How to play the US dollar’s rise from the dead

The dollar is in long-term decline, and for well-known reasons. But it still has life in it yet, says David Stevenson.

If an investment-minded alien arrived from Mars to analyse the world’s monetary and financial system in the hunt for a safe place to put its money, there’s a good chance it would opt for the US dollar. The dollar is still the global reserve currency: large amounts are held by governments and institutions world-wide as part of their foreign-exchange reserves. Almost all the world’s major commodities are priced in dollars. How could such an essential component of the global economy be anything but rock solid?

Of course, as we Earthlings are only too aware, it’s been anything but. Against most other major currencies, the dollar has been in long-term decline. The Bank of England trade-weighted dollar index, which measures its value against the currencies of countries where the US does business, has plunged from 165 in early 1985 to 77 today, ie, more than halving in just over quarter of a century. Compared with gold, it has declined by 90% over the last ten years. Against the CRB/Reuters All Commodities index, it has lost three-quarters of its value in that time.

So why has the dollar been such a disaster for so long? After all, between 1980 and 1984 the buck doubled in value, with other countries happy to see their own currencies depreciate against it. While this was great for dollar investors, US manufacturers had a horrendous time. They just couldn’t compete on the world stage as their exports became hugely more expensive. The US trade deficit surged. Foreign-exchange (forex) traders worked themselves into a frenzy every time the latest figures were published.

As a result, an informal coalition of major American firms, ranging from grain exporters to car producers to high-tech businesses, came together. Its purpose was to lobby politicians to bring in ‘protectionist’ policies, such as tariffs and quotas, to curb imports and discourage foreign takeovers of domestic markets. But protectionism is bad for business. Other countries America was dealing with could have retaliated with similar measures. It might all have become very messy. The American authorities had to do something.

Eventually a compromise was agreed. The so-called Plaza Accord was signed in September 1985 at the eponymous hotel in New York between the finance ministers of Britain, France, Germany, Japan and the US. The aim was to lower the dollar’s value via concerted intervention in the forex markets – ie, those countries’ central banks would sell the US currency and buy their own.

So, problem solved? At first glance, it seemed so. The dollar fell by 51% between 1985 and 1987. That cheered up those US manufacturers, who could now sell their exports again. But for the dollar, it simply marked the beginning of a very slippery slope. Indeed, it was around then that both the American government and the nation’s consumers started to get addicted to borrowing big.

The chart below tells the story. The blue line is the dollar’s value. The red line shows the growth since 1970 in US federal, ie, central government, debt as a percentage of GDP. The black line is Americans’ household debt, again as a proportion of annual output. Sure, the country managed to drag back its state borrowings between 1996 and 2002. And that coincided with a 50% bounce in the buck between late-1995 and 2001. But this proved a relatively brief respite. Over the last decade, America’s indebtedness to the rest of the world has soared. US consumers, until recently, have been racking up their borrowings too.

Then there’s the other side of the coin. Rising debt has gone hand in hand with rapid rises in US monetary aggregates (the amount of money in circulation). The Fed stopped publishing numbers for US M3 – broad money supply – in 2006. But its annual growth was more than 8% between 2000 and 2009, says Capital Economics, who have calculated that bank lending grew by 7% a year while global dollar liquidity grew almost 10% a year during that time. In short, lots more dollars have been supplied to the market, which has been bad for the buck.

Yet a currency’s value is set by both supply and demand. Shouldn’t that reserve currency status have shored up the dollar’s value? You might think that. But no one likes hanging on to a currency that’s shedding value, not even a central banker. Global reserves held in dollars have been steadily declining. The black line on the chart below shows the decline in the US currency’s trade-weighted value. The red line shows the proportion of global forex reserves constituted by dollars. As you can see, they’ve been closely matched.

Of late, things have got even worse for the dollar. The Great Recession of 2008-2009 began with a surge in mortgage defaults, which contaminated bank balance sheets so badly that lending completely dried up. Major players went bust, with Lehman Brothers the biggest headline grabber. To begin with, the buck got a boost. It was seen as a safe haven while other assets cratered. But then the Fed slashed US interest rates almost to zero. That made the dollar an unappealing currency to hold as depositors’ returns dried up. Indeed, many investors ‘short sold’ it in the so-called ‘carry trade’, ie, they borrowed it and used the proceeds to buy other currencies and assets.

