August Strategy Meeting

Decoupling is DifficultFor historical reasons US Treasury securities are considered among the soundest investments in the world. As such their valuation has been a reliable indicator of how the world perceives the USA. If the current indication is to be believed than the USA is currently enjoying the height of solvency and safety! After all, treasury yields are at all time lows while their corresponding prices are at all time highs. US Treasury securities have also acted as a lubricant which allowed globalization to seep around the world. At its heights in the year 2000 the US dollar, and related short term US Treasuries, accounted for as much as 75% of global currency reserves. This allowed for predictable US dollar denominated trade and the ‘export’ of the USA economic and political will. Because there were three massive economic shocks over the past ten years which caused general economic hardship nearly the world round, many believe that globalization is here to stay. Perhaps now is a good time to reconsider this assertion.

Some Cracks Appear

The US dollar has been in decline versus a basket of global currencies for some time. This is not a good long term trend as the USA is losing its purchasing power which will eventually lead to a loss of influence. One positive side effect is that folks with stronger currencies can purchase more US Treasuries as the US dollar declines in value. During the 2000s, the USA massively expanded its indebtedness by selling Treasuries. Thankfully the dollar is still considered a safe harbor.Federal Reserve Trade Weighted Exchange Index: Broad

A mountain of articles have been written about how interconnected the world economy has become as a result of globalization – which is led by the lubricating role of the US dollar in finance and economics. While it has been an advantage to participate with the USA during the recent unparalleled period of prosperity, it will be even more important for those same countries to avoid the debilitating effects of debt deleveraging that must take place. It appears that several countries have already taken matters into their own hands by steadily insulating themselves against the USA economy. China is one such case in point (chart, above). In short, the USA is just not as important to China as well as various other developing and emerging economies as it was a decade ago.China's Insulation Against the U.S. Economy

While using the example of China, it is important to mention that they have been reducing their exposure to US Treasury holdings over the past few months (3.6% decline in May and 2.7% decline in June). Of additional concern is that they are reportedly swapping longer maturity for shorter maturity Treasuries – thus their ‘commitment’ to the USA is becoming shorter than it once was. These statistics are doubly important when it is considered that in proportion to total Chinese currency reserves, the US dollar has been declining in weighting.US Treasuries held by China

Finally, we have noted for two years that businesses in the USA have not been setting aside enough money to cover depreciation of their plant and equipment. So while the press has reported that some companies have cash piling up on balance sheets, it is really already spoken for and will be required to maintain and upgrade their operations. More alarming, this past month marked the first time since World War II and the Great Depression where USA businesses saw a contraction in capital stock. Capital stock is the total physical stuff that businesses employ in order to produce goods and services. Apparently the economic outlook is considered so bleak by the captains of industry that the same companies with cash available on their balance sheets are choosing not to invest it. The effects of this type of decision making likely indicates that a renewal of the current deep economic contraction is close at hand.

A Stinky Flotation Device?

A friend recently shared a terrific metaphor. It’s a picture of being afloat at sea with a really terrible smelling and textured flotation device acting as the only means to keep from drowning. While the floatation device may be especially revolting, it is hard to abandon when someone shows up with a life raft. After all, it is what has gotten you this far – and its familiar. Humans are creatures of habit.

Considering that the US dollar as well as US Treasuries have for so long served as bastions of safety, it is unimaginable by many that these same securities just might be slowly morphing into something revolting. The charts in this Strategy Update detail how countries representing 46% of global economic output are reacting. They are selling their US dollars, reducing their dependence on the USA and Europe, and reducing the relative importance of US Treasuries to their foreign reserves. We firmly believe that these are the first signs of a move to unwind globalization across the planet. While the process is in its infancy, it appears that decoupling is very much alive. It just will take some time. We have been, and are, taking steps to make sure that your portfolios are appropriately positioned for a more regionalized world.