leadership transition, the ultimate goal of the Communist Party remains intact: to maintain social stability, so as to remain in power. We believe there are several aspects to this notion, none the least being the support of strong, sustainable economic growth and the containment of inflationary pressures. Regarding the latter: should inflation get out of hand, the risk of social upheaval may become elevated. China's close management of the dissemination of any news discussing the "Arab Spring" uprisings is indicative of the strength of its resolve in maintaining social stability. One of the contributing factors causing the "Arab Spring" was runaway inflation.
In China and other Asian nations, allowing the respective currencies to float more freely may act as a natural valve in alleviating the inflationary pressures being experienced. Moreover, we consider China and countries such as Malaysia, Singapore, South Korea and Taiwan to have the pricing power to allow their currencies to appreciate. These countries now produce relatively higher value-add goods and services compared to other Asian nations; therefore we believe they have the ability to pass on price pressures to the end consumer - Western consumers. With a concurrent focus on the development of their domestic economies, we believe Asian nations will eventually be less reliant on exports to the West, with a renewed focus on domestic demand, as well as demand within Asia, as a source of future growth. The result may be stronger Asian currencies over the medium to long-term, while western nations may experience increases in import prices going forward.
Regarding the U.S. dollar, we consider the more dovish FOMC voting member composition to be a negative for the currency, as it will likely lead to more expansionary policies relative to global central bank counterparts. In our view, the aforementioned debt ceiling debacle is just one increment in the ongoing marginal deterioration of the U.S.'s safe haven status; concurrent degradation to the long-term sustainability of the U.S.'s fiscal situation may ultimately erode confidence that the U.S. will honor its future obligations. Importantly, we do not doubt these obligations will be fulfilled, but the manner in which they are likely to be fulfilled gives us grave cause for concern. In our assessment, future obligations are unlikely to be met through much needed austerity measures, either from spending cuts or revenue increases, as neither side of the political aisle has shown a willingness to comprehensively and satisfactorily address the issues. Rather, future obligations are likely to be met through the path of least resistance: inflation. Said another way, devaluation of the currency.
We continue to believe the currency asset class may provide investors with the opportunity to access enhanced risk-adjusted returns and valuable diversification benefits. We are excited about the outlook for the asset class and believe many investment opportunities continue to exist in the space.
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