The letter below came from a Gowdie Family Wealth reader recently. Since the answer has a lot to do with my current strategy for Aussie investors, I thought I’d answer it here.
‘I’ve been wondering about the parlous state of the US economy – if/when it goes kaput will the Aussie $ strengthen against the greenback?
With the debt ceiling issued now settled (at least until Feb 2014) things will continue as before – more excessive spending financed by the Fed’s $85 billion per month asset purchases.
Yes the US is in a parlous state, however my theory is GFC Mk II will not come from the US. There are countries in a far worse position than the US that I think will crumble well before they do. Japan, Italy, Spain, Greece and more importantly France are so far down the ‘debt hole’ that there is no coming back.
The ageing demographic in Japan is a real worry; lower tax revenues + higher entitlement spending is a no win equation for a country with public debt nudging 250% of GDP.
The southern European states and France have an embedded socialist culture. Again, retiring boomers are going to test the elasticity in these countries’ welfare and healthcare budgets.
Based on nothing other than history my forecast is that the spark which sets fire to the global debt tinder is going to come from a source no one is really looking for. The surprise factor is what throws markets into a death spiral.
Expect the Unexpected
Look at the US share markets over the past few weeks leading up to the debt ceiling ‘crisis’. Yes, they were down a few hundred points. But nowhere near the 6,000+ point fall that accompanied GFC Mk 1.
This tells us the market was a little concerned but not overly worried. Everyone was looking in the direction of the debt ceiling ‘crisis’. It was not an unexpected ‘crisis’.
Ironically, the one we have to worry about is the one we don’t know about – as illustrated by former US Defence Secretary Donald Rumsfeld’s famous line about the ‘unknown unknowns,‘ which leads me to answer your question regarding the USD versus the AUD.
Here’s the important part:
IF (and that’s all I can go by is IF) the next financial crisis is sparked beyond the shores of the US, there will be a scramble to buy USD as investors rush to the perceived safety of US Treasuries. Yes these are the same Treasuries that up until last Wednesday may have been defaulted on – the markets are so fickle!
This is what happened in GFC Mk 1. Nearly every currency fell against the USD as money poured into the US Treasury market. At one stage, investors were buying negative yields just to have the security of a US Treasury Bond.
So while the US economy is rickety, there are others on a far less stable footing that I think will topple well before the US. The domino effect should see the USD strengthen significantly.
My assessment could be wrong. However, the odds of the US being the first to teeter are, in my opinion, low. The Fed can print money till the cows come home, whereas most other sovereigns (especially those with a history of default) are more likely to shirk their bond holders and in turn spark a rout in the bond market.
Time will tell but I am still comfortable with holding US dollars at this stage. The Reserve Bank of Australia will also want our dollar sub-90c to restore some competitiveness to our manufacturing industry. In fact, don’t be surprised if the RBA starts participating (via dollar selling) in the global currency war (the one no G20 official speaks about.)
The skittishness we have witnessed is all part of the theatre that accompanies the growing instability in the global post-GFC economy. Anyone with a passing interest in markets and the economy either consciously or subconsciously knows the system is being propped up rather than genuinely recovering.
Eventually something gives and I suspect it is going to be a left-field event. Waiting and watching for this debt drama to play out is never easy. Each day feels like a week. This is why patience (together with cash) is the greatest asset for prudent long-term investors.
Contributing Editor, Money Morning