Preparing for greenback devaluation

Rallying stock markets and the nascent economic recovery have renewed concerns about the valuation of the U.S. dollar. There is a growing perception that the greenback will likely see a pullback in value as things improve — which will impact the foreign holdings of Canadian investors.

The U.S. dollar’s role as the world’s reserve currency may not be in jeopardy anytime soon, but there are some who believe it role as a store of value would be greatly diminished as fears about deflation and the world financial crisis subsidize.

Arguably, the most influential commentator raising this concern is U.S.-based bond-fund giant PIMCO. The firm’s managing director and portfolio manager, Curtis Mewbourne, says the continued ascension of emerging market economies could result in significant devaluation of the U.S. dollar.

Emerging countries hold the lion’s share of international reserves, mainly in the form of U.S. dollars and to a lesser extent euros. They appear to be increasingly concerned the weakening U.S. economy and banking system, the increase in money supply and other factors may reduce the value of the dollar over time,” Mewbourne says. “Notably, they have been voicing concerns in international forums such as recent G8 meetings, and have taken some (perhaps small) steps to reduce dependency on the U.S. dollar.”

Mewbourne notes the greenback’s position as the world’s reserve currency is pretty much unassailable for now — the currencies of the emerging markets such as India and China are not freely convertible. So the U.S. dollar becomes the de-facto store of value for most cross-border transactions. With mounting debt and an inflationary environment that will likely follow recovery, the long-term outlook for the U.S. is not particularly good.

Many investors and nations will likely want to obtain value through hard commodities as a trade against the diminishing the currency. The U.S. government may be happy to oblige since it has built up a massive debt load to help fund its stimulus programs, which will be greatly reduced through currency devaluation.

“Indeed, in emerging countries we’re seeing some central banks intervening in order to limit appreciation of their currencies as capital flows back into their economies. These preliminary signs of a reversal in the traditional pattern of capital flows during a deleveraging cycle may well mark an important shift in currency preferences,” Mewbourne says. “In combination with other factors, that likely means a continued devaluing of the U.S. dollar versus other currencies, especially the emerging market currencies. Accordingly, investors should consider whether it makes sense to take advantage of any periods of U.S. dollar strength to diversify their currency exposure.”

Loonie looking strong Canadian investors need to be cognizant of the fact that the loonie is viewed by many international traders as a petro-dollar — it’s fortunes are intimately tied to the price of oil and the hard commodities it produces. The loonie is expected to do well against continued U.S. dollar weakness, according to a new economics report from RBC assistant chief economist Dawn Desjardins.

“Canada’s dollar put in a very strong performance in July as investors’ appetite for risk picked up. The loonie managed to outperform all other G10 currencies in the month, as higher commodity prices lifted the economy’s prospects,” Desjardins says. “Going forward, the ebb and flow of monthly economic news will likely result in periods of risk aversion that will lead investors back to the safety of the large, liquid U.S.-dollar market. However, the medium-term prospects favour the Canadian dollar trading toward 95 U.S. cents as rebounding global demand for commodities sparks interest in the currency.”

Desjardins adds that structurally, Canada has a much smaller fiscal deficit relative to GDP, and a perceived stable financial system will support the currency. RBC expects the country’s GDP growth to outpace that of the United States, the United Kingdom and Eurozone next year.

This creates significant downside risk for Canadian investors with money in foreign asset classes. Already, the surging loonie has wiped out nearly half they would have achieved being invested in U.S. equities. For example, according to data provided by Morningstar Canada, the RBC U.S. Equity Fund in U.S. dollars delivered 10.45% return over the last three months. The non-U.S. dollar denominated version of the fund, which had to convert back to Canadian currency, delivered 4.67% over the same period.

Further, data from Morningstar Canada shows in the United States the S&P 500 Index’s 7.6% gain was virtually wiped out by the U.S. dollar’s 7.2% drop against the loonie, resulting in a paltry 0.6% gain for the Morningstar U.S. Equity Fund Index.

Currency swings expected U.S. devaluation, however, isn’t expected to be immediate, according to CIBC World Markets economist, Krishen Rangasamy.

Rangasamy says CIBC expects a contraction in confidence over the coming months, which will once again drive investors back into cash.

“There has been some optimism in equity markets since March. Equities have rallied and it’s probably a little overdone, so there may be a period of further risk aversion ahead,” he says. “Usually when the markets don’t do so well, the U.S. dollar tends to gain — the correlation is very close to one. When you have a bad day in the market, the U.S. dollar tends to gain steam, and the reverse happens when it’s a good day in the market. We’re expecting further risk aversion ahead. There might be a number of economic numbers that don’t favour the U.S. markets.”

The contraction, which CIBC expects to hit after the third quarter as economic news remains poor, will likely drive the U.S. dollar up. Once things have completely stabilized, he expects the dollar to continue on its long-term devaluation trend it’s been on since 2002.

“In the U.S. we’re expecting the third quarter to be pretty good. You’re going to see a pop with businesses restoring their inventories. Production will ramp up in both Canada and the U.S. We see growth, which could take markets by surprise, coming down in the fourth quarter,” he says. “We see that trend of depreciation continuing into next year due to rising inflation.”

He adds, “This will likely create an environment of a weak U.S. dollar accompanied by strong commodity prices.”

(08/20/09)