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February 5, 2019
Government policies have a strong influence on the economy and markets. Those policies can accomplish both their intended results, but also create unintended consequences. The specific government policies that we are referring to include zero interest rates, quantitative easing, excessive growth of government spending in excess of tax collections and GDP growth, tax cuts, tariffs, and restrictions on foreign governments. All of these policies may have good intentions but they do not occur in a vacuum. We believe there are three unintended or ignored consequences:
In the past decade U.S. government debt has increased 2.8X the growth in GDP and an expanding portion of this debt is dependent on foreign ownership. This excessive growth rate in government debt, combined with our increasing dependence on foreign ownership, is risking loss of the dollar’s reserve status, especially when combined with tariffs and other restrictions on foreign governments.
Corporate debt leverage is now the highest in history. Furthermore most of the corporate debt expansion has been taken on to buy shares back and pay dividends, not for capital expenditures. In spite of growing corporate profits, and historically low interest rates, the quality of corporate debt is the worst in modern history. Thus a recession and/or rising interest rates could lead to rising bankruptcies.
Inflation has not been a problem in the U.S. since the 1970s. However a multitude of factors could lead to higher inflation in the next couple of years. Labor markets are the tightest they have been in decades and wage pressures are beginning to surface (up 3.2% YoY in December, highest in a decade). Capital expenditures have been lagging throughout the decade long expansion. Thus productivity gains are not offsetting wage pressures. Tariffs are causing price increases on imported goods. While the recent decline in oil prices will have a short run moderating effect, companies have shown a greater confidence in increasing prices.
Financial markets are giving increasing signals of a serious economic slowdown or recession which could also provide a temporary respite in inflation pressures. However offsetting that is the possibility of Federal Reserve (FRB) monetary easing. The FRB has a duel mandate to maintain full employment and to moderate inflation. However history suggests that if there are policy errors, it will be on the side of easing to prevent employment from increasing. Furthermore the dollar is overvalued on a purchasing power basis, which argues for dollar weakness. Any FRB easing, or renewed dollar weakness, will lead to higher inflation, and possibly stagflation.
Throughout our lifetimes the dollar has been the world’s reserve currency. Therefore it is widely assumed that the dollar will always maintain that status. However, no currency has maintained that position indefinitely. Furthermore, the dollar is the first reserve currency in history to be a purely fiat currency (not backed by anything other than trust in the issuing government). The dollar became the reserve currency in 1944 when it was the only currency backed by gold. All other currencies were pegged to the dollar and foreign governments could exchange excess dollars for gold at $35 oz. This lasted until 1971 when the U.S. suspended gold conversion in order to stem its loss of gold to other countries. Since that time the U.S. has had a special privilege in that it has been able to issue unlimited amounts of dollar denominated debt, and the rest of the world has purchased this debt. However, the conditions that supported this regime have been eroding, and there is increasing evidence that the dollar’s reserve status could end.
The world has moved from a U.S. centric to a multi-polar world in the last two decades. After dominating the world after WW II through the fall of the Soviet Union, the U.S. has been increasingly challenged economically, militarily, politically, and now financially. Challenges to the U.S. are coming from China, Russia, Iran, and now also Europe. These challenges have accelerated in the last two years on a multitude of fronts. The U.S. attempts to place restrictions on Russia and Iran, as well as tariffs on a wide range of countries, have led to counter moves by many countries.
Trading and funds transfers used to be almost exclusively carried out in dollars, even when U.S. entities were not involved in the transactions. China and other countries have increasingly arranged trade transfers that bypass the dollar. Europe, China, and Russia have now built funds transfer systems that do not use dollars. This has been done so that the U.S. cannot restrict their financial activities. China, now being the largest oil importer, is encouraging oil exporters to transact business in the Yuan, not the dollar. This is a similar action to that of U.S. in the mid-1970s, when the U.S., then the largest oil importer, encouraged the Arab oil exporters to only price oil in dollars in return for military protection. This cemented the dollar’s reserve status.
Many experts including Ray Dalio, head of the largest hedge fund, Larry Fink, head of the largest money manager, and Marco Kolanovic, a well-respected strategist for J.P. Morgan, are all voicing concern about the dollar’s future as the world’s reserve currency.
The U.S. remains highly dependent on foreigners to buy our Treasury debt because the U.S. does not have a large enough pool of savings. This dependence continues to grow, and has been exacerbated by last year’s tax cut. At the same time the imposition of tariffs, to cut our balance of payments deficit, reduces the pool of U.S. dollars available in foreign hands to recycle into Treasuries. The result of all these trends may be a loss of dollar reserve status, and possibly a period where no currency dominates—in other words a currency no man’s land such as occurred between WW I and II. If this occurs the dollar is likely to lose value as foreign countries reduce the percentage of dollars in their reserves.
The world is unlikely to return to a gold standard, but gold may well play a larger role in government’s currency reserves. Gold is the only asset in their reserves, unlike fiat currencies which are liabilities of the other countries that issue them. The increasing uncertainty since 2008 is what has caused central banks to once again begin accumulating gold after several decades of being net sellers. While the U.S. has the largest gold reserve, it is miniscule compared to its liabilities of debt held by foreigners.
Where as in the 1970s, U.S. gold holdings ranged between 25 and 110 percent of foreign held debt, that percentage is only 4.5 percent now. If gold were to rise in price so that the U.S. would have 40 percent backing for its foreign obligations, gold would have to rise by a significant multiple of its current price. No one knows if that will happen but trends are clearly pointing in that direction. Gold has been in a long-term rising trend since the dollar became a fiat currency. It has spent the last five years in a tight trading range below $1360 oz. It may well be about to embark on the next multi-year advancing phase. The unintended consequences of government policy are potentially laying the groundwork once again for a substantial rise in the price of gold, much as happened after the closing of the gold window in 1971.