Mon, 12 Sep 2011
Investors can't just rely on the traditional paradigms of diversification, argues Merk Funds' Axel Merk.
Nadia Papagiannis: Hello, my name is Nadia Papagiannis. I'm an alternatives investment strategist here at Morningstar.
Today I have with me Axel Merk, manager of the Merk Hard Currency Fund (MERKX) and the Merk Asian Currency Fund (MEAFX), and most recently the Absolute Currency Fund.
Axel, thanks for joining us today.
Axel Merk: Good to be with you.
Papagiannis: Axel, a couple of days ago, Fed Chairman Bernanke in his speech talked about how the slow growth in the United States coupled by trade deficits related to oil is having a negative impact on the U.S. dollar, and similarly yesterday Bill Gross in his speech at the Morningstar conference talked about his negative outlook on the U.S. dollar. What does that mean for investors and how can they hedge their portfolio against this?
Merk: Well, firstly you pointed out that Bernanke talks about the dollar. Remember Greenspan never talked about the dollar. Bernanke, in our view, considers the dollar a monetary policy tool, an environment where the economy doesn't grow, and he's done everything on interest rates and printing money, he actively works on debasing the dollar, in our view.
Now, with regard to the trade deficit, one thing that investors may not be aware of is that in the U.S. we need economic growth to have a strong currency, and that is why a weak dollar is something that Bernanke welcomes a lot.
It is not the same case everywhere else in the world. In Japan, for example, it's the opposite. We have a current account surplus. We have a trade surplus, and we do not have the same sensitivity to the yen as we have in the dollar. In Japan, when you have consumers save more, when you have the economy stall out, when you have an ineffective government that doesn't spend money or doesn't exert pressure on the Bank of Japan, the yen strengthens. So you have the opposite.
And the eurozone, by the way, is just about in between. The current account is about in balance, and as a result the eurozone doesn't need significant economic growth to have a strong currency, and you have to keep those dynamics in mind in a world that's increasingly unstable.
One of the things we have said is that there's no such thing anymore as a safe asset, and investors may want to take a diversified approach to something as mundane as cash, and that means that as in the U.S. where dollar assets may not be as safe as people thought, people may want to take a diversified approach. Central banks diversify to baskets of currencies. We very actively try to address currency risk in portfolios, manage that actively and try to profit from that obviously and taking into account the trade deficit is one of the aspects that we look at.
Papagiannis: How is the risk of our currency being debased, how is that related to inflation and a possible rise in interest rates, and how should investors position their portfolios against that?
Merk: Well we see the inflationary impact at the gas pump very clearly. If you look at folks at the Federal Reserve, they say, "Oh, don't worry about commodity inflation, because it's all transitory." The term transitory taking on a whole new meaning these days, but when it comes to currencies, you have to look at that as well in an international context, especially if you look at the European Central bank. The European Central Bank yet again came out and talked about strong vigilance that they have to worry that these high commodity prices don't lead to what they call "second round effects." In a broader context, the Europeans, just like the rest of the world, they take commodity inflation very seriously.
Now, if you put that into the context that Saudi Arabia is already producing oil near their peak levels of 2008, where is that going to go as the U.S. economy does recover, if indeed we do have strong economic growth? That means high commodity prices will be with us for a considerable period and that means that monetary policy around the world will be far tighter than in the U.S., even everything else being equal.
We also have accommodating policies in the U.S. because we are fighting market forces and consumers are being subsidized, but more importantly, just because of high commodity prices, we will see higher interest rates, not just in Europe and the rest of the world, that will continue to have downward pressure on the U.S. dollar for a very long period to come and, of course, as a result investors may want to position themselves accordingly that even if your stocks go up, ... if the purchasing power goes down, it doesn't help you very much.
So you want to actively manage the currency risk of your domestic portfolio, of your fixed-income portfolio in particular, and as interest rates go up, as inflation goes up, you may want to be on the short end of the yield curve--that means cash.
But U.S. dollar cash is not safe anymore, and so as a result a fixed-income portfolio that's international but with a very short duration and, by the way, our funds all have a very firm commitment to the short end of the yield curve, and with that you might be able to mitigate some of those risks.
Papagiannis: So what about on the equity side. I can also get currency exposure through stocks, so can I just invest in international stocks?
Merk: Well that argument is brought up a lot. U.S. corporations hedge a substantial part of their overseas earnings, so that they are not exposed to the currency risk, so you get some of that. Alternatively, of course, international equities are often cited as a way to diversify--but remember that most mutual funds invest in the large caps abroad. Well, what do these companies do? They try to sell to American consumers. So the diversification you get by investing in international equities is also limited. You get some of that. And there are many ways you can address that. The important thing here to remember is that in a world where there's no safe asset, you have to take a more active approach. You can't just rely on the traditional paradigms on how to have your diversification, but you actually need to look at the dynamics in your portfolio and see that you are getting the diversification that you're really looking for.
Papagiannis: So your recommendation is diversify your cash currencies and go to the shorter end of the yield curve rather than the longer end?
Merk: By all means. There is a lot of money that has piled up into the long end of the yield curve. The volatility at the long end of the yield curve is abnormally low. You don't have to be somebody who says, "Oh, the Chinese are going to dump the Treasuries" to say that there is a bubble in the bond market. The volatility is too low. There are many investors that are yield chasing and as a result they go out on long end of the yield curve, and as the volatility increases, there will be a very rude awakening in that segment of the market. So you want to manage that very actively.
Traditionally, people want to go to cash, but you don't have to go to cash. There are alternative these days. You can have an absolute return type of strategy or as far as international fixed income is concerned, you don't have to go back to U.S. dollar cash. You can now stay in international cash. You can do that with hard currencies, Asian currencies, or other possible avenues.
Papagiannis: Thank you very much, Axel, for those wonderful investment ideas.
Merk: My pleasure.