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The undercurrents of war and economics are mysterious:
The official line from the United States and the European Union is that Tehran must be punished for continuing its efforts to develop a nuclear weapon. The punishment: sanctions on Iran’s oil exports, which are meant to isolate Iran and depress the value of its currency to such a point that the country crumbles.
But that line doesn’t make sense, and the sanctions will not achieve their goals. Iran is far from isolated and its friends – like India – will stand by the oil-producing nation until the US either backs down or acknowledges the real matter at hand. That matter is the American dollar and its role as the global reserve currency.
Guest post by Axel Merk & Kieran Osborne, CFA, Merk Funds
January 5, 2012
In 2012, policy makers around the world may be driven by the realization that the theme of 2011 was not a Euro-specific crisis, but simply another stage in a global financial crisis. Central bankers may ramp up their printing presses in an effort to limit “contagion” concerns. As such, the currency markets may be the purest way to take a view on the “mania” of policy makers. Market movements may continue to be largely driven by political rhetoric, rather than company earnings announcements or economic data. We don’t believe this trend will abate over the foreseeable future, especially given the likely leadership changes throughout several G-7 nations.
The primary motivating force behind politicians’ decision-making may be quite different, and more often than not, at odds with those of the broader market or sound economic fundamentals. Moreover, we have witnessed an unprecedented period of political posturing and increased polarization of views. This has only served to underpin the increased levels of market volatility experienced in 2011.
Central banks of the U.S., Japan and the U.K. have shown they are most willing to put in place expansionary policies. For one, there will be a more dovish composition of Federal Open Market Committee (FOMC) voting members in 2012. Many Western and Asian policy makers have already begun to ease. From a currency perspective, we believe these dynamics will serve to benefit the currencies of commodity producing nations, while underpinning Asian economic growth.
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Local agitations…
The European sovereign debt crisis dominated headlines for much of 2011. Market practitioners traded on the back of any change in sentiment regarding the ability of policy makers to put in place comprehensive measures to address the issues. Initially focused on the nations of Greece, Ireland, Italy, Portugal and Spain, the crisis quickly grew to engulf many core European countries, even having an effect on stalwart Germany, which suffered a failed bond auction towards the end of the year. Nonetheless, sovereign spreads over corresponding German bunds were used as a bellwether for market-ascribed fiscal health of European countries; we saw many spreads widen markedly during 2011.
Any communication from Germany (Merkel) and France (Sarkozy) was closely watched. Colloquially known as “Merkozy,” the two leaders took it upon themselves to meet ahead of important EU summits to set the stage for subsequent discussions amongst Heads of State. Notwithstanding, differences in culture and communication only added to market uncertainty. On the one hand, the French approach appeared to set the bar high, providing optimistic assessments on the outcome of upcoming meetings. In contrast, the Germans tended to be the polar opposite, managing expectations to the downside. More broadly, the differences in cultures and motives across Europe were epitomized when, after EU leaders painstakingly came to agreement on measures to address sovereign debt risks in October, then-Greek Prime Minister Papandreou announced a surprise referendum to vote on whether the Greek populace backed implementing the austerity measures that were just agreed on. Many in Europe took this as a slap in the face. After all, amongst the agreed upon measures was a 50% “haircut” to be applied to Greek government bonds and an additional injection of €130 billion into Greece. Not surprisingly, Merkozy told Papandreou, in no uncertain terms, that if he was to go ahead with the referendum, then the Greek populace would have to be asked whether Greece should remain part of the EU and the euro, and by the way, Greece would not receive any aid until the referendum results were finalized, as there was no certainty that Greece would still be a part of the EU. Not surprisingly, Papandreou backed down from the proposed referendum. Ultimately, though, he probably got what he wanted: to resign and leave the debacle behind him, but not before giving the markets a heart attack in the process.
The above example is indicative of the varying motivations that influence different factions within the EU (not to mention Italy’s Berlusconi, or the U.K.’s recent decision to veto proposed EU-wide fiscal changes). Moreover, it is not a Europe-specific trait, but a global one: look at the debt ceiling debacle as a prime example of the shambolic state the U.S. political system finds itself in. Indeed, that event prompted S&P to subsequently downgrade the credit rating of the U.S., citing politicians’ inability to come to an agreement when it was most needed, as a leading cause. This severely affected market optimism and confidence, further weakening the market’s trust in politicians. Compounding matters, Moody’s moved the U.S. credit outlook from “stable” to “negative” on the back of the “Super Committee” failing to come up with anything regarding a sustainable long-term fiscal outlook. Political bickering is nothing new, but it appears we have entered a period of increased polarization. Importantly, this dynamic is unlikely to abate over the foreseeable future. Unfortunately, it is likely to result in ongoing market confusion and enhanced levels of volatility into 2012.
