 Follow the Money...
out of the U.S. dollar?
Kieran Osborne
May 12, 2009
Recently, stock markets appear
to have experienced an almost euphoric phase, seemingly shrugging
off most negative news flow day after day. Whether or not you
believe in the so-called "green shoots" of economic
recovery, a significant economic rebound, or a continued decline
in economic activity, one thing seems abundantly clear: investors
have been becoming less risk averse. The most commonly followed
"fear indicator", the VIX index, has retracted (likewise,
other commonly followed indicators such as the TED
spread has tightened and OIS
spreads have reverted to levels not seen since the Lehman
Brothers collapse), three month T-bill yields have recently risen
and equity markets around the world have rebounded from March
lows.
Let's not get ahead of ourselves
just yet though. We consider the impetus for the recent stock
market rally has been news flow and data pointing to economic
stabilization in the U.S., not an economic rebound. Negative
news flow and data still seems to predominate, though it appears
to be dissipating. As such, we may well be nearing an economic
trough, as the rate of decline of economic growth (also referred
to as the second derivative of economic growth), appears to be
slowing. That said, positive news flow continues to be conspicuous
in its absence. Hence, we would caution against misinterpreting
current data as a precursor to a looming economic recovery. Indeed,
significant economic overhang and headwinds remain, while an
economic stabilization, in and of itself, does not portend an
imminent economic rebound.
In our opinion, it is unlikely
that economic growth will exhibit a "hockey stick"
rebound because so many issues must still be worked through,
many of which may curtail economic growth for an extended period
of time. For instance, numerous mortgage holders who bought homes
around the peak of the housing bubble are yet to refinance their
loans, the unemployment rate continues to climb, and de-leveraging
is likely to continue at both the corporate and personal levels.
All of which will constrain consumer spending, the main driving
force behind economic growth. Moreover, the ambiguousness of
the present administration's intentions and policies creates
a heightened level of investment uncertainty, while the inflationary
implications of present Federal Reserve interventions is increasingly
worrying (please see our previous newsletter entitled:
(Un)Intended
Consequences: Uncertainty, Inflation & Inflexibility.
Nonetheless, we may be entering
a phase of lower market volatility and a reversal of risk aversion
trades. With the onset of the financial crisis, many investors
pulled their money out of investment positions in international
markets and into the U.S. dollar in a perceived "flight
to safety". We consider this phenomenon transient in nature
- most of these funds did not flow to "sticky" long-term
asset classes (in light of the capitulation in U.S. stock markets,
it certainly doesn't appear much ended up in equities). Just
witness the yield squeeze exhibited by short-term U.S. T-bills
during the crisis. Thus much of this money may be set for imminent
redeployment. We believe a reversal of these positions bodes
well for many international currencies.
In our opinion, investor risk
appetite will remain at an elevated level relative to those seen
at the height of the crisis, in part due to a misinterpretation
of current data as "green shoots" of economic recovery
(a more apt analogy might be of spring sun counteracting the
growing size of an out of control snowball racing towards a village),
but also due to the generally held view that the worst is behind
us. Indeed, the market recently shrugged off the very real prospect
of a global pandemic in the swine flu. While we continue to see
challenges ahead, we nevertheless consider present dynamics augur
well for many currencies outside of the U.S. dollar. In light
of present expectations, we consider investors are increasingly
likely to redeploy funds internationally, reversing their "flight
to safety" trades. We believe certain countries may be better
placed than others, particularly China, which can actually afford
its stimulus, and whose growth outlook, in our opinion, appears
more favorable. Much of Asia may benefit too, while those countries
that benefit from a rise in commodity prices, such as Australia,
Norway, New Zealand, and to a lesser extent Canada (we consider
its close proximity and inter-dependence with the U.S. economy
as a drawback) are also likely to benefit from increased investment
flows.
Additionally, we consider gold
will be a net beneficiary of current policies and market interventions.
As previously noted, we believe present initiatives are creating
significant latent inflationary pressures. This inflationary
overhang appears to have already spooked the market: the spread
between long-term TIPS
and equivalent maturity Treasury bonds has widened, and the price
of gold has appreciated. We consider that the evolution and transpiration
of economic ramifications, brought about by present initiatives,
will act as a catalyst in underpinning the strength in the price
of gold going forward.
The flip side of all this begs
the question - if investors increasingly move towards riskier
assets, and away from government issues, who will be left (or,
more to the point, willing) to purchase the government bonds
required to fund the administration's unprecedented level of
spending? Especially given the low yields on these securities,
a factor compounded by the Fed's intervention in the market.
Indeed, the Fed may have to ramp up purchases of these securities
if others abstain, monetizing government debt, and driving the
price of these assets further from "fair" market value,
compounding inflationary pressures in the process.
In light of these dynamics,
investors may want to consider whether a basket of hard or Asian
currencies would be a beneficial addition to their portfolios.
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. To learn more about the Funds,
or to subscribe
to our free newsletter, please visit www.merkfund.com.
May 12, 2009
Kieran Osborne
Contact
Merk
©2005-2009 Merk Investments LLC.
All Rights Reserved.
Kieran Osborne is Senior Analyst and
member of the portfolio management group at Merk Investments;
he is an expert on macro trends and currencies and has significant
international market experience. Prior to Merk Investments, Mr.
Osborne was an equity analyst at Brook Asset Management, where
he worked in both the Australian and New Zealand markets. He has
also worked in New York for MCM Associates, a U.S. hedge fund.
321gold Ltd
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