Strange doings, currency wars, and unintended consequences

By Edward A. Studzinski

Imagine the Creator as a low comedian, and at once the world becomes explicable.     H.L. Mencken

January 2015 has perhaps not begun in the fashion for which most investors would have hoped. Instead of continuing on from last year where things seemed to be in their proper order, we have started with recurrent volatility, political incompetence, an increase in terrorist incidents around the world, currency instability in both the developed and developing markets, and more than a faint scent of deflation creeping into the nostrils and minds of central bankers. Through the end of January, the Dow, the S&P 500, and the NASDAQ are all in negative territory. Consumers, rather than following the lead of the mass market media who were telling them that the fall in energy prices presented a tax cut for them to spend, have elected to save for a rainy day. Perhaps the most unappreciated or underappreciated set of changed circumstances for most investors to deal with is the rising specter of currency wars.

So, what is a currency war? With thanks to author Adam Chan, who has written thoughtfully on this subject in the January 29, 2015 issue of The Institutional Strategist, a currency war is usually thought of as an effort by a country’s central bank to deliberately devalue their currency in an effort to stimulate exports. The most recent example of this is the announcement a few weeks ago by the European Central Bank that they would be undertaking another quantitative easing or QE in shorthand. More than a trillion Euros will be spent over the next eighteen months repurchasing government bonds. This has had the immediate effect of producing negative yields on the market prices of most European government bonds in the stronger economies there such as Germany. Add to this the compound effect of another sixty billion Yen a month of QE by the Bank of Japan going forward. Against the U.S. dollar, those two currencies have depreciated respectively 20% and 15% over the last year.

We have started to see the effects of this in earnings season this quarter, where multinational U.S. companies that report in dollars but earn various streams of revenues overseas, have started to miss estimates and guide towards lower numbers going forward. The strong dollar makes their goods and services less competitive around the world. But it ignores another dynamic going on, seen in the collapse of energy and other commodity prices, as well as loss of competitiveness in manufacturing.

Countries such as the BRIC emerging market countries (Brazil, Russia, India, China) but especially China and Russia, resent a situation where the developed countries of the world print money to sustain their economies (and keep the politicians in office) by purchasing hard assets such as oil, minerals, and manufactured goods for essentially nothing. For them, it makes no sense to allow this to continue.

The end result is the presence in the room of another six hundred pound gorilla, gold. I am not talking about gold as a commodity, but rather gold as a currency. Note that over the last year, the price of gold has stayed fairly flat while a well-known commodity index, the CRB, is down more than 25% in value. Reportedly, former Federal Reserve Chairman Alan Greenspan supported this view last November when he said, “Gold is still a currency. “ He went on to refer to it as the “premier currency.” In that vein, for a multitude of reasons, we are seeing some rather interesting actions taking place around the world recently by central banks, most of which have not attracted a great deal of notice in this country.

In January of this year, the Bundesbank announced that in 2014 it repatriated 120 tons of its gold reserves back to Germany, 85 tons from New York and the balance from Paris. Of more interest, IN TOTAL SECRECY, the central bank of the Netherlands repatriated 122 tons of its gold from the New York Federal Reserve, which it announced in November of 2014. The Dutch rationale was explained as part of a currency “Plan B” in the event the Netherlands left the Euro. But it still begs the question as to why two of the strongest economies in Europe would no longer want to leave some of their gold reserves on deposit/storage in New York. And why are Austria and Belgium now considering a similar repatriation of their gold assets from New York?

At the same time, we have seen Russia, with its currency under attack and not by its own doing or desire as a result of economic sanctions. Putin apparently believes this is a deliberate effort to stimulate unrest in Russia and force him from power (just because you are paranoid, it doesn’t mean you are wrong). As a counter to that, you see the Russian central bank being the largest central bank purchaser of gold, 55 tons, in Q314. Why? He is interested in breaking the petrodollar standard in which the U.S. currency is used as the currency to denominate energy purchases and trade. Russia converts its proceeds from the sale of oil into gold. They end up holding gold rather than U.S. Treasuries. If he is successful, there will be considerably less incentive for countries to own U.S. government securities and for the dollar to be the currency of global trade. Note that Russia has a positive balance of trade with most of its neighbors and trading partners.