Ongoing political uncertainty is likely to continue to weigh on markets. With ongoing financial tensions in Europe evolving into contagion risks to global economic growth, we believe central banks around the world may begin another round of expansionary monetary policies in 2012. The process is already underway – policy makers in Asia, notably China, have already begun relaxing policies, while the central banks of Australia, Norway, Sweden and the ECB have all cut target rates. There will be a much more dovish composition of FOMC voting members in 2012 and the central banks of Japan and the U.K. have also shown they are most willing to put in place expansionary policies. We believe these trends will benefit the currencies of commodity producing nations, as well as the Asian region.
In Europe, we are likely to witness a protracted process towards greater integration, but we must stress that it is unlikely to happen in a timely fashion. We have long argued that the process will be drawn-out and likely to be ugly at times. That’s because policy makers have differing motivations – namely reelection and thus, pandering to their respective constituencies – that muddies the political debate. The market simply needs to come to grips with this reality. Importantly, we don’t believe it is in any country’s interest to leave the Eurozone, either weak or strong. Former Greek Prime Minister Papandreou’s quick decision to cancel the referendum as soon as Greece’s euro membership came into question is a prime example. On the other side of the coin, Germany’s economy would be nowhere near as strong as it is today if it weren’t a part of the euro; Germany is effectively operating with an artificially weak Deutschemark, which has propelled its export-driven economy, and policy makers realize this. That said, we do believe that sovereign nations may eventually default, Greece being the primary candidate, but if the European financial system is adequately protected, the Eurozone may ultimately emerge from this crisis stronger.
Germany in particular, finds itself in a challenging situation. The Eurozone needs a clear leader, a country to steer the bloc in the right direction and implement tough decisions and fiscal austerity across nations, for the good of the whole. Germany is the natural choice for such a role, but given its history in Europe, the Germans still appear reticent to take up this mantle. They are in a tough position, not wanting to be seen as imposing their will on the European populace, yet understanding some form of fiscal discipline is sorely needed. This only compounds the problems faced in Europe and is likely to exacerbate the length of time to come to agreement on comprehensive reform.
Our view is that European politicians must focus on saving the financial industry – European banks – instead of overtly focusing on the sovereigns themselves. Unfortunately, political dynamics and realities make this very difficult. To protect their respective financial industries, the fiscal position of sovereigns must be compromised; politicians have to make the choice to essentially sacrifice their country’s credit ratings for the good of the whole. This is politically unpalatable, but in our view, an eventuality should the Eurozone survive. Politicians need to embrace this reality; the problem is that it could be a very messy road getting to that point. Furthermore, politicians are not known for taking proactive decisions, for the obvious reason that should the decision prove unpopular or disastrous, they lose their job. In this context, it is the bond market that has been forcing policymaker’s hands. It is only when spreads widen to such a level that funding costs threaten long-term fiscal sustainability, that politicians jump to action. Said another way: market volatility and stress is implicitly required for politicians to implement any substantive reform.
Global ramifications…
This dynamic has been seen in the Eurozone, but is lacking in the U.S. The bond markets haven’t forced Washington to implement any stringent austerity measures to date. It is likely that Europe continues to muddle through, putting in place piecemeal fixes, as markets force politicians into action. What is sorely needed is a defined process that clarifies how rescue funds are to be deployed, which may help mitigate the patchwork approach to addressing issues anytime a crisis flares up. Nonetheless, austerity measures have been put in place in Europe, and on this front; Europe is ahead of the curve relative to the U.S.
What is important to realize is that this is not a Europe-specific problem; it is a truly global one. We believe a key reason why central banks decided upon their coordinated action to provide dollar swap facilities (primarily aimed at thawing European dollar funding) was to alleviate global contagion fears. Indeed, after the announcement, Asian currencies exhibited some of the greatest strength. In our opinion, there is a very good reason for this. Asian countries may have the most at risk should the European banks decide to pare down their dollar exposures.
