U.S. Investors Overexposed to U.S. Dollar Risk?
By Axel Merk
June 16, 2011
This white paper analyzes the extent to which U.S. investors, on aggregate, are inherently exposed to the currency risk of the U.S. dollar via their financial asset holdings. We first outline recent trends in the value of the U.S. dollar, showing that the currency has experienced significant deterioration in value, and highlight developments that may continue to underpin ongoing weakness in the currency. Next, we describe why a weak currency matters to investors and consumers alike, as it may cause deterioration in purchasing power and lower relative living standards. We then research the aggregate financial holdings owned by the U.S. private sector, as reported by the Federal Reserve Statistics Department. We find that on aggregate, nearly 90% of the U.S. personal sector’s financial assets leave investors susceptible to U.S. dollar risks.
U.S. Dollar Decline
The U.S. dollar has experienced significant weakness over recent years. We believe there are many factors that have contributed to this weakness, and in our opinion many of these factors have yet to fully play out, meaning there is a risk the U.S. dollar experiences ongoing deterioration for an extended period of time. U.S. investors may want to take this possibility into consideration when assessing the U.S. dollar risk inherent in their investment portfolios. As will be outlined in more detail within this report, our analysis into the aggregate financial asset holdings of the U.S. personal sector finds that the vast majority of investor’s financial assets are denominated in U.S. dollars and as a result, significant U.S. dollar risk exposure is evident. For the one-year period ended April 2011, the U.S. dollar declined 10.91%, declined 7.71% year to date, and declined 13.81% over the previous 2 years.
These performance numbers are based on the U.S. Dollar Index, a trade-weighted basket of currencies that was established in the 1970’s. If we look at international currency performance relative to the dollar, an even clearer picture emerges:
We consider there to be a plethora of reasons why the U.S. dollar has experienced such price weakness recently – from the current account deficit, to the easy money approach taken by the Federal Reserve (Fed), to the relative deterioration of the U.S. fiscal situation, in comparison to international counterparts. In our opinion, the present divergence in international monetary policies are implicitly weakening the U.S. dollar and causing inflationary pressures to mount. While many international central banks are tightening – the most notable recent development being the European Central Bank’s decision to raise interest rates – the U.S. Federal Reserve (Fed) continues to ease via it’s quantitative easing policies (QE2). Consider the following: when the Fed purchases U.S. Treasuries, it may be artificially overvaluing those same instruments by driving down yields. As a result, rational investors are evermore incentivized to look abroad for less manipulated, higher rates of return, and sell the dollar. Combine this with the supply-side dynamics, where the Fed has continued to expand its balance sheet (the change in a central bank’s balance sheet can be thought of as a proxy for the amount of additional money that has been printed) – basic economic theory tells us that, all else equal, an increase in supply of an asset is likely to result in a decline in the value of that asset. Unfortunately, in this case the asset in question is the U.S. dollar.
Why should U.S. investors be concerned about a decline in the U.S. dollar?
One reason is that internationally, living standards of U.S. consumers are deteriorating relative to the rest of the world; one dollar bought more international goods two years ago compared with today. Contrast that with a country like Australia, which has experienced significant currency strength. One Australian dollar buys more international goods today than it did two years ago. For the U.S., this weak dollar dynamic is compounded if international goods are inflating in value. More concretely, let us illustrate a tangible example of how these trends work in practice:
Both the U.S. and Australia import goods from China. Through March 31, 2011, prices of Chinese goods rose at an average annualized rate of 6.6% over the preceding two years. If we assume this inflation level was indicative of the price increase of Chinese exported goods, as priced in Chinese renminbi, a widget costing 100 renminbi two years ago would now cost 113.63 renminbi.
While $100 U.S. dollars would have bought 6.8 Chinese-made widgets two years ago, $100 now only buys 5.8 widgets; in U.S. dollars, the price of Chinese-made widgets increased 18.6%. Conversely, $100 Australian dollars would have bought 4.7 widgets two years ago, but now buys 6.0 widgets; in Australian dollars, the price of Chinese-made widgets declined 20.6%. The Australian dollar has greater purchasing power, while the U.S. dollar has lost purchasing power.
