July 25, 2005
In a move that was widely viewed as more symbolic than substantive, China finally took a first step at revaluing the yuan last week, changing its peg by 2.1%.
One feature of this "baby step" is far more important than investors seem to believe. In announcing that it will peg against a basket of currencies rather than only the U.S. dollar, China has just done what France did in the early 1970's, which was to abandon the "de facto dollar standard" of the time. Back then, the Bretton Woods system of managed exchange rates used the U.S. dollar as the center currency, and other countries held their foreign currency reserves in dollars. When, starting in the mid-1960's, the U.S. began accumulating huge budget deficits as a combined result of entitlement growth and military spending, U.S. dollars were effectively forced into the hands of our trading partners, who were by the logic of the system obliged to accumulate them in order to keep exchange rates fixed. This ability of the U.S. to flood the global monetary system with dollars was seen by other countries as an "inordinate privilege," and the subsequent abandonment of the Bretton Woods system ushered in the dollar crisis and inflation of the 1970's.
While many of us were taught in introductory economics that the 1970's inflation was due to "oil price shocks" and money growth, it's very hard to actually find this in the data. With all apologies to Milton Friedman, inflation is not a monetary phenomenon but a fiscal one - it occurs always and everywhere when fiscal authorities create government liabilities in excess of economic growth. One might argue that this is a semantic distinction, since it's naturally assumed that all governments are Banana Republics at heart, and ultimately finance their excess spending by printing money. But it underscores that it's fiscal policy, not its puppet - monetary policy - that determines inflation.
Indeed, inefficient government spending is inflationary regardless of whether it is financed by printing money, issuing bonds, or even raising taxes. Government bonds and currency compete at the margin, which means that the value of money is not independent of the quantity of bonds outstanding. Indeed, interest rates move in order to ensure that the entire quantity of each of these liabilities is held in equilibrium. Also, to the extent that taxes reduce the private savings that might otherwise be available for investment, taxes weaken the demand for government liabilities, which reduces their value. As a result, it turns out that government spending growth itself (over and above real productivity growth) has a higher correlation with inflation than money growth does.
What does this have to do with China ? Well, it's exactly the modern-day dollar standard with China that has allowed the U.S. to continue a maladjusted fiscal policy without consequence. Just as important, our huge reliance on foreign capital inflows has been the sole factor that has allowed U.S. gross domestic investment to grow in recent years. U.S. domestic savings have not increased materially since about 1996. I certainly don't believe that China's tiny move is about to change all of this overnight, so there's no particular reason why China's move should necessarily create enormous near-term movements in the U.S. dollar, bonds, or gross domestic investment. It's just that we've officially started the end game.
There's no such thing as a "baby step"
when you're standing at the edge
As a first step, a 2.1% exchange rate move is indeed very small, and is unlikely to have much effect at all over the very short-run. Since profit maximizing producers always operate on the elastic part of their demand curve (so that a rise in prices would be expected to reduce revenues), it follows that Chinese producers will most probably offset part of the higher yuan exchange rate by dropping their yuan prices. As a result, there will probably only be a partial "pass through" of the exchange rate change onto the prices we observe for Chinese goods as measured in U.S. dollars. So it's very true that from a price standpoint, the change isn't likely to have much effect.
Still, it's important to keep in mind that whatever outcomes we see in the real economy (the current account deficit, gross domestic investment, GDP growth) will probably not be the result of price changes (exchange rates, import prices) but the result of reduced capital availability (a smaller inflow of foreign savings). It's not the 2.1% revaluation that creates significant risk for the U.S. economy, but China 's diversification to a basket of currencies, and also the inevitability of additional much more significant revaluations in the not-too-distant future.
Crawling pegs, historically, are very hard to sustain without periods of major turmoil. This is especially true today given the profound depth of the U.S. current account deficit. A shift away from a pure dollar standard for China 's peg necessarily reduces the need to accumulate U.S. dollar reserves. A few unsound pieces of analysis popped up last week suggesting that China's move might actually increase demand for dollars (e.g. China's purchase of say, Japanese yen would presumably give Japan more money to purchase dollars), but it's ridiculous to believe that any such indirect effect would outweigh the direct effect that China just isn't going to be purchasing U.S. dollar assets as eagerly anymore.
