The Daily Reckoning PRESENTS: As the dollar continues its
stately decline... or, as your Paris editor notes above,
possibly approaches its rout... certain "reflatables" are
poised to profit. But be careful how you choose them!
INCREASINGLY WICKED INFLATION
By Christopher Mayer
Inflation proper - an expansion of the money supply - has
been going on for quite a while. It was the fuel for the
late nineties boom. But a different sort of inflation is
now beginning to emerge, a growing menace to indebted
consumers.
What we are talking about here might be more accurately
described as price inflation - a general and widespread
increase in prices, or stated differently, a general and
widespread decline in the purchasing power of money. In the
dollar's decline, we have started to see this... but it is
only the beginning.
Bill Gross of PIMCO, the Warren Buffett of the bond world,
has long been an astute observer of the bond market, and
financial markets generally. His December 2003 Investment
Outlook contained a nice summation of an investment thesis
for 2004. In short, Gross is in the inflation camp... as am
I.
Gross seems to take Fed officials at their word when they
talk about "printing presses." Wisely, in my estimation.
There are few things government cudgels do with much skill,
but one of them is certainly destroying the value of their
own currencies. History gives us plenty of examples, most
famously the great German hyperinflation of the early 1920s
or France in the 1790s. But there are recent examples, too,
especially in Latin America and the old Soviet bloc
countries. All paper monetary systems tend toward the
valueless and crisis-ridden, as history proves.
In Gross's view, the reflationary effort is only in its
infancy and is not likely to immediately jump up and bite
investors. [Note: reflation is the somewhat contrived term
often used to describe an attempt to revive a previous
inflationary boom by increasing or stepping up inflation.]
Nonetheless, the stance for investors today should be one
of preparing for increasingly wicked inflation.
Gross presents the following asset categories, which he
ranks by his own personal preference. These include
commodities and tangible assets, foreign currencies, real
estate, TIPS, and global bonds and equities denominated in
non-dollar currencies. Gross calls these
"reflatables"... and if you are shopping for places to put
your money, this list would be a good place to start.
Reflecting on his choices, in particular global bonds,
Gross notes the likelihood that foreign currency gains will
dominate returns, even if yields should move higher.
Foreign credit markets present slightly higher yields to
begin with, though one has to wrestle (sometimes) with
estimating the additional political risk. Similarly, global
equities offer cheaper valuations than U.S. equities. Gross
notes that the UK's FTSE yields 3.7% compared to 1.6% for
the S&P, as well as selling for lower P/E multiples.
There is no doubt the dollar is weakening. Long held as the
international currency of choice, it has been weakening for
at least a year, and there are suggestions that it may be
the beginning of a significant revaluation.
First, there is the simple raw evidence of market data. The
dollar seems to make new lows against the euro every day;
the dollar declined 20% against the euro in 2003. It also
reached an eleven-year low against the pound and a ten-year
low against the Canadian dollar. These are not isolated
examples, but recurring strands of a larger fabric of soft
comparisons against foreign currencies. From its peak in
2001, the U.S. dollar index, which charts the currency
against a basket of six major foreign currencies, has
declined more than 25%.
Another clue is found in the gold market. The yellow metal
had a tremendous year in 2003 and now trades north of $410
per ounce - a level not seen in more than eight years - and
is up more than 25% from one year ago. Gold is up 60% from
its low of $255 per ounce in 1999.
In addition to cold numbers, there is anecdotal evidence of
interest. Warren Buffett, for one, is selling the dollar.
In his article for Fortune ("Why I'm not buying the U.S.
dollar") Buffett writes, "Through the spring of 2002, I had
lived nearly 72 years without purchasing a foreign
currency. Since then Berkshire has made significant
investments in - and today holds - several currencies. I
won't give you the particulars; in fact, it is largely
irrelevant which currencies they are. What does matter is
the underlying point: To hold other currencies is to
believe that the dollar will decline."
When the Oracle of Omaha does something he has never done
before, that is worth noting.
Buffett cites primarily the unprecedented size of the U.S.
balance of payments deficit. Foreigners hold $9 trillion
worth of U.S. dollar-denominated assets. Much of that is in
U.S. bonds. The accumulation of this debt has surpassed all
previous records. Foreigners are not likely to continue
buying dollars at record-setting levels and any shifting in
this trend will result in a further weakening of the
dollar.
Buffett is not alone - Soros, Templeton, Jim Rogers and
other investment luminaries are betting on a dollar
decline. That is not a crowd one is going to make a lot of
money betting against.
With continued weakening of the dollar playing a
significant part of the investment backdrop, investors find
themselves in a tough spot. During the boom of 1995-1999,
it was easy enough to refrain from buying tech stocks, for
example. The risks today seem more nebulous and far-
reaching, and hedging seems more difficult. It is easy to
understand the bullish case for reflatables - but it is
more difficult finding concrete investment ideas that
represent good values in these areas.
Looking at commodities, for example, many gold companies
seem expensive and lack Ben Graham's margin of safety. They
have become speculations on the price of gold - a good
speculation, perhaps, but a speculation nonetheless. Better
to own the metal itself, at this point, but that is not
easy to do.
Investors can widen their search and explore other tangible
assets. But again, in most of these instances, the readily
available and liquid investments are going to be in
commodity-oriented companies that have their attendant
risks and are not pure plays on the underlying commodities
themselves. Real estate is similar, except that most people
have real estate exposure with their investment in their
own homes.
A weakening dollar naturally implies that several (many?)
foreign currencies will do better relative to the dollar.
Hence, investments in non-dollar-denominated foreign
securities should do well relative to the dollar, all else
being equal. The problem is that international investing
(especially the emerging market variety) has its own risks,
often overlooked.
In summary, Bill Gross's "reflatables" have a great deal of
investment appeal at the theoretical level. Finding
concrete ideas and opportunities that meet a rigorous test
for a margin of safety is more difficult. That is always
the more difficult task.
Regards,
Christopher Mayer,
for The Daily Reckoning
Editor's note: Christopher W. Mayer is a veteran of the
banking industry, specifically in the area of corporate
lending. A financial writer since 1998, Christopher's
essays have appeared in a wide variety of publications,
from the Mises.org Daily Article series to here in The
Daily Reckoning.