Making short-term predictions about the US dollar is notoriously difficult. So
why do we say the dollar may fall after Tuesday's mid-term elections in the
United States? Once we know what the future composition of Congress will be,
the markets can shift focus from the excitement of the moment to what may lie
ahead.
We believe we have just seen the beginning of a more pronounced slowdown that
will likely push us into recession. The reason we are more negative than many
economists is that high levels of
consumer debt make the economy much more interest-rate-sensitive than in past
economic cycles.
An area where this is particularly apparent is in the housing market, as
consumers in the US, a so-called ownership society, have massive levels of debt
accumulated in their homes. Given that only short-term interest rates have
risen, only the most speculative homeowners with adjustable rate mortgages
should have been affected.
But in a world where the speculators have driven up prices, the speculators are
also dragging the entire market down with them as the housing bubble deflates.
If and when long-term rates reflect that we may be heading into an inflationary
or stagflationary environment, the fallout for the housing market could be
severe, as higher long-term rates squeeze masses of homeowners who need to
refinance their mortgages in the months and years ahead.
For now, market commentators try to grab on to every bit of good news released.
The "best" news seems to come from corporations that are involved in the
option-backdating scandals: these companies do not report their balance sheets
while they investigate their wrongdoings. Wall Street loves them, as revenue is
the only reliable number released - and US executives have become experts at
generating top-line growth.
Indeed, in recent months, just about any piece of news has been interpreted as
good news by the markets. Even in a perfect world, it is time to get very
concerned about such exuberance. But the world is not perfect: when retail
stores have same-store sales increases behind the rate of inflation, when
hourly wages rise at a rate higher than economic growth, we have all the
hallmarks of stagflation.
Remember those who were touting to buy stocks at the top of the dot-com bubble?
Remember those who said there was nothing to fear from the housing market only
this year? These are the same pundits who called the top of the commodity boom
this summer. It turns out that while the US economy is slowing down, oil is
about 50% higher than two years ago, gold is again above US$600 an ounce, and
base metals hover once again near their highs.
Investors have been distracted from the big picture. And this is where the
election may play a pivotal role. None of the challenges have gone away, but we
now are faced with a US economy that may slide into recession. The best news
about the new composition in Congress is likely to be that it will get less
done, which means that politicians can spend less. But just as equity and bond
markets have priced in perfection, investors have also given more confidence to
the dollar than it may deserve. Then again, many investors are not aware of
just how much the dollar has weakened.
If you have managed to avoid the fall in the dollar, your purchasing power will
be much stronger now. This year, the dollar has resumed its downward trend that
was interrupted in 2005. As long as the US economy focuses on growth rather
than savings and investments, this trend may continue.
When we say the dollar may weaken after the election, we know as little as
anyone what will happen to the dollar in the days that follow the election. But
we believe that the focus will shift to what is ahead. Given that timing
currency moves is extremely difficult, investors may want to consider taking a
long-term approach by broadly diversifying into a basket of hard currencies,
that is, those currencies backed by sound monetary policy.
Axel Merk is the portfolio manager of the
Merk Hard Currency Fund, a no-load mutual fund that invests in a basket
of hard currencies from countries with strong monetary policies assembled to
protect against the depreciation of the US dollar relative to other currencies.
