Currency Wars — January 2015

January 27, 2015

Dow Jones Average: 17,387
S&P 500 Index: 2,030


Currency Wars


Seismic shifts, with far reaching implications, have taken place in the currency markets during the
past six months. In a globalized economy, exchange rates affect every corporation, citizen, or
institution that imports or exports products, engages in travel, holds assets in foreign countries, or
borrows and lends internationally. There are advantages and disadvantages to both weak and strong
currencies. The health of export industries, domestic inflation rates, access to international capital,
and the relative wealth of a nation’s citizens are all impacted by currency exchange rates. With so
much at stake, it is no wonder that all countries try to manage the exchange rate of their currency.
The typical currency control and manipulation that most countries engage in can be viewed in a
hostile light, particularly when the fallout from sudden changes in exchange rates can be business
failures, job losses, or even food deprivation.

With economic growth currently stalled in much of the world, most countries want to weaken
their currency to boost their export industries. The problem is that currency values are relative;
if some countries weaken their currency values, other countries must experience a commensurate
increase. Currency wars can break out, as countries try to undercut each other with respect to
exchange rates. One risk is that countries, which lower their currency too much, may trigger
an inflation spiral that angers their population. It can be a tough balancing act for government
leaders and central bankers. But with deflation more of a concern than inflation in key regions,
such as Europe and Japan, there is a global race toward weaker currencies, in the hopes of
spurring export-driven growth.

There are multiple ways in which countries control, influence, and manipulate their currency
exchange rate. The national (central) bank of a country holds reserves that are invested in bonds, both
domestic and foreign. Central banks often adjust their holdings to influence or control exchange rates.
Some smaller countries peg their currency to the currency of a larger country, while others only allow
for a narrow trading range. Interest rate policy also influences exchange rates, with higher interest
rates attracting investors to bonds denominated in a certain currency. Capital controls, which prevent
citizens from taking money out of a country, are the most severe tactic for controlling currency values.

The United States currently stands out as one of the few major economic powers not trying to
weaken its currency. The U.S. Dollar has been on a tear since June 2014, rising dramatically and
persistently against almost all other currencies in the world. The move has been atypical of the
foreign exchange market, where currencies often trade in tight bands, and large moves usually
unfold over a period of years. Improving economic conditions in the U.S. and the prospect of
slightly higher interest rates have supported the rise in the U.S. Dollar.

The sudden surge in the U.S. Dollar is causing some serious economic dislocation. In recent
weeks numerous companies have reported earnings that have been severely impacted by currency
translation. It is challenging for companies to pay staff in a relatively expensive currency, such as the
U.S. Dollar, while earning less valuable currency from foreign sales. A much greater concern for the
world economy is the strain being felt by governments and businesses that took out loans denominated
in U.S. Dollars, which must be repaid using devalued currencies. Some analysts estimate that trillions
of dollars of such obligations are outstanding, posing a risk to the entire global financial system. If the
U.S. Dollar experienced a price retracement to June 2014 levels, it would be a great relief for many U.S.
corporations and foreign borrowers.

Current Strategy

While the equity markets in the U.S. enjoyed another year of gains in 2014, the results for various
industry sectors were decidedly mixed. Investors bid up the prices of economically defensive sectors,
such as utility, medical, and consumer staples stocks, while shunning retail, energy, and basic materials.
It was the opposite of what one would expect during a period of economic improvement. Even though
economic conditions have clearly improved in the U.S., investors were troubled by economic weakness
in Europe (again), China, Japan, and most emerging economies. In that context the move to defensive
sectors made sense.

We had a busy year on the equity front. Two of our major holdings, i.e., Vodafone and Sapient
were involved in major corporate transactions or mergers, which led to a sale of both positions at
premium prices. The Vodafone gain of over sixty percent consisted of Verizon shares received from
Vodafone, a huge cash dividend, and the sale of the remaining Vodafone shares. We were active on
the buy side as well, with purchases in the technology, auto, machinery, and shipping areas. Stocks still
offer the best possibility for an investment return, but they are not without risk. Investors who overpaid
for popular stocks, or were positioned in the wrong sectors last year, found that out the hard way. We
are willing to buy whenever we find quality companies that are slightly undervalued or even reasonably
priced. In a very high market it can take a while for such situations to materialize.

The fixed income markets were somewhat tortuous in 2014. That may not be saying much,
because fixed income markets have offered only difficult, unsatisfying choices for some time. Most
analysts and investors went into 2014 expecting firm or slightly rising interest rates, in-line with the
Federal Reserve Board’s guidance. Instead rates for ten-year U.S. treasuries went down from about
2.75 percent to 1.75 percent. Economic events in other parts of the world trumped conditions in the
U.S. With interest rates falling to less than one percent in much of Europe, and remaining below one
in Japan, global investors moved into U.S. bonds as the best of bad alternatives. The U.S. Dollar was
pushed higher by this movement of global capital. A rise in U.S. interest rates would draw in more
capital and exacerbate the currency situation. The Fed may be reluctant to raise rates for that reason.
In this frozen, fixed income environment we are holding firmly onto stocks that pay decent dividends,
and occasionally buying longer-dated municipal bonds.


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