American Dollar

Most Americans are proud of the fact that we have a strong and stable currency; the dollar has maintained strong relative value against other currencies through a financial crisis, which originated in the United States and has recently strengthened significantly against gold and the yen. So why is this a "problem"?

First of all, our economy seems able to function reasonably well at current relative valuation levels. The recent slowdown is likely the result of ill-advised tax increases and spending cuts; it appears that the private sector growth may enable us to avoid a recession. However, a significant appreciation of the dollar against other currencies could create problems.

To better understand this, it may be helpful to go back to the early 1980s when the revered Central Banker Paul Volcker raised interest rates and tamed inflation. One result of this action was that the dollar appreciated against most other currencies; this had the beneficial effect of reducing inflation. But it also had some nasty side effects. As the dollar goes up in value against other countries, imported products become less expensive in dollar terms and products exported from the United States become more expensive in the countries to which they are exported. Industries that face foreign competition can be absolutely devastated if the dollar appreciates too rapidly. In the 1980s, we talked about the "Rust Belt" as the steel industry withered away, one automaker had to be rescued and another was on the ropes, and lots of manufacturing jobs were lost.

I have to make a confession. As a lawyer, I was not confronted with foreign competition and was even able to do well representing some importers. As I traveled, I soon learned that I could save enough money by buying all my clothes overseas rather than at home to cover the expenses of the trip. When my wife and I decided we wanted to spend a week seeing the latest plays, we discovered that the all-in costs of a week in London were less than a week in New York. So a strong dollar is just great for international travelers.

But for Main Street America it could be a disaster given the fragile nature of the economy. And it is a real danger. The reason is that the other "strong" currencies have gradually left the stage. For years and years, the Deutsche mark was a super-strong currency going back to the days of Ludwig Erhard; it has been subsumed into a less than robust euro. The yen strengthened against the dollar for years but that trend has been reversed and Japanese policy seems clearly aimed at a weakening yen. Where does this leave us? Pretty much alone as a target for investment dollars in a global "risk off" environment. If risk is perceived to be increasing and investors stampede toward safety, the dollar is pretty much the only place left to go.

I think that there are two nasty scenarios that cause me to lose sleep here. The first is a "leverage event" or financial failure, which sends shock waves through the markets and leads to a global "risk off" trade. With the mark and yen no longer available, this will inevitably lead to a run up in the dollar against other currencies and complicate our efforts to engineer a recovery. A big enough run up could decimate exports and pitch us into recession.

The second danger is that, as the United States becomes less and less dependent on imported oil, an event in the Middle East leads to a spike in the world oil price. Because the United States will not be importing much (or any) oil, this event will not immediately lead to an increase in our trade deficit but it will devastate many of our trading partners and the dollar will appreciate significantly against their currencies. Thus, at the very time American consumers are reeling from higher gasoline prices, exports will decline and imports will replace domestic production leading to a nasty recession. This was, to a degree, the pattern often described as stagflation in the 1970s.

So what are the implications for investors? First of all, this problem is yet another reason that I think the Fed is unlikely to back off its expansive monetary policy in the near or intermediate term. Just imagine what an increase in interest rates would do in the currency markets right now! Fed officials are unlikely to articulate foreign exchange issues as being a motivating force in policy pronouncements, but the macroeconomic effects of a stronger dollar will weigh on their minds in considering the danger of deflation and recession associated with tightening. So all of the investment theses that depend on continued low interest rates are, to a degree buttressed by this additional factor. In short, agency mortgage REITs and BDCs still look pretty good.

A second issue is important to understand. Certain U.S. companies are particularly vulnerable to a stronger dollar. Philip Morris International (PM) derives virtually all of its revenues from sales outside the United States (I have described it as a "coward's way to bet against the dollar"). PM's dollar-denominated earnings automatically decrease as the dollar appreciates against other currencies (although hedging strategies can temporarily ease the pain). I am still long PM but the currency issue is something to bear in mind in valuing an otherwise very strong company. Other companies that rely on exports - the pharma industry and certain parts of tech are also vulnerable. On the other hand, Yum Brands (YUM), which does a huge business in China (the most famous American military leader in China is clearly Colonel Saunders) may ride this out because China has kept its currency "pegged" in a range of dollar valuations. Finally, companies that are more heavily focused on the domestic market like Verizon (VZ) and AT&T (T) may be relatively attractive.

I am not advocating an investment strategy based entirely on this consideration. I think it is just one of many factors that have to be thrown into the mix. However, I think that, with the developments in Japan which have the effect of eliminating one of the more attractive alternative "strong" currencies to the dollar, it is an increasingly important factor.