Dear Fellow Investors:
At Smead Capital Management, we believe the interest on September 18th in emerging markets, oil and gold are the last gasps of a dying trend. Our discipline demands that you must avoid popular investments and completely avoid investments attached to a perceived “new era.” We argue that the international investment markets reaction to Bernanke’s reprieve on September 18th is proof of a vision we have of the future. Here is what Brendan Conway shared on his September 27th “Focus on the Funds” Blog at Barron’s:
New data from Lipper show just how eagerly investors responded to the Federal Reserve’s decision to leave out the monetary punch bowl: $34.6 billion in fresh money for mutual funds and ETFs for the week ending Sept. 25.
The biggest net new money flowed to risk-loving ETFs iShares MECI Emerging Markets Index ETF (EEM), 1.6 billion, and Market Vectors Gold Miners ETF (GDX), $900 million.
We believe that the easy money policies practiced by the Fed have both laid the groundwork for the US to rebound and have simultaneously allowed a dramatically over-cooked trend to continue long after it should have ended. We believe that our easy money in the US has allowed the day of reckoning for the “global synchronized trade” to be pushed back in the same way that the Y2k rollover date elongated the tech bubble in 1999-2000.
To understand why we believe that the end of QE and other accommodative policies by the Fed will be the death knell of the “global synchronized trade,” you have to look at what has happened since October 24th, 2012 when the Japanese openly declared war on Yen strength. The Yen was purposely weakened from 80 yen/dollar to 100 in a matter of less than a year. Since then gold, commodities and emerging stock markets have performed very poorly compared to developed stock markets like the US, Japan and Germany. All of this is incredibly important because the Chinese have pegged their currency (Yuan) to the US dollar. OUR VIEW IS THAT ANYTHING WHICH CAUSES THE US DOLLAR TO BECOME SIGNIFICANTLY MORE VALUABLE IS A CURSE TO THE GLOBALLY SYNCHRONIZED TRADE! We think the Fed, by allowing the open market to set interest rates over the next three years, lays the groundwork for both higher interest rates and a significant attraction from international investors to the US dollar.
A quick lesson in international economics is needed at this point. Under the gold standard, if a country boomed like China it would have taken in a massive amount of gold. Your money supply was completely a function of how much gold you had. Therefore, as your economy boomed, your prices would inflate as the money supply grew. Your trading partners would be tortured by the exact opposite circumstance. Their lack of gold would cause their money supply to contract and they would see falling prices in their own country and would be in no position to buy the goods from the trading partner who had boomed. Therein lies what business cycles looked like before 1971 when the US went off the gold standard.
It seems to us that currencies now serve the purpose that gold use to serve. If your economy booms, then your currency will theoretically soar in value as trading partners buy your currency to purchase your produce. Most likely, the currency of the countries which feed the booming country its inputs soar in value as the boom country buys your currency to purchase the inputs. Commodity-producing nations boom at the expense of commodity-importing nations until the currency values change enough to make this virtuous circle break.
We contend that Federal Reserve Board Chairman, Ben Bernanke, gave everyone outside the US a temporary reprieve by postponing the initiation of the removal of the Fed’s easy money policies. Beginning in 2008, and accelerating since then, the Fed has used a zero fed funds rate, a low discount rate and a massive bond-buying program in an attempt to stimulate the US economy. Bernanke is America’s foremost expert on the Great Depression of the 1930’s and has sought to do things correctly which were handled mistakenly back then. The deep recession of 2007-2009 was contained to unemployment just above 10% and the US economy has been slowly but surely recovering.
While he did this, a world of much different and more exciting things were going on in the emerging market economies, in commodities and in emerging stock markets. China grew its GDP at a rate of 10% compounded for 30 years with nary a recession. Oil rose from $11 per barrel in 1999 to $145 in 2008. Gold rose from around $250 in 1999 to a peak around $1900. Major commodity-producing countries like Brazil, Australia, Russia and Canada boomed on the back of China’s success as they fed inputs into the Chinese economy. Institutional and individual investors in the US poured billions of dollars into emerging market mutual funds and ETFs, international bonds/bond funds and gold in response to what they observed. It seemed that a new era of globalism was upon us and the sense of being a pioneer for investors was truly evident.
In today’s post-gold-standard world, the currencies of the countries which fed China’s boom like Australia and Canada have seen huge currency strength in relation to the dollar, just as the textbooks say they should have. I can remember not too many years ago that the Canadian dollar traded for 65 cents. It is over 100 cents today. The Australian dollar was 108 cents per US dollar as recently as two years ago. However, China’s currency has not appreciated measurably versus the US dollar despite amassing $3.5 trillion in foreign currency reserves primarily held in US dollars at the New York Branch of the Federal Reserve!
Our vision is that somewhere in the process of the US Fed pulling away from QE and ultimately allowing the open market to set short and long-term Treasury rates, the US dollar will soar, commodity prices will plummet and China will have its first full-blown business cycle. Commodity-producing nations will see their currencies decline and the US will enjoy a stimulus that no politician can create. Lower input prices like gasoline will join favorable demographics, historically-affordable housing, well-financed banks and historically-strong household debt service ratios to lead a very elongated period of economic growth. Lastly, because China has chosen to postpone their business cycle, the next one will be a whopper. We believe the next twenty years in economic history belong to the US, not to China.
Best Wishes
William Smead
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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