Much has been said and written about the US budget and trade deficits and that, as a consequence of these, the US dollar is following a one-way street down hill. After all, even the richest of the rich (source: Forbes), Bill Gates of Microsoft and Warren Buffett of Berkshire Hathaway are short the greenback, diversifying or hedging their bets into other currencies. However, to take the euro as the most eligible alternative currency to protect against further depreciation of the US dollar has not been a profitable trade for most of the period since the beginning of 2004. While the calendar year 2004 saw the euro appreciate by 7.9%, the first half of this year saw a loss of 8.2% which took one back to square one. To make things worse, since the Fed raised its benchmark interest rate any euro hedging now comes at a cost. In the meantime, this interest rate gap has widened further in favour of the US dollar. To be sure, this is not designed to make a case for the euro, but rather bring into question the hasty conclusions of some managers about how to tackle the task of diversification in general and whether or not currency diversification brings specific advantages.
Let's take a look at the performance of various non-US dollar denominated asset classes over the same time period as above. Of particular interest here is the comparison of US blue chip equities vs. European or Japanese large caps and US high-grade fixed income securities vs. European or Japanese top rated bonds. The charts (opposite) show that diversification in both European government bonds and European equity was indeed a worthwhile exercise, resulting in capital gains in excess of 2% to 10% compared to the respective US Treasury or S&P500 Index returns.
Noted the time period covering 2004 and early 2005 doesn't include any specifically dramatic event. In fact, the last 12 months go into the history books as one of the calmest periods as measured by equity and bond market volatility. Hedge Funds in particular have come under increased scrutiny as they are supposed to be the ideal "all weather" diversification instrument. After all, their absolute return approach combined with historically low correlation to traditional asset classes is the industry's hallmark marketing pledge.
It is exactly the question of correlation that is of great concern when we put together various asset classes in a global portfolio. Increased East-West trade imbalances lead to commercial capital shifts out of the US that will have to be compensated by equivalent financial capital into the US. An expansive fiscal policy combined with laissez-faire consumer spending leading to record low household savings is only exacerbating the problem. This topic is of course widely discussed in the international press and there is not much to add. What we find less in the headlines is the issue of a potential residential housing market bubble in the US, a bursting of which could lead to widespread and global financial market reaction. Even the minutes of the May 3 FOMC meeting, issued recently, addressed the issue as follows: "...a number of local real estate markets were still regarded as 'hot', with signs of possible speculative excesses in some areas." This was the first time that the FOMC had made such a clear statement without dismissing the trend as either geographically isolated or temporary. In this context, a rise in the monthly announcement of housing starts should not be viewed as a positive development. More and more buyers are reported to be investors as opposed to people who intend to take up residency in the purchased property. Estimates by certain real estate agents put the number of investors as high as 70% to 80%. On top of that, according to the Mortgage Bankers Association (www.mbaa.org), adjustable-rate mortgages and interest-only products accounted for 63% of mortgage originations in the second-half of 2004. The MBA survey represents about half of the mortgages originated last year. The switch from fixed-rate to adjustable-rate mortgages is a typical sign at the end of a refinancing boom as many home owners and investors prefer the (currently) lower rates as it reduces monthly capital outlay. While such behaviour is of course legitimate it comes with two relevant caveats. First, equity extraction from refinancing and savings from lower monthly capital outlays for mortgage payments should not be viewed as unencumbered. They should lead to increased savings rather than one-for-one dollar consumer spending. Second, such financing patterns are only sustainable as long as long-term interest rates don't rise. And here is the crux of the matter: as long as interest rates remain low and consumer spending high, expectations for ever higher property prices will only accelerate investment interest. In a classic bubble then, the clever (or lucky) ones among them will be able to find the next fool to pay an even higher price for an asset that nobody really actually wants or needs. When the bubble finally bursts, the implications will be most hard felt by the bankers who are left in the rain with outstanding non-performing loans. That brings us to potential international financial market contagion and the question whether one could possibly diversify such risk away. After all, in times of crises correlation among markets tends to increase, distorting the intended diversification benefits.
Nevertheless, in order to fully appreciate and exploit the benefits of diversification we just have to observe a small number of basic rules. Boom, distress, and panic are transmitted between national economies through a variety of connections: arbitrage in commodities or securities, movements of money in various forms, interest rate changes through arbitrage or co-operation among monetary authorities, but also, pure psychology. The Fed's monetary policy and equity prices on Wall Street are readily accepted as global barometers as to what the financial market conditions might be in other markets, at least in the short-term. Short-term correlation, therefore, will always be higher, and also more erratic or random, than medium- or longer-term correlation. This spells rule number 1 in diversification: time matters - what may be highly correlated today may not be equally-related tomorrow. Again, psychology is a factor that is widely responsible for markets moving in tandem in case of an unexpected event or a shock. Diversification benefits are exploited over time as financial instruments like currencies, stocks and bonds gravitate toward their medium-term trends reflecting more appropriately their fundamental values. Rule number 2: diversify broadly - tells us to consider all available asset classes, domestic and international, big and small, high-grade and lower quality, developed and emerging markets and including alternative investments like hedge funds and private equity. This may seem obvious but we recognize in our daily lives as investment advisors that such benefits are readily dismissed by investors who point out the risks involved in some of the specialist or satellite asset classes like high-yield or emerging market debt or emerging market equity. Ironically, fund-of-hedge-funds have now become almost a mainstream diversification tool in global portfolios while only seven years ago, during the hedge fund and emerging market crisis of 1998, the industry'zs survival was questioned by many. And last but not least, rule number 3: Rebalance - in direct relation to the time and scope issues of rules 1 and 2, instead of jumping in and out of asset classes it is highly recommended to maintain a strategic structure while taking advantage of the sometimes wild fluctuations within or among certain sub-classes. Many times, such rebalancing exercises go against our intuitions, and our feelings toward certain assets under certain market conditions. But history has proven that a systematic approach will lead to long-term success. Long-term success means preserving wealth through difficult periods (including protection against inflation) as well as achieving capital gains. At LGT we do follow such simple but not always intuitively obvious investment rules and we have a number of tried and tested funds that have proven to deliver the promises of wealth preservation and capital appreciation.
Whether the US dollar continues its multi-year decline or will stage a turnaround in 2005, whether or when the US property bubble bursts, whether yields rise or equity markets fall, we believe the benefits of diversification will overcome the short-term implications and, yes, this will eventually provide a hiding place from any crisis.