November 9, 2004

 

 

Investors are faced with a number of concerns these days, including slowing economic growth, uncertain corporate earnings, high oil prices and terrorism.  However, a less heavily discussed, but equally important, risk is the weakness of the U.S. dollar.  During the 1990s, the U.S. economy was the envy of the entire world, and the dollar appreciated almost continuously against other currencies.  However, over the past 3 years, as the U.S. economy suffered a recession and, at times, a less than spectacular recovery, the cracks in the dollar’s armor have begun to show.  Since it’s peak in 2001, the dollar has declined by 15% vs. a basket of foreign currencies.  What caused this reversal?  What are the near-term implications of a weaker dollar?  Most importantly, how is Westwood managing the risks associated with the dollar weakness?

First we look back.  The decade of the 1990’s can best be described as “American Utopia.”  The U.S. economy grew rapidly and stock prices advanced briskly.  This situation, coupled with weak economic growth in Europe and Japan, resulted in huge inflows of foreign capital into the U.S.  The end of the Cold War resulted in a peace dividend that set the foundation for a budget surplus in the U.S., while the importation of cheaper foreign goods kept inflation low.  Additionally, short-term interest rates were at a relatively high level, providing an attractive real rate of return on U.S. assets to foreign investors.   The U.S. was the economic growth engine of the world, and our sturdy currency and manageable trade deficit reflected this strength.

Today the situation is considerably different.  Although the U.S. economy has officially recovered from the recession of 2001, we are no longer the growth engine of the world.  Emerging economies such as China, India, and Turkey are growing much faster than the U.S. and have taken a significant share of the global trade market away from the U.S. and other developed economies.  The market share that the U.S. holds in foreign markets is the lowest it has been since the late 1970’s.  In addition, the Fed’s aggressive monetary easing of the past 2 years has resulted in historically low interest rates, which serve to reduce the attractiveness of U.S. assets to foreign investors.  At the same time, as the chart on the next page shows, the trade deficit has risen to record highs.  The U.S. consumers’ appetite for foreign goods has put an alarming amount of dollars into the hands of foreigners.  In fact, the U.S. now imports nearly twice as many goods as it exports and the difference is being financed through borrowing.  Another factor weighing on the dollar is the record U.S. budget deficit, which has been created by increased defense spending following 9/11 as well as the fiscal stimulus that was needed to help the economy rebound from the 2001 recession.  Given the factors listed above, it is not surprising that the dollar has declined in value relative to other currencies.

What are the potential implications of this dramatic shift in the strength of the dollar?  First, higher inflation will likely result as foreign goods become more expensive to U.S. consumers.  The other side of the coin is that U.S. goods gain a competitive price advantage in both domestic & foreign markets.  Second, to help stem further declines in the value of the dollar, the Fed will likely continue to raise short-term rates in an effort to increase the return on dollar-based assets to foreign investors and to slow the pace at which consumers are buying imported products.  Third, long-term interest rates will likely rise in anticipation of increased inflationary pressures and the higher level of borrowing required by the U.S. government.  And finally, the trade deficit will become a much bigger issue for U.S. policy makers, even as a weaker dollar and higher interest rates reduce the demand for imports.  One positive side effect of a weaker dollar is that the debt held by foreigners is being devalued along with the dollar, meaning that the U.S. may have the opportunity to pay back this debt with cheaper dollars than those in which it was originally borrowed.

At this point, the magnitude of the dollar decline is relatively mild.  Despite the fall that began a few years ago, the dollar remains much stronger relative to foreign currencies than it was at the beginning of the 1990’s.  The real problem is not necessarily a decline in the value of the dollar relative to foreign currencies but, that by running simultaneous large trade and fiscal deficits, the U.S. is more dependent on foreign capital than ever before.  As the events of the Asian contagion of the late 1990’s taught us, this situation has the potential to destabilize the economy.  The U.S.’s deteriorating competitive position in the global trade market reduces our ability to grow GDP as both U.S. and foreign consumers opt to purchase goods from China, India, et al, instead of from domestic manufacturers.  This phenomenon results in fewer U.S. exports and greater U.S. imports which has directly contributed to a record trade deficit.  When combined with the record budget deficit, Americans are now in the debt of foreigners like never before.  Given the current climate of geopolitical instability and the U.S.’s commitment to the War on Terror, it is not prudent to be in a financial position that could compromise our standing with the rest of the world. 

How do we correct this problem?  Many believe that another 15% decline in the value of the dollar would be sufficient to strengthen U.S. global competitiveness to the point where the trade gap could improve materially.  In addition, a revaluation of the Chinese currency, the Yuan, would also improve the ability of U.S. firms to compete globally.  Rising inflation in China, which we are now starting to see, will also reduce that country’s ability to flood the world market with cheap goods.  Also, higher U.S. interest rates will likely slow consumer consumption and reduce imports, thereby improving the trade gap further.  Continued strong U.S. economic growth would increase the return on dollar-based assets to foreign investors, which in turn would increase the demand for, and the value of, the dollar.

Why has the dollar’s decline over the past 3 years not resulted in improved U.S. competitiveness?  Namely because we now import a much larger percentage of goods from low cost producing, emerging economies like China and India as opposed to the high cost producing countries such as Japan and Canada.  This evolution of trade partners has also prevented the dollar’s slide from so far having a meaningful impact on domestic inflation.  Another contributing factor is that foreign central banks have been willing to recycle their holdings of dollars back into the U.S. treasury market, which has prevented an even greater decline in the dollar and kept interest rates artificially low.  Ultimately, the goal is to reduce our dependence on foreign capital, and to do so we must increase our ability to compete in the global marketplace.

At Westwood, we are not waiting for secular changes to correct the dollar’s weakness.  On the contrary, we are investing in some of the opportunities this dollar weakness has created.  Specifically, we are buying the stocks of companies that produce products sold to strong emerging economies such as China and India.  The infrastructure
build-out required in these countries will continue to benefit U.S. industrial firms as well as the producers of a variety of commodities including oil & gas, copper, and aluminum.  In addition, we are investing in multinational companies that will produce higher U.S. dollar-based revenues as a result of sales denominated in stronger foreign currencies.  Finally, we are investing in high quality companies that should be able to grow their earnings faster than expected in spite of rising interest rates and higher inflation. 

The U.S. is facing an unprecedented fiscal situation.  However, we have always demonstrated the resiliency and creativity necessary to overcome trying times and we believe America will once again prevail.  In the meantime, as investors it is important to recognize the risks and manage our investment portfolios accordingly.

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