The Fed also decided to dig the country’s financial system out of the hole it was in by supplying the market with yet more dollars through several targeted schemes, which culminated in QE: quantitative easing. This is where central banks buy bonds from investors and lenders using computer-created cash to inject extra money into the banking system. Through two batches of QE (QE1 and QE2), the Fed grew its balance sheet – the monetary base – from about $900bn pre-crisis to some $2.5trn now. The Fed’s actions raised fears that this money would seep out from bank vaults into the wider economy, adding extra supply that would damage the dollar further.

By now our Martian observer would have reached a simple conclusion: in order to boost US exports and GDP growth, Fed chairman Ben Bernanke had clearly chosen to trash the dollar. And with the US recovery looking wobbly, there are ongoing rumbles about possible QE3, which would mean yet more potential supply of greenbacks. So against such headwinds, why might even the most contrarian investor expect a dollar rally?

 

Here’s why. It’s impossible to forecast whether or not the Fed will introduce a version of QE3. But right now, the odds are against an immediate renewal. “The Fed’s ability to ease monetary policy further is severely limited,” says Comstock Partners. “A further increase would be much harder to undo. And any significant balance-sheet increase could also run into heavy opposition from elements of Congress that want to restrict or even eliminate the Fed”, which is “certainly subject to outside political pressures”. That’s another way of saying that, if the Fed is keen to look after its own interests, it’s likely to sit on its hands for now.

Meanwhile, despite all the QE so far, the ‘money multiplier’ – which converts base money into broad money via bank loans – isn’t working like it used too. What does this mean? US M3 has been decreasing for much of 2011, notes Capital Economics. May saw a 3.9% year-on-year increase, but that could be the near–term peak. Meanwhile, bank loans have been shrinking for months as “banks hoard cash and securities”, says David Schawel of Economic Musings. “Despite a banking system flush with liquidity, it’s not turning over.” So although global dollar liquidity is still expanding strongly, its growth rate is slowing. This all adds up to a slower supply of dollars, which would help the currency’s value.

Also, some of the reasons for implementing QE have gone. For example, with China showing signs of allowing its currency to appreciate against the dollar, and still fearful of inflation – it raised interest rates again, just this week – the ‘currency war’ between the US and China may have been won. That may mean the Fed has less incentive to pursue an unofficial ‘weak dollar’ policy.

There’s been a very clear risk with QE, too. Remember those raw materials priced in dollars? “QE2 has produced some undesirable side effects, such as soaring commodity prices,” points out Comstock Partners. “QE3 could easily exacerbate these trends, more than offsetting whatever beneficial effects it might produce.” In other words, America already has a growing inflation problem, which many people blame on QE.

So Bernanke can no longer blame fear of deflation as a rationale for rushing to print more money. Nor will rising inflation help with the popular perception that the Fed has bailed out Wall Street at the expense of the ordinary American consumer.

And that’s not all. The headline consumer price inflation (CPI) hit a 3.6% annualrate, a two-year high, in May. Producer price inflation is running at 7.2% year-on-year. Yet US ten-year Treasury bonds yield just over 3%. “At some point that [return] will become impossibly unattractive,” says Martin Hutchinson on Moneymorning.com. In other words, Treasury yields may soon be forced much higher to lure new investors. But when that happens, the dollar would be the first port of call – because those investors would need to buy it first.

 

The catalyst for this bond yield rise could turn out to be the current spat among US politicians about the ‘debt ceiling’ – America’s self-imposed limit on how much its government can borrow. If a deal can’t be hammered out, technically the US would have to default on its debts, as it wouldn’t be able to pay them. Despite the posturing, the chances are a compromise will be agreed, if only to kick the can down the road until it becomes someone else’s problem. But the US is still likely to have to pay more for its money, funded by extra dollar buying.

At first glance neither outcome may seem appealing for the dollar in the very near-term. But this doesn’t factor in the market’s current view of the dollar. In a nutshell, everyone hates it. This means that any immediate bad news – including America’s ongoing chunky trade deficit – is almost certainly ‘in the price’. This is typified by that ‘carry trade’ I mentioned earlier, where investors have been selling dollars to invest in assets elsewhere. That antipathy to the dollar could be the trigger to turn the currency’s fortunes around.

