Axel Merk Makes a Case for Currency
Source: The Gold Report 09/11/2009
Having pioneered the currency asset class as head of Merk Investments, LLC, Axel Merk suggests that these times-with inflation looming, the U.S. dollar failing, equity markets remaining volatile and economic recovery stumbling-might call for investors to further diversify their portfolios with baskets of foreign currencies. Axel, who strongly recommends The Gold Report as a brilliant resource in his about-to-be released book (Sustainable Wealth: Achieving Financial Security in a Volatile World of Debt and Consumption), looks at the wider picture too. For instance, he tells us that while a world reserve currency is impractical, ungovernable, unworkable and unlikely, diversification within each country's reserves would make sense in the global economy.
The Gold Report: Axel, you've been successfully identifying macro trends for decades, and then recommending appropriate investment strategies based on those trends. What macro trends do you see today?
Axel Merk: We have two major forces-one inflationary and the other deflationary-playing out, and by now many investors are familiar with them. Let me expand on that just a tad. After the credit bubble burst, the market forces wanted a major contraction. Those forces are still firmly in place. Lacking monetary and fiscal subsidies, we would have a very severe recession if not a depression.
On the other hand, of course, we have the government forces, mostly driving in monetary inflation to reflate the system. Depending on the mood of the day in the market, one force or the other is winning out. On days when the market is up, it's the inflationary-reflationary forces.
When we have the flight to quality and when credit contraction occurs, the dollar often benefits. Each time the pendulum swings in that same direction again, the dollar benefits less than in the previous swing, because the government prints more money and leaves a bigger hole in the balance sheet.
TGR: When the credit bubble first burst, the market wanted a contraction, and then we had a flight to quality. Will market forces ultimately prevail over any government subsidies?
AM: Ben Bernanke doesn't want to go down in history as the one who oversaw the next Great Depression. I do believe the market forces ultimately will prevail, but only because the government has some tools that will play a major role. The most important of those tools is the printing press. So while we play this back-and-forth game, we're printing ever more money.
The Federal Reserve wants us to believe that there's no inflation in the pipeline due to the output gap (or economic slack). That fairy tale is very difficult to believe for anybody who's serious about macroeconomics, including central bankers. Every central banker knows that the primary drivers of inflation are inflationary expectations-not the output gap. The Federal Reserve wants to print money and have very accommodating policies to boost the economy without it being reflected in the higher cost of borrowing. For the time being, they're getting away with it. But ultimately the Fed is going to have a huge problem-which is that it has to combat inflation while at the same time it won't be in the position to do so.
TGR: If the predictor of inflation is the expectation of inflation, and if the government can convince us that we won't have inflation, why would the expanded money supply cause inflation?
AM: I doubt that in the long run you can convince the public that having huge deficits and huge money printing won't cause inflation. There's a reason the U.S. dollar made it to the status of the world's reserve currency. Over many decades the Fed has pursued a sounder monetary policy than other central banks. You can't now turn this upside down and impose unsound, imprudent policies on the rest of the world for too long.
Just because it's in nobody's interest for the dollar to fall steeply doesn't mean you should get away with the sort of policies that have been pursued. You can do that for a while, but ultimately the market will impose a higher cost of borrowing on the U.S. or otherwise force the U.S. to rein in its behavior. And if the government then continues to press the other way, the damage is going to be dramatic.
So I wouldn't say that the populace will buy the government policies forever. They're giving the government the benefit of the doubt for now, and in the meantime, of course, investors can position themselves for the risk that things will change. We don't have a crystal ball, but we know the risks.
TGR: Can you highlight the major risks that should worry investors?
AM: The major risk is that the Fed gets what we believe it wants. Bernanke has said repeatedly that one of the ways we got out of the Great Depression was by getting off the gold standard and allowing inflation-allowing prices to rise. Remember, if you have too much debt, inflation helps you; it bails you out.
So many homeowners are under water with their homes, you have a choice of home prices coming down, homeowners downsizing and declaring bankruptcy-a scenario politicians don't want-or you induce inflation to allow prices to rise. That's what the Fed wants, and they might just get more than they bargained for. So inflation is the big risk and its side effect is there is no such thing anymore as safe assets.
Cash is no longer a store of value. We are encouraging investors to take a diversified approach with something as mundane as cash, and the dollar is obviously the focal point. Will the dollar hold up? In the past it has been in the interest of the world to keep the dollar steady, but it just might not be sustainable. So people should be paying the most attention to inflation and the dollar.
TGR: If inflation takes off, the U.S. dollar devalues. What are our alternatives?
AM: Obviously, it's a complex situation. Some say they'll have gold and nothing but gold, but I would think that even the staunchest gold bugs probably don't have all of their money in gold just for practical reasons. So the question is what to do with the part that you don't have in gold.
Let's look at a couple of the regions in the world, starting with one of the more controversial ones, the Eurozone. Many people think the Eurozone is doomed just as much as other places because the banking system has major issues. In recent months, we've been far more optimistic on the Eurozone than others and it goes back to what Bernanke has said about going off the gold standard.