The coordinated action was aimed at putting a cap on the cost to access dollar funding via the swap market for European banks. These costs were approaching untenable levels. The Fed provided the ECB with cheaper access to dollar funding so that the ECB could, in turn, provide such funding to the European financial industry. The ECB also relaxed collateral requirements, making it cheaper to access such funding. European banks were demanding dollar liabilities (through the swap market, swapping euro payments for dollar payments). Why? To manage asset and liability risks. A bank aims to approximately match asset-liability risks, such as duration and currency exposures, such that market movements have little effect on the equity component of their capital structure. In this circumstance, European banks were demanding dollar liabilities to match dollar-denominated assets. The largest assets for a bank are typically loans; thus as the costs to access dollar liabilities increased, so too did the risk that European banks would simply pare down dollar-denominated loans.
So why did Asian economies benefit from the dollar swap announcement? In our view, it is because Asian businesses have accessed dollar denominated loans from European banks; the dollar-denominated assets sitting on European banks books are loans made to emerging market Asian economies, amongst others. Asian businesses’ reliance on European funding may have been magnified with restrictive policies put in place in the region. For instance, China had increased the reserve requirements for domestic banks and in some cases restricted lending altogether. Therefore, Asian economic growth may be at risk should European banks decide to pare down their dollar-denominated assets.
Faced with rising costs to access dollar liabilities, a bank has options: stomach and/or pass on the increased costs, raise more capital, or pare down dollar-denominated assets (de-leverage). With the coordinated announcement, the intent was to limit costs; concurrently, however, policies are incentivizing de-leveraging.
The inherent design of bank regulation carries much of the blame. National regulators typically consider their own government debt risk-free. In the U.S., Treasuries are risk-free by regulation. Similarly, European banks are incentivized to carry much of their capital in their respective sovereign debt, as those securities comply with capitalization rules. This has caused significant stress in the inter-bank lending market, where those banks perceived to have large exposures to risky sovereigns (e.g. Greece, Italy) are shunned. In Europe, where each Eurozone government regulates its own banking system, it’s urgently necessarily to centralize bank regulation, so that each member country’s bank is not ex-ante over-exposed to their own government paper. Naturally, the respective governments are opposed to such moves, as it may increase the cost of government funding, should banks have to evaluate the creditworthiness of their own governments.
Rather, banks appear to favor following a concerted effort to shrink outstanding loans to meet capital requirements. Indeed, PriceWaterhouseCoopers recently noted that European banks are expected to sell unprecedented levels of loan portfolios over the foreseeable future. Those same loans underpin ongoing business investment and expansion. Moreover, much of the dollar-denominated loans have been made to emerging economies in Asia and Eastern Europe; given that Asia has been the engine of global growth, there is a significant risk to the outlook for the global economy. This is why it is a truly global problem.
What the world needs is a change of oil, to keep the motor running smoothly; indeed, Chinese policy makers recently reversed the aforementioned restrictive policies, relaxing required reserve ratios for banks and even temporarily weakening the currency (albeit moderately). Chinese issuance of dim sum bonds in Hong Kong has exploded in recent times, and may be an additional source of funding that will take an evermore-important role in substituting European bank financing, should European banks continue to pare-down assets. Indeed, the three biggest underwriters of dim sum bonds – HSBC, Standard Chartered, and Deutsche Bank anticipate that issuance will double in 2012. Other Asian policy makers have followed step, implementing easier policies and in many cases, intervening to weaken their respective currencies. We believe this is the start of another period of easier monetary policy globally.
With ongoing European bank deleveraging acting as a headwind to global growth, central banks are likely to favor a more expansionary stance in 2012. We have already witnessed the central banks of Australia, Norway, Sweden and the ECB cut target rates. The ECB in particular has also offered two three-year long-term refinancing operations (LTROs), the first of which garnered demand from 523 banks for a total of €489.2 billion (approximately €193 billion in additional lending). We believe it is only time before the Fed, Bank of Japan and Bank of England get back on the horse and restart their printing presses. In the U.S., the composition of voting members of the FOMC is set to become much more dovish in 2012. The Bank of England has shown the willingness to expand the balance sheet even with inflation running around 5%, and the Bank of Japan has applied expansionary policies to the purchase of a broad range of asset classes, including listed REITs, ETFs and corporate debt. Should we enter another period of easy monetary policy, we believe the beneficiaries will be the economies of commodity-producing nations, and in turn result in strength of their respective currencies.
Asia matures…
In 2012, we will also witness one of the more significant leadership changes of recent years – we’re not talking about the U.S. Presidential election in November, but the transition of power in China. The Communist Party is set to appoint seven new members to the currently nine-member Politburo Standing Committee – China’s topmost leadership body. Xi Jinping and Li Keqiang are set to become the President and Premier of State, respectively, replacing Hu Jintao and Wen Jiabao. Given that China maintains centralized government control over much of the country, even a marginal change in leadership composition may have deep and far reaching implications for China and investors globally. We believe that current and expected initiatives, in concert with economic realities and political dynamics, are likely to lead to the adoption of more flexible market dynamics and ongoing gradual strengthening of the Chinese currency through 2012.
