By
Axel Merk
:
Looking beyond the fiscal cliff, we are afraid the greenback may
be at risk no matter who wins the election. We examine the risk to
the U.S. dollar in the context of the likely policies pursued under
either an Obama or Romney administration.
(click image to enlarge)
|
Some context:
The budget deficit as a percentage of Gross Domestic Product ((
GDP
)) in the U.S. is worse than that of some of the weak eurozone
countries (Portugal, Italy); the eurozone as a whole has a far
lower deficit. If the "fiscal cliff" were to take place -- that is,
if the tax hikes and government spending cuts were to take effect
as currently scheduled -- the U.S. would still face a deficit
exceeding 3% of GDP before factoring in any economic slowdown as a
result of the cliff. The fiscal cliff the U.S. is facing would
impose eurozone style austerity measures and -- just as in the
eurozone -- not eliminate the deficit.
Why does it matter?
Unlike the eurozone, the U.S. has a significant current account
deficit. The current account deficit is exactly the amount
foreigners must buy in U.S. dollar denominated assets to keep the
dollar from falling. As a result, the U.S. dollar may be vulnerable
should foreigners reduce their appetite for U.S. bonds. In
contrast, the fallout from the eurozone debt crisis has had a
limited effect on the euro because the eurozone as a whole does not
need inflows from abroad to keep the currency stable.
U.S. bond market at risk:
Foreigners don't need to sell U.S. bonds for there to be a risk to
the U.S. dollar: they simply need to include fewer Treasuries in
their purchases going forward. Should the decades-old bull market
in U.S. bonds turn into a bear market, foreigners might be inclined
to deploy fewer of their reserves into U.S. Treasuries. We see
three primary scenarios that could lead to a sell-off in the U.S
bond market:
- A return to normal times
- Strong economic growth
- A crisis of confidence in U.S. bonds
Normal times:
Why would "normal" times be a threat to the U.S. bond market? In
our analysis, one of the best bubble indicators is below-average
volatility in an asset or asset class. When tech stocks seemingly
went nowhere but up in the late 1990s, when housing prices
seemingly went nowhere but up last decade, when we had the
hallmarks of a "goldilocks" economy -- respective asset price
volatilities were below their historic norms. The 2008 crisis was
triggered by a return of risk to the markets: as investors had to
price in rising volatility -- for no apparent reason -- banks had
to de-lever to make their sophisticated value-at-risk models work.
Similarly, as investors more broadly pared down their risk, the
credit bubble burst. With regard to the bond market, we only need
to return to historic levels of volatility for there to be a
potentially rather rude awakening: we have had many yield chasers
going out ever further on the yield and credit curves (buying
longer-dated and less creditworthy securities) that might run for
the hills as volatility picks up in the bond market.
Strong economic growth:
Some argue that we can outgrow our challenges, but the looming
explosion of entitlement spending makes relying on growth
unfeasible. However, our concern is with the fallout higher growth
might have on the bond market. We got a glimpse of that earlier
this year as a couple of economic indicators came in better than
expected, leading to a sharp sell-off in the bond market. Good luck
to the Federal Reserve in containing fallout in the bond market if
indeed we get the sort of growth Fed Chairman Ben Bernanke is
advocating.
Crisis of confidence:
If there is one lesson to be taken from the eurozone debt crisis,
it is that
the only language policy makers appear to be listening to is
that of the bond market.
Policy makers decide between the political cost of acting versus
the political cost of not acting. As such, we are not very
optimistic that we will implement true entitlement reform unless
and until the bond market forces us to. As indicated, however,
should that happen, the risk to the U.S. dollar might be
significant.