The above example highlights one of our key concerns surrounding the ongoing weakness in the U.S. dollar: weakness in a currency often manifests itself in a loss of purchasing power, or inflation. Consumers are already experiencing the effects of inflation through rising gas prices at the pump and food prices at supermarkets and restaurants throughout the country. Moreover, we appear to be entering a period of increased global inflation: the price of many inputs that go into manufactured products abroad has been increasing at an accelerated rate, as have food prices, which puts upward pressure on labor costs in emerging markets (where food makes up a significant proportion of income expenditure). Indeed, we have recently witnessed double-digit percentage increases in labor costs throughout many emerging markets, such as China. These input price increases may likely flow into the final price that U.S. importers pay, and ultimately the U.S. consumer. Industry executives have been sending ominous signs. Li & Fung, an established sourcing and logistics company operating out of Hong Kong, recently warned that a new era of higher priced exports had begun, as manufacturers pass on the rising costs of raw materials and labor. Walmart is a notable client of Li & Fung.
To an extent, we have already witnessed these dynamics play out. In the spring of 2008, as oil and commodity prices were soaring, import prices began to rise. Many goods increased in price, the most mundane items suddenly increased in price. For example, we heard stories such as the price for coat hangers increasing by over 200%. Asian manufacturers could no longer afford to absorb the increased cost of raw materials and were passing them on to U.S. importers. Of course, when the financial crisis struck later that year, inflationary concerns dissipated substantially due to the economic fallout.
Conversely, a strong currency not only helps to increase the relative living standards of a nation, but also helps to contain inflationary pressures. Extending our U.S./Australian example above, Australia’s central bank (the Reserve Bank of Australia, or RBA) has been a vocal proponent of a free floating currency, believing the recent strength in the Australian dollar has helped to contain inflationary pressures in the face of global increases in prices, and helps mitigate boom-bust economic cycles. The RBA points to the current increased demand for resources and corresponding currency strength as support for the latter hypothesis: when the Australian dollar appreciates, it naturally increases the price of exported resources, in turn helping to smooth and contain international demand (Australia is an extremely resource-rich nation).
From an investor’s standpoint, investing in strong currencies, whose value is underpinned by solid fundamentals, may help mitigate against a decline in purchasing power brought about by a weakening U.S. dollar.
There are numerous examples of the debilitating economic effects of a decline in purchasing power evident today – from small business owner’s rising input costs (and inability to pass these costs on), to households’ inability to keep pace with the rising cost of food and gas prices. With many salaries stagnant due to the large labor slack brought about by high unemployment, and housing prices remaining depressed, many are caught in the middle, having either to dip into savings or cut spending drastically, as the purchasing power of the dollar is eroded. Indeed, even the price of pulp used to produce paper has increased by over 50% in the previous two years; quite literally, the U.S. dollar may not be worth the paper it is being printed on. Concerns surrounding inflation and deterioration in purchasing power appear to be at the forefront of investor’s minds. In March 2011, Merk Investments conducted a survey of members of the American Association of Individual Investors. Nearly 70% of respondents listed “inflation and purchasing power” as a key investment portfolio concern, second only to current portfolio positioning:
Measures of implied inflation expectations have been rising recently, possibly in large part due to the significant increase in the price of oil. By analyzing the difference between various maturity Treasury securities and equivalent maturity Treasury Inflation Protected Securities (TIPS), we can assess the market’s implied expectations for inflation over a variety of different timeframes. Amongst the measures of implied inflation expectations that we track are: five year inflation expectations two years from today, and nine year inflation expectations one year from today. As the following chart illustrates, both these measures of implied inflation expectations have been trending upwards since August 2010:
How Exposed are U.S. Investors to the U.S. Dollar?