If you don't devalue your currency, if you don't print yourself out of this mess by trying to devalue yourself, you'll end up with much less economic growth but with a much stronger currency. We believe that's what the European Central Bank is focusing on. They have been providing unlimited liquidity to the banking system, so they can keep zombie banks alive and keep the economy afloat. But by not pursuing policies as aggressive as the Federal Reserve's, we believe that they will have a much stronger currency. Also remember that structurally the European Union is far more rigid than the U.S. It's far more difficult to print money. You can't just print money and inject it in the bank. The money is coming from the state governments.
Similarly, on the spending side, as a result of that structural rigidity, no centralized body can just ramp up the spending as rapidly as happens in the U.S. So the EU, and the Eurozone in particular, will fare better relative to the U.S.
Of course, there might be more prudent places such as Norway, which we have been advocating, that has the resource income and at the same time is linked to the Euro and other European currencies. The correlation to those currencies is very high. Rounding up the Western European currencies, Switzerland is traditionally considered a safe haven, though the Swiss have worked very hard to try to discredit the Swiss franc. Another reason to move over to Norway if one likes European currencies.
Looking over to another region, especially for gold investors, is the Australian dollar. It has the highest correlation to the price of gold of all the world currencies. Australia tends to benefit from the monetary stimulus that's pushed everywhere in the world, and the Australians might be among the first to raise rates again. The Australian dollar, in our view, benefits whenever the reflationary trend is invoked. To an extent, the same is true of the Canadian dollar, although its dynamics are far more complex.
In Asia, pressures to allow the currencies to appreciate will only intensify, partially because of the domestic stimuli that these countries have been pursuing. China, in particular, has been very effective with its stimulus because it's one of the few countries in the world that can afford a stimulus. The most efficient way to prevent inflationary problems down the road, in our view, is by allowing the currency to appreciate-particularly because the Chinese have taken all the steps in that direction.
If you look at the weaker Asian countries, they can compete on price alone. These are countries such as the Philippines and Vietnam that deliver goods at the low end of the value chain. Their lives depend on exporting to the U.S. Because we don't expect a quick consumer recovery in the U.S., some of these countries may even engage in competitive devaluation.
TGR: Do you see any potential for adopting a different reserve currency?
AM: It comes down to what is realistic. In recent months, the heads of state in different countries have been saying, We have to go away from the dollar. And then their finance ministers come out and say, Well, we can't. If you compare the heads of state and the finance ministers to corporate executives, with the CEOs saying one thing and the CFOs saying something else, eventually the CEOs are going to come out ahead. Part of the reason is because there is no easy substitute for the U.S. dollar. The Eurozone is a distant second, and then there's just about nothing else.
TGR: What does the balance look like in your baskets of currencies?
AM: We have two mutual funds, the Merk Hard Currency Fund and the Merk Asian Currency Fund. In the former, we invest in currencies that we consider backed by sound monetary policy. That's obviously a relative statement, but we have taken altogether about half of the Western European currencies in the that fund-Euros, Norwegian krone and Swiss franc-plus about 14% or so in gold and the rest spread out among Australian, Canadian and New Zealand dollars.
TGR: What about the British pound?
AM: We do not have the pound sterling in the Merk Hard Currency Fund. We believe that the Bank of England is the yo-yo central bank of the major central banks, and the U.K. is going to have major issues. Nor do we have the Swedish krona in the basket.
TGR: How about your Asian Currency Fund?
AM: We've ramped up our exposure to the Chinese yuan to about 60%, so this fund is really a play on the China appreciation. Asian currencies have very different dynamics. Many of them trade in a very small trading band to the U.S. dollar and it's mostly in anticipation that some of these currencies may revalue over time.
TGR: Are you looking to store value in your funds or to create wealth, which in this case would be some denomination of cash?
AM: Our objectives state that we seek to profit from a fall in the dollar versus our baskets. Ultimately, the hope would be that you can increase your purchasing power. Having said that, our goal is not to have some gangbuster returns that investors can achieve by investing in very profitable companies. At certain times, it might make sense to diversify to these baskets of currencies just as with a gold investment. Most people don't buy gold expecting to make a fortune. In fact, many people fear that their gold investment will go through the roof, which would mean that many other assets they hold may be going down the drain. So it's a balancing act, it's a diversification act, and it's in that spirit that we offer these funds.
TGR: As an individual investor looking at baskets of currencies to hedge against the devalued dollar, what percentage of the portfolio would you recommend?
AM: We're not allowed to give specific allocation advice. Some people put a big percentage of their assets in it. Some people put 5% of their money in it, some put substantially more. And, obviously, some people don't consider it.
TGR: How should investors look at the opportunity of investing in a basket of currencies as part of their portfolio?