Obama versus Romney:
A key difference promoted between Obama's and Romney's view of the
world is the level of government spending. But independent of our
political preferences, any level of government spending must be
financed through revenue and borrowing. And that's where we have a
problem:
Obama's slowing spending growth:
Listening to budget experts in support of Obama's policies, we hear
a lot about how spending growth has slowed since 2008. The problem
with that argument is that spending levels at the outset of
President Obama's administration were unsustainably high. Trillion
dollar deficits are simply not good enough, even if the rate of
growth of such deficits is low. When quizzed on the sustainability
of the deficit considering the risk to the bond market, we hear
that the U.S. dollar is a reserve currency and, as such, we have
plenty of time to get to a more sustainable path. We certainly
don't have a crystal ball, and we know that it may be all but
impossible to time if and when the U.S. bond market will tell the
government that enough is enough. Forecasting when the tech or
housing bubbles would burst was also extremely difficult, although
the warning signs were there for all to see. However, relying on
the bond market behaving is, in our view, bad policy. Any policy
maker who agrees that there's a potential risk should set policy to
mitigate that risk sooner rather than later. Conversely, any
investor who agrees that there's a risk to the bond market should
consider taking it into account in his or her portfolio allocation
now.
Romney's sustainable budget:
Supporters of a Romney presidency are quick to point out how a
Romney/Ryan budget leads to a sustainable budget over time. Indeed,
the most positive aspect of the proposal is that it puts a budget
on healthcare. Many are not aware that the current healthcare
system in the U.S. does not have a budget -- it simply lists
entitlements: not surprisingly, costs are exploding. One can argue
about how one goes about introducing a budget, but the fact that
Romney wants to introduce a healthcare budget is extremely
important for long-term fiscal sustainability. Because kid you not:
Medicare as we know it won't be around in 20 years -- it's
mathematically impossible -- there aren't enough rich folks out
there to tax to make it work. But the Romney/Ryan budget plan has a
key flaw: we believe it's most unlikely to be implemented (before
those opposing a Romney/Ryan budget breathe a sigh of relief,
please re-read the section on Obama's spending growth). Our
pessimism is based not on current polls favoring an Obama/Biden
administration, but on the likely stalemate in Congress. Good luck
getting a budget through Congress without it being watered down
rather severely. But even if Romney/Ryan principles were to
prevail, Romney has already made so many concessions, from
continued subsidization of student loans to preserving defense
spending, that a Romney/Ryan budget is at risk of looking very much
like the sort of budget we see anywhere in the world: one that
replaces the faces, cuts "wasteful" spending and replaces it with
"worthy" spending. Clearly, what is "wasteful" and "worthy" is in
the eye of the beholder. But don't worry, as in four years,
citizens have the opportunity to vote for change yet again.
Unfortunately, we might replace the faces, but the deficits may
remain.
Real wages haven't gone anywhere over the past decade. Voters
are frustrated. In such an environment, politicians able to distill
their messages into Tweets may have better chances of being
elected. That is, we believe more populist politicians may
increasingly become members of Congress. In that context, the rise
of the Tea Party on the right, as well as Occupy Wall Street on the
left, is no coincidence. As far as policies are concerned, however,
the implication may be that real entitlement reform -- key to
making our budgets sustainable -- remains elusive. In the U.S.,
just as in the eurozone, we may be tempted to "kick the can down
the road" until the bond market forces us to tackle our
problems.
Until then, we believe inflation is the path of least
resistance: the government nominally delivers on promises made, but
the real value of entitlements received is eroded. We just point to
the most recent debt ceiling discussion where both Democrats and
Republicans appeared open to changing the definition of the
Consumer Price Index ((
CPI
)) to do just that. Investors may want to consider these risks in
their portfolio allocation.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Disclaimer:
This report was prepared by Merk Investments LLC, and reflects the
current opinions of the authors. It is based upon sources and data
believed to be accurate and reliable. Opinions and forward looking
statements expressed are subject to change without notice. This
information does not constitute a solicitation or an offer to buy
or sell any investment security, nor provide investment advice.
See also
Google's Predictions For Holiday Shopping:
Retailers Investing More In Mobile, In-Store Tech
on seekingalpha.com