Current Market Conditions And Currencies

Hey, The Investor’s Podcast Network Community!

For years, financial experts have been lining up to tell the public what is wrong with our current monetary system, and it seems like the uproar has exploded over the last few months. Preston and I are also very vocal with our criticisms of the excessive money printing and how unsustainable we see it in the long run. You can find Preston’s thoughtful write-up about this here.

Today, I’m sticking my neck out and providing my thoughts on what I think will happen in the next decade. However, I want to go about it differently. I will not talk about why the system is broken. Instead, I will talk about what I think is most likely to happen and, in turn, the implications for us as investors.

It’s well over a century ago that the US overtook UK’s position as the world’s largest economy. However, it still took many decades before the US dollar arguably became the dominant world currency that it is today. It happened in 1944, when the Bretton Woods agreement was ratified. The US dollar was pegged to gold at $35 per ounce, and all other major currencies were pegged to the US dollar. At the end of the war, European countries were highly indebted. They transferred large amounts of gold into the United States, which at that time was the only country with a currency backed directly by gold. Back then, the US had 75% of the world’s monetary gold.

Ever since Nixon took the US off the gold standard in 1971, it’s been debated endlessly if our current fiat-based monetary system will break down and if we will revert to a gold standard. As difficult as it is to allocate percentages to that scenario, the probability of that happening in the next decade is, in my estimate, only about 1-5%. Why would I say that when pundits around the world had predicted the end of the monetary system for years and today, more than ever, argue that it will happen sooner rather than later?

Let’s take a step back and look at the fiat-based reserve currency system we have today. Then, let’s take a look at the global reserve currency system. Today, central banks mainly hold three currencies in their foreign exchange reserves: USD (61%), EUR (21%), and JPY (6%).

The advantage (but also the disadvantage) of fiat currencies is that you can’t default on your debt since you can always print more money. The US has not been shy doing that and has now reached a level of debt-to-GDP ratio of 107%, which will only accelerate with the COVID-19 crisis unraveling. From just a 32% debt-to-GDP ratio in 1981, we’re now at the highest level since the end of the second world war.

However, when you are a major global reserve currency, you’re playing by different rules than other countries since you borrow and print in the same currency. It’s not so much the exact debt ratio that is important; it’s whether investors and institutions will lose faith in the US dollar and stop seeing it as a reliable store of wealth. No other fiat currency is in a position to replace the US dollar at the moment. For instance, no other country has a deep and liquid bond market like the US, which is required for another country to step in with their currency.

I also do not see a gold standard as a realistic alternative for several reasons. One is the simple fact that the US, if left with a choice, has no incentive to go back to a gold standard. Being pegged to gold is essentially the same as being pegged to a foreign currency. You also restrict your tool kit dramatically. Therefore, the US would relinquish a lot of its control of the current monetary system if it accepted a gold standard. The eurozone has more gold than the US; China is the world’s biggest producer of gold; Russia and China are the two countries that have been accumulating the most gold in the world in recent years. The US has even less incentive when you add to the equation that it has a major trade deficit that would deplete gold reserves.

Aside from gold bugs, I have a hard time seeing who has an interest in reverting to a gold standard over the next decade. Europe is, if not happy, quite pleased with the current situation compared to the alternative. Japan and China have no interest in a new monetary system anytime soon. The two of them combined own more than $2T of US treasuries. They need the US and Europe to buy their goods whether or not it’s fueled with credit. They are also very realistic about not being able to offer a global reserve currency system alternative at the moment.

Many have intellectually argued that currencies with a fixed monetary baseline, whether it’s gold or even bitcoin, will solve our problems. I hear the arguments and agree with many points. However, I find the discussion incomplete. Don’t be fooled. There is no such thing as a “perfect monetary system.” A fixed monetary baseline doesn’t solve our problems either. It just gives us another set of problems that may or may not be better. It all depends on which problem you’re trying to solve.

The best example is when the US was taken off the gold standard in 1933, which was arguably the key to recover from the Great Depression. While on the gold standard, the FED had to hike rates to maintain the peg to gold. This was during a time when the economy desperately needed more liquidity and was expanding its monetary baseline. If we had been on the gold standard before COVID-19 brought the world economy into a depression, it would have been much worse. On the other hand, Weimar Republic in 1924 (Germany today) could not have stabilized the “rentenmark” if they hadn’t effectively pegged their currency to gold. Two different problems with two different monetary solutions.