We consider China will increasingly focus on growing the domestic economy and middle class, while relying less on the export sector as a driver of economic growth. Moreover, Chinese politicians are likely to allow a gradual appreciation of the Chinese Renminbi, as a natural valve in addressing inflationary pressures. For an in-depth analysis of the implications of China’s leadership transition, please read our White Paper on the topic.
In the U.S., it is unlikely that long-term fiscal reform will be implemented ahead of the November election. That said, the debt-ceiling debacle and inability of the Super Committee to come to agreement has only frayed the confidence in Washington. Ultimately, we believe these dynamics serve to erode the safe haven status the U.S. dollar has held for so long, and combined with the Fed reopening the monetary floodgates, may underpin ongoing weakness in the U.S. dollar. We continue to see asymmetric risks to the outlook for U.S. Government paper. Should the market aggressively price-in the unsustainable fiscal situation, we may witness a substantial increase in yields. Such an event may precipitate government action similar to that seen in Europe. Unfortunately, the market is simply not applying the pressure on Washington, seemingly giving U.S. policy makers a pass. As such, there is little incentive to implement fiscal reform in the U.S. and thus the long-term situation is likely to deteriorate over the near term. On a relative basis, those countries that are putting measures in place to get their houses in order may appear more attractive investment propositions.
With so many dynamics set to unfold throughout 2012, we are excited by the potential investment opportunities, Specifically, we believe strategic value may be found outside of the U.S. dollar, in the Asian region and commodity producing nations.
Please register for our Webinar on Thursday, January 19, or sign up for our newsletter to be informed as we discuss global dynamics and their impact on currencies. We manage the Merk Funds, transparent no-load currency mutual funds through which investors may add currency exposure to their portfolios while potentially mitigating stock market, credit and interest risks with the ease of investing in no-load mutual funds. To learn more about the Funds, please visit www.merkfunds.com.
Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com
Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.
The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.
The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.
The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.
The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.
The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.
This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.
Guest post by Axel Merk, Merk Funds
January 18, 2012
With the Year of the Dragon around the corner, will the renminbi be unshackled? Will there be a surge in domestic consumption, or will a housing bust weigh on the economy, dragging down global economic growth? To understand how dynamics may play out in China, try to put yourself into the shoes of the proverbial Chinese consumer. Better yet, put yourself into hundreds of millions of such shoes…
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First, let’s put the Chinese housing market into perspective. High-net-worth individuals own, on average, an astounding 3.3 housing units per person (2011 Allianz survey). Many of these “investment properties” have recently been developed and are not occupied. Rents are so low compared to the value of homes that it isn’t even worth looking for tenants. In 2010, about 5.1% of total national employment was in the construction industry, up from 3.8% in 2006. In Spain, known for its colossal housing bust, employment in the construction industry peaked around 2007, at 13.5% of the total workforce (about half those jobs have since been lost). In the U.S., residential construction supported 4.2% of the total workforce in the mid 1990’s and grew to over 5% in 2005, before dropping to around 3% in 2008. While China does not appear to have Spanish excesses, these metrics suggest China may still be vulnerable, given the recent U.S. experience.
However, there are some key differences between China and the U.S. Maybe most notably, most Chinese still hold the traditional view that home ownership is a prerequisite for marriage and the one child policy has fostered a culture where parents want their children to own a home – apparently at just about any price. Which brings us to an important point: with mom and dad paying for the house, many homes are paid for in cash. Indeed, according to a 2010 Citi survey, only 18% of households borrow money from banks to buy property; a further 15% borrow money from relatives. This is vastly different from the U.S. experience, where consumers drowning in debt financed the property boom.
Unfortunately, many U.S. homeowners have recently experienced first hand that when property prices fall, the debt remains. It is the debt overhang that causes consumers to stop spending, banks to stop lending and real estate developers to collapse.
| White Papers Merk White Papers provide in-depth information into currency as an asset class. Portfolio Benefits of The Currency Asset Class The Currency Asset Class: A New Era of Investment Opportunity The Archive: |
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Chinese consumers come from a different vantage point: afraid of inflation and limited in ability to invest abroad, the Chinese put much of their money into stocks, real estate, and precious metals. Of these choices, real estate has been most broadly embraced so far. We don’t doubt for a minute that Chinese real estate prices could plunge. However, we take exception to the conclusion that China is thus destined to suffer the same consequence as Spain or the U.S. When leverage is not employed, consumers may react to a drop in real estate prices similarly as they would to a drop in stock prices.