“Because everyone is so bearish on it – including me – I decided to go ‘long’ the dollar,” contrarian investor Jim Rogers tells Oliver Ludwig at IndexUniverse.com. “What I’ve found over the years is that when everybody is on one side of the boat, you should go to the other side, at least for a while. So I have.” Rogers, a keen precious metals investor, has no illusions about the dollar’s prospects over the horizon. “Longer-term,” he says, “the dollar is a disaster. The US is the largest debtor nation in the world’s history. No country has resolved this sort of challenge without a semi-crisis or crisis.”

That’s a story for another day. Today we’re focusing on what a dollar bounce would mean for investors. Below we look at some of the best stocks to benefit.

The four stocks to buy now

So how do you profit from a rallying dollar? Companies with a large proportion of their sales in America’s currency, either through exports to the US, or because their revenues are generated in dollars via manufacturing operations in the US, will get the biggest fillip. When converted back into local currencies, their profits will automatically be boosted. The best place to look is right here in Britain. Across the board, FTSE 100 companies generate more than 50% of their profits either in the dollar or in currencies pegged to it — such as China’s yuan or Saudi Arabia’s riyal.

However, against the backdrop of a global economy that’s still sluggish, you have to be picky. Slowdowns are looming in several emerging economies. Cyclical companies whose sales are very dependent on these will see their earnings hit. For several months, we’ve advised buying defensive stocks that don’t need economic growth to make their money. We’re also keen on out-of-favour high yielders whose dividends are rising faster than inflation. And we like ‘value’ stocks whose strong fundamentals aren’t fully reflected in their share prices. Major dollar earners in these sectors would be even more appealing if there’s a big bounce in the dollar. Yet despite the rise in the overall market, investors have largely continued to overlook a number of such shares, creating a good buying opportunity.

Top of the list is one of our old favourites. National Grid (LSE: NG) owns the high voltage electricity transmission network in England and Wales and operates the system across Great Britain. It also owns and operates Britain’s high-pressure gas transmission system. But more than 60% of its revenues come from its operations in the US, where it distributes electricity to about 3.3 million houses and businesses in the northeast, and where it’s also the largest distributor of natural gas. At the moment, those US units contribute just 38% of National Grid’s operating income. A healthy dollar bounce would give this a significant boost in sterling terms. Despite rallying this year, National Grid has undershot the FTSE 100 index by almost 30% since the market lows of March 2009. It still looks good value on a current year p/e of 12. Meanwhile, following last year’s inflation-busting 8% hike, the prospective yield is a tasty 6.6%.

Pharma giant GlaxoSmithKline (LSE: GSK) gets more than a third of its revenues and more than 40% of its operating income from the US. Its shares have lagged the market by at least 20% since that market low. That’s due to concerns about slowing sales in 2011 as some major drugs have gone ‘off-patent’. But management believes turnover growth will be back on track from next year as sales kick in from new product launches. “GSK also continues to make efforts to position its business on a decent footing, which was clearly evident from the company’s recent cost-cutting initiatives,” says First Global’s pharma team. On a sub-12 current year p/e and 5% prospective yield, this is another good value stock set to benefit from a stronger dollar.

And for the even more contrarian-minded, it’s also tempting to look at another set of stocks. These companies have under-performed massively because they’re seen as being vulnerable to cutbacks in state spending, but they also have enormous dollar exposure, which could make up for it.

Take aerospace engineering specialist Cobham (LSE: COB), which has lagged the FTSE 100 by a third since March 2009. This company generates 60% of its sales in America. The 3% yield certainly isn’t too much to write home about. But on a current year p/e of just ten, the dividend is three times covered, which means Cobham looks cheap.

Then there’s major defence contractor BAE Systems (LSE: BAE), the Pentagon’s fifth-largest military supplier. BAE has underperformed the FTSE 100 by 45% since March 2009. But it gets almost half its turnover from the US. On a 7.7 p/e and near-6% prospective yield, this stock is even cheaper than Cobham. A dollar bounce would be very good news for BAE.

Category: Economics