Now, my point in writing about this is not to engender a discussion about the wisdom or lack thereof in investing in gold, in one fashion or another. The students of history among you will remember that at various points in time it has been illegal for U.S. citizens to own gold, and that on occasion a fixed price has been set when the U.S. government has called it in. My purpose is to point out that there have been some very strange doings in asset class prices this year and last. For most readers of this publication, since their liabilities are denominated in U.S. dollars, they should focus on trying to pay those liabilities without exposing themselves to the vagaries of currency fluctuations, which even professionals have trouble getting right. This is the announced reason, and a good one, as to why the Tweedy, Browne Value Fund and Global Value Fund hedge their investments in foreign securities back into U.S. dollars. It is also why the Wisdom Tree ETF’s which are hedged products have been so successful in attracting assets. What it means is you are going to have to pay considerably more attention this year to a fund’s prospectus and its discussion of hedging policies, especially if you invest in international and/or emerging market mutual funds, both equity and fixed income.

My final thoughts have to do with unintended consequences, diversification, and investment goals and objectives. The last one is most important, but especially this year. Know yourself as an investor! Look at the maximum drawdown numbers my colleague Charles puts out in his quantitative work on fund performance. Know what you can tolerate emotionally in terms of seeing a market value decline in the value of your investment, and what your time horizon is for needing to sell those assets. Warren Buffett used to speak about evaluating investments with the thought as to whether you would still be comfortable with the investment, reflecting ownership in a business, if the stock market were to close for a couple of years. I would argue that fund investments should be evaluated in similar fashion. Christopher Browne of Tweedy, Browne suggested that you should pay attention to the portfolio manager’s investment style and his or her record in the context of that style. Focus on whose record it is that you are looking at in a fund. Looking at Fidelity Magellan’s record after Peter Lynch left the fund was irrelevant, as the successor manager (or managers as is often the case) had a different investment management style. THERE IS A REASON WHY MORNINGSTAR HAS CHANGED THEIR METHODOLOGY FROM FOLLOWING AND EVALUATING FUNDS TO FOLLOWING AND EVALUATING MANAGERS.

You are not building an investment ark, where you need two of everything.

Diversification is another key issue to consider. Outstanding Investor Digest, in Volume XV, Number 7, published a lecture and Q&A with Philip Fisher that he gave at Stanford Business School. If you don’t know who Philip Fisher was, you owe it to yourself to read some of his work. Fisher believed strongly that you had achieved most of the benefits of risk reduction from diversification with a portfolio of from seven to ten stocks. After that, the benefits became marginal. The quote worth remembering, “The last thing I want is a lot of good stocks. I want a very few outstanding ones.” I think the same discipline should apply to mutual fund portfolios. You are not building an investment ark, where you need two of everything.

Finally, I do expect this to be a year of unintended consequences, both for institutional and individual investors. It is a year (but the same applies every year) when predominant in your mind should not be, “How much money can I make with this investment?” which is often tied to bragging rights at having done better than your brother-in-law. The focus should be, “How much money could I lose?” And my friend Bruce would ask if you could stand the real loss, and what impact it might have on your standard of living? In 2007 and 2008, many people found that they had to change their standard of living and not for the better because their investments were too “risky” for them and they had inadequate cash reserves to carry them through several years rather than liquidate things in a depressed market.

Finally, I make two suggestions. One, the 2010 documentary on the financial crisis by Charles Ferguson entitled “Inside Job” is worth seeing and if you can’t find it, the interview of Mr. Ferguson by Charlie Rose, which is to be found on line, is quite good. As an aside, there are those who think many of the most important and least watched interviews in our society today are conducted by Mr. Rose, which I agree with and think says something about the state of our society. And for those who think history does not repeat itself, I would suggest reading volume I, With Fire and Sword of the great trilogy of Henryk Sienkiewicz about the Cossack wars of the Sixteenth Century set in present day Ukraine. I think of Sienkiewicz as the Walter Scott of Poland, and you have it all in these novels – revolution and uprising in Ukraine, conflict between the Polish-Lithuanian Commonwealth and Moscow – it’s all there, but many, many years ago. And much of what is happening today, has happened before.

I will leave you with a few sentences from the beginning pages of that novel.

It took an experienced ear to tell the difference between the ordinary baying of the wolves and the howl of vampires. Sometimes entire regiments of tormented souls were seen to drift across the moonlit Steppe so that sentries sounded the alarm and garrisons stood to arms. But such ghostly armies were seen only before a great war.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. Until January of 2012, he was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the eleven plus years that he was in that role, the fund increased more than 35 times in size. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the aerospace & defense, financial services, and spirits & tobacco industries, having followed and owned companies as diverse as Alliant Techsystems, Catellus Development, GATX, General Dynamics, InBev, Kirby, Legacy Hotels, L-3, Nestle, Partner Re, Philip Morris International, Progressive Insurance, Rockwell Collins, Safeco Insurance, Teledyne, Textron, and UST. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing from Northwestern University. A Chartered Financial Analyst, Ed belongs to the Investment Analyst Societies of both Boston and Chicago. He is admitted to the Bar in Illinois, the District of Columbia, and North Carolina.