With the risk of a further deterioration in the purchasing power of the U.S. dollar, how exposed are U.S. investors? To answer this question, we analyzed data compiled by the Federal Reserve Statistics department, specifically the data found in Z.1 Release: Flow of Funds Accounts of the United States. This statistical release provides an aggregated balance of financial assets across various sectors of the U.S. economy, therefore providing a snapshot at various points in time of the allocation across asset classes for each sector. Specifically, we analyzed the breakdown across asset classes for the personal sector.
The financial assets of the personal sector, as defined in the Z.1 Release, include nonfarm non-corporate business assets and farm business assets; we subtract these assets from our analysis. We assume that the resulting asset breakdown can be used as a proxy for the aggregate U.S. household’s financial allocation. Next, we stripped out checkable deposits and currency from the data – assuming that this value is transitory in nature (i.e. it is used for day-to-day expenses and is replenished on an ongoing basis via personal income) and therefore not considered a core investment holding. Also excluded from the analysis were miscellaneous and other assets, which are largely made up of insurance-related items and unidentified assets, and private life-insurance reserves. We analyzed the data over a five-year time period through the end of 2010. The average aggregate asset allocations are depicted in the chart below.
We depict household real estate net of mortgage debt. Gross household real estate actually makes up the largest portion of the U.S. personal sector’s assets, and therefore trends in house prices can have a large bearing on the aggregate net worth of the private sector. As the following chart outlines, the net household real estate allocation has declined significantly over the five-year timeframe, from a 26.0% allocation to 14.2%, largely reflecting the decline and ongoing stagnation in property prices. (As an aside, but very much related, it is unsurprising that the Fed may have wanted to instigate property price inflation via the purchase of mortgage-backed securities in 2008 and 2009.)
In terms of absolute value, we can see that total assets declined through 2008, predominantly led by a decline in housing and equity prices:
Excluding housing, and focusing on the more intangible financial assets recorded in Release Z.1 may be representative of the assets typically referred to and associated with savings and investment underlying retirement and future obligations. These allocations may be indicative of those investors typically associate with personal investment retirement portfolios.
(Please see Appendix 1 for a detailed analysis of the underlying allocations depicted in the charts above.) For the purposes of this analysis, we include net household real estate in the following calculations, as, in our view it should be considered a key component of any personal investment portfolio. Our analysis finds that approximately 91.9% of aggregate assets are denominated in U.S. dollars. The analysis also finds that approximately 10.7% of aggregate personal sector assets provide exposure to international currencies (including international currency exposure via U.S. dollar denominated assets). In essence, nearly 90% of the aggregate U.S. personal sector’s assets leave investors susceptible to U.S. dollar risk.
International Currency Exposure
To calculate the estimated international currency exposure, we first sum all assets denominated in foreign currencies: international cash, international equities, and international fixed income. We estimate this represents 8.1% of aggregate private sector assets; 91.9% of aggregate private sector assets are denominated in U.S. dollars. It’s important to note, however, that many of these international investments may themselves be hedged to the U.S. dollar; therefore, the real aggregate foreign currency exposure may actually be much lower than 8.1%.
Next, we assessed the international currency exposure derived from owning U.S. corporate equities. The underlying theory is that by investing in a U.S. corporation that has significant international operating earnings, an investor is essentially creating a de-facto exposure to the currencies where those international operations are located; should the U.S. dollar fall vs. those currencies, the international business earnings will be enhanced when translated into U.S. dollars, which will in turn be reflected in higher earnings growth, driving the price of the stock up. However, this de-facto currency exposure may be limited depending upon the extent to which the business employs economic hedging to it’s foreign currency exposures, which we illuminate below.
During the time period 2006 through 2009, S&P estimates that U.S. corporate businesses included in the S&P 500 index derived approximately 46.0% of revenues from abroad. We assume that the S&P 500 index is indicative of the aggregate U.S. corporate equity exposure found in Release Z.1, and that the cost and margin structures of international operations are similar to that of domestic business models. Hence, we assume U.S. corporate earnings are comprised approximately 46.0% from international operations and 54.0% from U.S. operations.
