The U.S. has competitive advantages globally that are rooted in its geography, but the reason the U.S. dollar became the world’s reserve currency is that America has had the largest, strongest (steadily growing and conservatively financed) economy and a stable political system (anchored in the U.S. Constitution).
Yet for the dollar
to continue to be valued, the world has to believe in it. Since the end of World War II that’s been the case. People basically looked at the U.S. and many of them concluded that it was the safest place to keep their savings. They didn’t have to worry that if they put their money in the U.S. dollar it would lose its value. The dollar was not going to be diluted by hyperinflation or burned up by a foreign- or civil war. The U.S. political system was stable and strong, and people didn’t have to worry that at some point they wouldn’t be able to take their money out of U.S. banks.
The problem with being the envy of the world is that it changes your behavior. You start believing that you are very special for reasons that are not grounded in reality. You start believing that bad things happen only to other people and nations because they are not as special as you. You can do anything you want — borrow and spend as much as you like — and nothing bad will happen to you. This behavior in turn starts to undermine the core reasons why people trusted your country and currency to begin with.
This is what is now happening to the U.S. In 2020 the ratio of U.S. debt to the output of the economy (debt to GDP) is likely going to exceed 120% (and might be as high as 130%). You can blame the coronavirus pandemic for some of that, but the national debt has been going up steadily. The U.S. has run huge budget deficits in bad times and in good, long before the virus.
The capitalist U.S. is more indebted than the ‘socialist’ EU.
In 2000, U.S. debt was $6 trillion — a 30% debt to GDP ratio. It was $14 trillion in 2010 and $23 trillion in 2019, increasing $1 trillion a year while the U.S. economy was booming. Or maybe this is why the economy was booming. The U.S. was charging $1 trillion a year, year after year, on its national credit card to buy things and to engineer this growth.
By 2019, 10 years after the Great Financial Crisis, the Fed was still running its policy of quantitative easing. Debt to GDP at that time topped 100% — eclipsing the EU’s ratio of 86%. (Yes, the capitalist U.S. is more indebted than the “socialist” EU). We have not acutely felt that debt burden, because interest rates declined over the last two decades.
Then COVID-19 arrived. The U.S. has spent 12% of GDP (so far) to keep its economy afloat during the shutdown — twice as much in terms of GDP as the rest of the world, four times as much as the largest European countries, three times as much as Japan.
Our debt has skyrocketed by perhaps another $6 trillion — it’s too soon to tell. The Fed already owned $2.5 trillion of U.S. government bonds in 2019, and now it owns $3.7 trillion worth and is a buyer of U.S. corporate bonds and ETFs. Stocks are likely to be next.
Credit rating agencies have put AAA-rated U.S. government debt on “negative watch,” signaling a possible downgrade.
Consequently, credit rating agencies have put AAA-rated U.S. government debt on “negative watch,” signaling a possible downgrade. Countries that borrow in their own currency don’t default on their debt, at least not by failing to make payments. Instead, the U.S. would “honor” its obligations via massive money printing, which could bring massive inflation and tank the U.S. dollar (who wants to own a currency that buys less and less?). God help you if you reached for yield and loaded up on long-term bonds (a trade that minted money for the past 30 years). Long-term bonds will be widow-makers in this scenario.
Capitalism and its discontents
But the large pile of U.S. debt is only part of the story. In the largest economy in the world, the staunchest advocate of free markets, the cost of money (arguably the most important commodity) is set by a dozen economists. (Think about that when you hear the U.S. calling another nation a manipulator of its currency.)
In 2020 the social fabric of American society is tearing apart. It is our tribe against their tribe. Every time you think the toxicity of our politics cannot get any worse, it does. Unlike in the country that came together during World War II or 9/11, this time the coronavirus has pulled us further apart. It doesn’t look like the outcome of the 2020 election will change that, and so the inertia of the past 20 years will persist.
The world used to look at the U.S. as the global leader, as a moral compass. Let me put it this way: if Martians landed on Earth today and took a careful look at Americans’ behavior, I doubt they’d conclude that we are the shining light of democracy.
This is incredibly difficult to write, but bad things don’t just happen to other countries; they can happen here too. America’s response to COVID-19 is a visceral reminder of this. We’d like to believe the U.S. is special, and it is special to us, but the laws of physics are not suspended here, and neither are medical and economic principles.
Though the U.S. dollar is unlikely to lose its reserve currency status in the near future — for no other reason than that there are no better alternatives (every contender has problems of its own) — the strength the dollar has experienced over the past decade will likely fade.
The virus has accelerated trends already in place — it has hastened the beginning of the end of globalization. Globalization was a tailwind to the U.S. dollar in its role as the central medium of global exchange, and deglobalization (localization) has the opposite effect. We are also knee-deep in a cold war with China.
There are so many reasons why I don’t want to like gold.
The dollar’s decline may bring higher prices, higher inflation (we are a net importer), and higher interest rates (the Fed will try to squash interest rates, until it cannot). In my firm’s portfolios we are already partially positioned for this shift by owning foreign stocks — a weaker dollar means foreign company earnings will go up in the U.S. dollar terms.
But there is another asset we’re buying — gold
This is something we have resisted doing for a long time. There are so many reasons why I don’t want to like gold: I have no idea how much it is worth (it doesn’t have cash flows); it is a medieval relic, and it has no productive value — it just sits in the vaults of central banks or under mattresses.
But gold hedges our clients against two scenarios: a weaker U.S. dollar and the debasement of all currencies (the dollar declines and so do other currencies). Dollar outflows will be looking for homes. Some money will flow into euros, British pounds, and Swiss francs, and some into gold — an incorruptible asset class (central banks and politicians cannot create more gold).
In the past our justification for not owning gold was that we’d rather own good companies, and we’ll continue to do that. Gold will become just another position in our portfolios — an unloved hedge. Meanwhile, the U.S. will have its challenges and will adapt to them. As investors, we will adapt as well — we just like to be early.
So, how does one invest in this overvalued market? Our strategy is spelled out in this fairly lengthy article.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver. He is the author of “The Little Book of Sideways Markets” (Wiley).