Wednesday, April 27, 2011

The Dollar's Slide: Terminal or Temporary?

We’ve had a number of clients write or call us lately concerned about the continuing weakness of the U.S. dollar. (It’s down about 10% since December against a basket of currencies.)  Here’s a representative example of their concerns:

“I feel the weak dollar (and growing weaker) is causing us problems and will cause greater problems if the world loses confidence in the US dollar as the world's monetary standard.  Oil is priced in $'s and the dollar's weakened position is costing US and world consumers.  When will the world say enough is enough and then what happens to the US economy?”

There is and old saying among economists that goes: “The solution to high prices is high prices.”  By this they mean that because of the law of supply and demand, higher prices tend to lead to lower demand.  Eventually, this lower demand will cause the sellers of the products to cut prices in order to regain the lost demand.  In this way, higher prices are self-correcting.

The dynamics of currency exchange rates are similar.  To a great extent, the problems tend to correct themselves over time.  As a quick primer, there are five major dynamics that have the most influence over the value of a country’s currency:

Interest Rates:  Holding everything else constant, higher interest rates for a given country relative to its trading partners would cause its currency to strengthen because the high rates would attract buyers.

Inflation:  Higher inflation in a country relative to its trading partners normally weakens its currency.

Balance of Trade: Shifts in a country’s balance of trade exert pressure on its currency.  Growing exports relative to imports strengthen its currency; weakening exports do just the opposite.

Budget Deficits:  Higher budget deficits as a percent of GDP weaken a country’s currency, while lower budget deficits strengthen its currency.

GDP: So long as a country’s inflation rate is muted, the higher the country’s GDP, the stronger will be its currency.

As with most aspects of investing, the expectations of how each of the above factors will behave in the future have as much impact on the value of the currency as their current levels.

This analysis, unfortunately, may produce as many questions as it answers, but such is the nature of discussing currencies.  Someone once said, “When it comes to currencies, everything affects everything.” Having said this, currency fluctuations are a daily concern for us because we own so many foreign based stocks.  Thus, based on our current holdings, we are keeping an eye on the Canadian dollar, the British pound, the Chinese yuan, the Swiss Franc, the Danish krone, and the euro.

Using the above five factors, let us offer a brief analysis of the most likely trend of the U.S. dollar over the next few years. 
  • Short-term interest rates in the U.S. are among the lowest in the world.   However, when the current round of quantitative easing (QE2) ends in June, those rates should rise, at least a little.  Further, the Fed is expected to begin raising the Federal Funds Rate (FFR) – now at 0.0% - 0.25% by year end.  So, both ending QE2 and raising the FFR should lift the US$.
  •  Core inflation in the U.S. is hovering around 1%, very low compared to our trading partners.  Thus, this is favorable for the dollar.  However, if inflation gets too high, the Fed will raise interest rates to fight it.  (Higher interest rates = stronger currency, part of that self-limiting mentioned above.)
  • A cheap dollar makes U.S.-manufactured goods more competitive overseas, helping to boost U.S. exports.  Higher exports improve our balance of trade and GDP and should give a lift to the dollar.  This is a prime example of the self-correcting qualities of a weak dollar.  Ironically, however, a weak dollar means that the cost of imports rise, especially oil.  This puts upward pressure on inflation.  Are you getting the picture of the concept of “everything affects everything?"
  • Budget deficits and high U.S. debt relative to GDP are the big killers right now for the value of the dollar.  Standard and Poors’ (S&P), in its recent change of outlook for US debt from stable to negative, said one of the reasons for the action was their belief that prospects for meaningful deficit reduction in the current political climate were low.  As you remember, the Dow Jones fell over 200 points for the day on that news, and S&P’s action jumped from the financial pages to the dinner table.  In doing so, S&P may have done us all a favor by turning up the heat on Washington to make progress on budget cutting.  S&P’s message was clear: clean up your financial house or face a downgrade of your bonds.  Downgrade or no, deficits will continue to play a role in the direction of the dollar.
  • The United States GDP is the largest in the world, so that helps.   But it is not growing as fast as GDP in the developing countries of China, India, Brazil and other Asian countries.  Indeed, U.S. GDP is growing more slowly than the global average right now, which has somewhat of a weakening influence on the dollar. 
So there you have it. Combining all these factors and comparing them with similar data from our major trading partner nations is producing a negative demand for the US dollar against most other major currencies.

We believe the two primary drivers of the weak dollar are the negative attitudes by some about QE2 and the size and growth rate of the US budget deficit.  As you know, we have been in favor of QE2 because we believe it has provided needed stimulus for the economy and consumer confidence.  We also believe the Federal Reserve has the will and the power to terminate it without disrupting the markets.  Our view has been validated by the rising stock prices over the last six months; unfortunately our optimism has not been shared by the currency traders.  With QE2 coming to an end, it would seem some pressure on the dollar should abate.  

The problem with the budget deficit is too big to solve in the near term.  Indeed, it is exacerbated by the political divide in Washington.  Yet, the problem is too big to ignore any longer.

As we have evaluated the issues surrounding the weakness in the U.S. dollar, in many cases, we believe they are self-limiting or self-correcting.  However, as we said earlier, the biggest problem facing the dollar is the lack of confidence in Washington’s willingness to make the tough decisions to limit the growth of the U.S. debt.  In light of this, pressure on the dollar may continue.

This discussion of the dollar is not simply an answer to a client question.  We deal with currency decisions everyday.  Four years ago we concluded that the dollar was likely to trend lower.  That was even before, the huge increase in government debt.  We redirected our portfolios to benefit from a falling dollar.  At present, more than 60% of the revenues of the companies we own comes from outside the US. Not only are our companies more competitive as a result of the lower dollar, but when their foreign profits are converted back into dollars, they are higher than if they had been produced in the U.S.  Additionally, nearly 20% of our portfolio companies are domiciled outside the US.  With these companies we are benefiting not only from their growing earnings and dividends, but also from the currency translations.  As an example, one of our biggest holdings is Nestle (NSRGY).  A few years ago Nestle’s stock price in Switzerland ended the year flat.  Taking into consideration the currency translations from the falling dollar versus the Swiss franc, NSRGY made a total return of nearly 11%.

Next time we’ll take a swing at the U.S. dollar’s declining importance as the reserve currency of choice.

Written by:  Randy Alsman and Greg Donaldson

Principals and Clients of Donaldson Capital Management own Nestle.