However, because U.S. corporations actively employ economic hedging policies on international operations, it is only the net un-hedged positions that generate currency exposure for investors. How are economic hedges employed? Most U.S. corporations utilize the U.S. dollar as their functional currency, and actively hedge income statement exposures to that functional currency, effectively nullifying any impact of currency price movements versus the U.S. dollar. Indeed, in our opinion, the presence of corporate hedging departments within the currency market creates inherent inefficiencies and potential profit opportunities. Feedback from a survey of FX departments of various large multi-national banks suggested that listed U.S. corporations hedge approximately 80% of their international income statement exposures back to U.S. dollars. This feedback is in-line with a study conducted by Citigroup, which found that approximately 80% of corporate America’s income statements are hedged to U.S. dollars. The larger the business, the more active the corporate hedging tends to be. Indeed, listed U.S. companies tend to employ economic hedging policies more prevalently; as a result of investor interest, these companies often provide earnings guidance; economic hedging allows management to better estimate future earnings and provide the market with earnings forecasts.
While approximately 46.0% of U.S. corporate earnings may be derived from abroad, the un-hedged portion that provides investors with international currency exposure actually only amounts to approximately 8.9% of total U.S. equity exposure. This equates to approximately 2.1% of the U.S. personal sector’s aggregated asset allocation.
We also include our estimate for U.S. investor’s allocations to currency investments, predominantly through currency mutual funds and exchange-traded vehicles. Release Z.1 does not break assets down to this level of detail, so our assessments rely on the relative market size of these vehicles. Using the relative market size of all listed currency vehicles as an estimate for U.S. investors aggregate direct currency vehicle investments, we find that currency exposure via mutual funds and exchange traded vehicles represents a very small fraction of the U.S. personal sector’s aggregated asset allocation. Indeed, approximately 0.04% of the total U.S. equity market, and 0.01% of aggregate personal sector allocation.
Summing the above estimated currency exposures, we find that the total international currency exposure for the aggregate U.S. personal sector is approximately 10.7%; 89.3% of the U.S. personal sector’s assets are directly linked to the risk of the U.S. dollar declining.
Of course, this is an estimate of the aggregate currency allocation for the private sector population as a whole, and individual asset allocations may differ significantly from the above analysis, depending upon individual risk profiles, outlook and market sentiment. Certain types of investors may have quite substantially different allocations. For instance, the American Association of Individual Investors (AAII), whose members tend to be active individual investors, estimates that historical portfolio allocations for AAII members has been approximately 60% stocks, 15% bonds and 25% cash.
Additionally, and as alluded to earlier, many investors may exclude the value of their homes from estimates of portfolio allocation, which would be the case in these AAII findings (unless all AAII members prefer to rent). Moreover, the data underlying the above analysis is a snapshot taken at certain points in time; portfolio allocation changes may occur on a periodic or frequent basis, and are an ongoing, dynamic process. However, it does highlight that in a world of increasing globalization, U.S. investor allocations appear overly exposed to the U.S. dollar and U.S. dollar denominated assets. U.S. investors may want to consider taking a more managed approach to their currency exposures, in light of the above analysis, and reduce the large apparent U.S. dollar risk present, especially if they believe there is a significant risk that the U.S. dollar will weaken and lose purchasing power going forward.
In the current environment, adding portfolio protection against a decline in the U.S. dollar may be of the utmost importance. There is a significant risk that the U.S. dollar continues to weaken, causing deterioration in purchasing power. Inflation expectations have risen recently, and protection against inflation and purchasing power has been shown to be a key investment concern. At the same time, our analysis demonstrates that U.S. investors appear to be, on aggregate, overly exposed to the U.S. dollar. Now may be the time to consider diversifying away from U.S. dollar denominated assets, or managing the U.S. dollar risk inherent in investor’s portfolios.
(c) Merk Funds