AM: People look at it in different ways. Some think of it as an international bond fund allocation. Others use it for cash holdings that they want to diversify. We caution that we are not a money market fund. We also believe that the markets are going to continue to be unstable, be it the equity markets or the bond markets. Volatility in the currency markets will persist, too, mostly because of the policies being pursued.
In our view, we will not get a sustainable recovery, so we're providing the international exposure without the added risk of an equity exposure that people would get internationally. That's attractive for people who don't like equities, bonds or cash. So where do they put their money, especially if they don't think real estate has bottomed?
TGR:A lot of gold bugs believe that the devalued dollar will push gold through the roof. So they look at gold as an asset that's appreciating, not just sustaining wealth. What's your view on that?
AM: That potential is certainly there, but people underestimate is how small the gold market is. That's one reason the volatility is so high, but another effect is that if and when there's a flight into gold, it can really take off much more than many other commodities or equities. In that context, I don't disagree with that. We have a gold component in our Hard Currency Fund and I personally hold gold in my children's college savings plans.
TGR: One reason you have a basket of currencies is that you expect the equity markets to be unstable going forward. A number of analysts forecast a major retraction before the end of the year. When you look at your macro trends, do you see that occurring?
AM: That risk is certainly there. Again, I don't have a crystal ball; but I do assess the world in terms of risk scenarios because while we have seen a lot of money thrown at the economy, much of it has been extremely inefficient. Furthermore, the earnings are not there, the consumer recovery is not there and the cash-for-clunkers program has cut into future sales. So there is risk of a decline in the market-even a serious decline.
The only opposing force to that is massive monetary stimulus. The Fed's programs will be much easier to jumpstart because the tools are in place. While market forces may warrant a significant decline, I would think that policymakers may act with an even more forceful push back if and when a significant decline materializes.
TGR: Even if Bernanke is that savvy and has various tools to deploy rapidly, don't we need consumer spending to reduce unemployment and increase earnings?
AM: First of all, I would hesitate to call Bernanke savvy. He is determined. Bernanke completely underestimated the political dimension. He has veered away from monetary policy and shifted over to fiscal policies. All these credit-easing programs are fiscal policies that generate political backlash and, as a result, the monetary policy becomes much less effective and ever more expensive. Secondly, increasing the monetary base doesn't mean the dollars that the Federal Reserve prints will be used in the economy. That's one of the reasons we have not seen inflation pop up yet.
But we are going to have a big mess on our hands and I don't think we're going to get out of it without a significant increase in inflation. It may not appear in the areas where people want it to appear and be a drag on the standard of living.
TGR: So we go into inflation in high single digits, double digits or hyperinflation. How do we eventually get that under control?
AM: I think we're going to have further erosion of the middle class. The sophisticated investor can deal with inflation. The savers-the middle class-cannot. We may move toward a more Latin American-style economy, and with that would come a backlash that favors populist politicians. In this age of social networking, where very small groups can mobilize people to come to disrupt healthcare town forums, or in Iran to rally on the streets, I'm just saying that politics will be driven more by populist voices. That will lead to the election of more populist leaders and will make it very difficult to get onto a sustainable path.
It's a very scary environment and it's one of the reasons more people get involved. They want to stop that trend. We're trying to do our part with our public contribution to some of these debates, but it is a very challenging environment. How will it ultimately play out? The only thing I can say in that regard is that throughout this crisis, democracy in general is still in reasonably good shape in the U.S. So, overall, we'll get through this. It's just very sad that we have to erode the purchasing power of the masses in the process of doing so, and violate many of the principles we believe in.
TGR: If it does turn around, what timeframe are we looking at-a decade, two decades, a generation or two?
AM: For the next decade, I would be most concerned about the inflationary issues. For the time being, we have to take the precaution that things may turn out more inflationary. I'm not a real gold bug, although I do like gold and have for the better part of this decade. But the policymakers just might come to their senses. If things get bad enough, they just might-but right now I don't see that in the cards.
TGR: Let's all hope we'll be pleasantly surprised.
Axel Merk is Founder, President and Chief Investment Officer of Merk Investments LLC-the Authority on Currencies and a pioneer in the currency asset class. His SEC-registered investment advisory firm, which manages mutual funds specializing in international currencies, started out in Switzerland 15 years ago. Axel relocated the business to Palo Alto, California, in 2001. The Merk Hard Currency Fund, established May 10, 2005, with assets of $362 million (as of early September) invests primarily in Euros, the Norwegian Krone, Canadian and Australian dollars and gold. In April 2008, Axel added the Merk Asian Currency Fund, and already it has assets of nearly $64 million (in the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand). Known for offering understandable advice and an uncanny ability to predict market movements, Axel is a regular guest on CNBC and Fox Business, and is frequently quoted in Barron's, the Wall Street Journal, Bloomberg News, USA Today and the Financial Times. His book, Sustainable Wealth: Achieving Financial Security in a Volatile World of Debt and Consumption [Sustainable Wealth.org], synthesizes macro trends, explains their effects on individual wealth, and suggests ways to build and preserve financial security in a volatile environment. It will hit the bookstores in October.
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