But let’s assume that a fixed monetary baseline would solve the problems we’re facing. How would you invest differently then? Perhaps, the surprising answer is that the optimal strategy doesn’t change. As investors, we shouldn’t base our strategy on what we think or hope would be the optimal monetary system. Rather, we should base our strategy on a correct analysis of what is most likely to happen and position ourselves accordingly. As we quickly learn as investors, just because we want something to happen doesn’t make it so.

It has always been difficult to read the label from inside the box, especially when we are continuously bombarded with information that makes us think our monetary system will change tomorrow. The key takeaway from this newsletter is that it won’t happen anytime soon, simply because the incentives are not aligned for it to happen. Time being infinite, it will of course eventually happen. Billionaire and hedge fund manager Ray Dalio has conducted a study and found that empires typically last for 250 years, give or take 150 years. Not surprisingly, this also implies that the US dollar won’t be the dominant currency in the world forever, just like how the British pound and the Dutch guilder were overthrown in the past. While the US is not in the same dominant position as it was after the second world war, when we zoom out, we quickly realize that major changes in our monetary system happen over multiple decades and centuries.

So what is the implication for you as an investor if we accept the premise that the monetary system we have today won’t change anytime soon?

There is no doubt that the money printing we see today is happening at a ridiculous rate. Debt accumulation will also continue as the global economy is working through the repercussions of COVID-19. At some point, we will see a major deleveraging, which will likely include a major redistribution of wealth. Eventually, though not anytime soon, we will have a new monetary system. As unsustainable as US’ debt-to-GDP ratio of 107% sounds, it can go on a lot longer than most people think. Japan’s debt-to-GDP ratio is 238% and is expected to reach 250% at the end of the year for the same reasons mentioned in this newsletter.

I would be highly surprised if we experience hyperinflation in the US or the eurozone, even though we see heavy money printing right now. Trillions of dollars have been added to the economy, but trillions of dollars have also vanished due to the current crisis. Actually, as I already mentioned in the discussion I had with Preston about current market conditions back in March, I fear deflationary forces to dominate.

As readers and listeners would know, I’ve for years talked about how and why I’ve accumulated US dollars — I expected that we would experience a dollar shortage when the next major crisis happened. So far, my investment thesis has proven true. And with a strong dollar at my back, I’ve started to diversify my portfolio by adding to other currencies and equities now trading at more attractive prices internationally.

In times of deflation, currencies become more attractive since you’ll effectively increase your purchasing power just from holding cash. You may be wondering if that also includes currencies such as gold. Going all the way back to the 17th century, deflationary periods have always been an attractive time to own gold. Furthermore, the upside can be very appealing, especially if we were to revert to a gold standard.

The US, the eurozone, China, and Japan own 33,000 tons of gold combined. Given that narrow money is $24T and the gold standard has previously shown to be stable when 40% of paper money is backed by gold, one could make the argument that an ounce of gold could potentially be worth roughly $10,000. Still, it will likely not happen unless we do revert to a gold standard.

As I mentioned above, I deem the probability of that happening in the next decade to be very low. Though still a real possibility, I estimate the probability of that happening to be between 1-5% only. Therefore, you can consider having a small allocation to gold in your portfolio to hedge your equity exposure and as protection if we would experience unexpected hyperinflation.

In our latest podcast episode, which came out just two days ago, Preston and I discussed in detail how we see the future of the monetary system would be and how we have positioned ourselves. Stay safe.

Your Friend,

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P.S. I’m so grateful that I always get so much great feedback on the newsletters. As we’ve grown — our show now has more than a million downloads per month — it has unfortunately been increasingly hard for me to keep up and respond to all of my emails. I’d love to continue interacting with you, so if you want to discuss investing with me, please post your questions and comments on our forum.

P.P.S. Preston and I are looking for a podcast host for our new show “Intrinsic Value Podcast.” In this show, the host will analyze a new stock, industry, or the current market conditions every week. You can read more about the position here.