In short, my impression is that there's a U.S. dollar crisis ahead. There's nothing to indicate that it's an immediate risk, and speculators will probably be very frustrated if they take positions that require particular short-term outcomes. But the potential for very disruptive adjustments should be taken into account by investors looking at the big picture.
Major dollar weakness will most probably be accompanied by a substantial softening in U.S. gross domestic investment (particularly housing investment) and downward pressure on real interest rates. While my bias is to expect at least some inflationary pressure, it's not a strong bias, and I don't have much of a view about nominal interest rates at all. To the extent that we get inflationary effects and slower demand for Treasuries from China, we might see upward pressure on nominal interest rates as well. But a substantial softening in the U.S. economy, particularly if default rates rise, would be accompanied by a decline in monetary velocity (see prior updates on this sort of effect) which would allow a further decline in both inflation and interest rates. Suffice it to say that I view inflation-protected securities as more defensive and potentially more effective than nominal bonds, regardless of which outcome we might observe.
As of last week, the Market Climate for stocks was characterized by unusually unfavorable valuations and relatively neutral market action. We're observing very good market breadth and leadership (in terms of advances vs. declines and new highs vs. new lows), but the major indices are also very overbought, and at present, even small deteriorations in breadth and leadership would imply measurable "momentum reversals."
For example, Investors Intelligence tracks what it calls "buying climaxes" and "selling climaxes." A buying climax is registered when a stock reaches a new 52-week high, but closes down for the week (technicians sometimes call these "key reversals"). Selling climaxes are the reverse. Large spikes in the number of buying or selling climaxes can often accompany extreme points in the market. Though my own view is that the interpretation of these is dependent on a large number of other factors including valuations, the general trend of interest rates, and so forth, buying climaxes have been picking up. In short, despite strong breadth and leadership, we've got such a momentum run here in the face of overvaluation, rising interest rates and excessive bullishness that any substantial reversal in this momentum would be a potentially important indication of exhaustion.
As usual, it's sufficient to observe valuations and the quality of market action as they are here, without placing too much emphasis on what might or might not happen to shift that evidence. For now, valuations are sufficiently elevated, combined with the overall quality of market action, to hold us to a defensive investment position in the Strategic Growth Fund. On a day-to-day basis, the "edges" of this position change depending on the opportunities that emerge, so for example, I've clipped off pieces of various holdings that have become overextended, while at the same time adding contingent call option positions to maintain a very mildly positive overall exposure to market fluctuations.
Needless to say, there is very little information to be derived from overly interpreting small day-to-day fluctuations in the Fund. The Fund can be up on a down day in the market, then down on a down day, or down on an up day then up on an up day. So much is dependent on the behavior of specific stocks on specific days that the bulk of this sort of movement can be interpreted as "noise." Meanwhile, since the Fund is not intended to track market fluctuations, there's no useful information in comparing the Fund's returns with the market if the period represents a trough-to-peak or peak-to-trough movement in the major indices. For most investment approaches, and certainly for the Strategic Growth Fund, you'll get the most meaningful evaluation of return and risk by measuring "peak-to-peak" across market cycles: from one market peak to another, including at least one substantial intervening decline, where the peaks are separated by at least a small number of years.
In bonds, the Market Climate last week was characterized by unfavorable valuations and also fairly neutral market action. The Strategic Total Return Fund continues to carry a duration of about 2.4 years, with about 20% of assets in precious metals shares accounting for most of the day-to-day fluctuations in the Fund. At present, that small duration sufficiently reflects the prevailing return/risk profile for longer-term bonds, so the bulk of the Fund's assets remain in shorter-duration Treasury inflation protected securities and Treasury bills, whose yields are increasingly competitive with longer term but more volatile bonds.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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