In a housing downturn, real estate developers may go bust; banks will face non-performing loans; and workers will lose their job. With regard to banks, China has the resources to act swiftly to bolster any banks should the government choose to do so. A drop in construction related jobs would have an impact on GDP, but while migrant workers working in the construction industry may earn much more than the average farmer, their income is a fraction of that of urban residents. As such, the drag caused by a housing bust in China on consumer spending may be limited.
To understand where consumption may be heading, one must look beyond housing. Notably, with government statistics not at the standards of most developed countries, a recent study concluded that household consumption may be underreported by as much as 20%, leading to a potential underestimation of GDP by 10%. China is already the world’s largest market for automobiles and internet use, as well as the second largest market for luxury goods.
Despite the State trying to micro-manage economic growth, China is said to be more capitalist than most Western countries these days. Differently said, despite government attempts to manage prices and bank lending, amongst others, Chinese businesses find plenty of ways around restrictions. We see these dynamics showing up in data such as inflation metrics that are stubbornly high, and a substantial amount of spending, notably on luxury goods, that appears to be under-reported. In many ways, the ineffectuality of China’s government is a good thing. Imagine that the government was more effective in controlling prices and credit: you’d end up with a Soviet Union-style economy, where tight government control that actually works leads to empty shelves and shortages of all sorts of goods and services. Not in China.
But Chinese policy makers are keenly aware of the dangers of runaway growth, notably inflation. From the price of food to the price of luxury goods, living costs have become expensive in China. It’s the inevitable result of rapidly “moving up the value chain” in the types of goods and services produced. As Chinese policy makers have come to the realization that administrative tools are not very effective in containing inflation, they have embraced currency appreciation as a tool to tame domestic inflationary pressures. A stronger Chinese renminbi will also serve as another catalyst for the rapid transformation of the Chinese economy towards a greater focus on domestic consumption. For an in-depth look at how the upcoming leadership transition in China may affect policies, please read our White Paper: China’s Leadership Transition: Social Stability May Require a Stronger Renminbi
Don’t count China out as an exporter as the renminbi strengthens. Indeed, we believe that China increasingly has pricing power and may be able to pass on its increasingly higher cost of doing business. American businesses are outsourcing ever more complex processes: China is best positioned to attract these projects; the more complex a process, the more pricing power the provider of such services may have.
Many Chinese businesses will undoubtedly fail in such an environment. But also consider how competitive the surviving businesses must be, having had to compete in an environment where some businesses were kept afloat through an artificially weak currency. Those that compete profitably within China may be well placed to compete with the rest of the world.
In summary, Chinese consumer spending is likely to have been under-reported for some time; we don’t think a housing bust in China will stifle consumer spending as much as some fear. Importantly, Chinese consumer spending may rise like an avalanche in years to come. China is right to prepare its economy for this rise, amongst others, by unshackling the renminbi. A currency serves as a natural valve for domestic policies, helping to tame inflationary pressures. Currencies of the more developed Asian neighbors may also benefit in the process.
Please register for our Webinar on Thursday, January 19, or sign up for our newsletter to be informed as we discuss global dynamics and their impact on currencies. We manage the Merk Funds, including the Merk Asian Currency Fund. To learn more about the Funds, please visit www.merkfunds.com.
Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com
Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.
The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.
The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.
The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.
The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.
The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.
This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.
Guest post by Tom Cleveland:
The year of 2011 will go down in the annals of currency trading as one to forget rather than remember. The global political stage was filled with uncertainty emanating from Europe, and regardless of the best efforts made, the “contagion” spread to every financial market on the planet, bringing severe volatility and “whip-saw” pricing behavior. Even Gold, the perennial “safe haven”, was losing some of its luster over the last half of the year. For currencies, however, choppy markets with wide ranging days were the norm. Many traders chose to avoid these high-risk conditions and sat on the sidelines.
For the five major currencies, whose pairs account for nearly two thirds of the overall volume in the market, the year was a rollercoaster ride. The diagram below tells the story in chronological order for this tumultuous year:
The price behavior for five forex ETFs are compared above to illustrate the true positive and negative daily machinations for the U.S. Dollar, Euro, Yen, Aussie Dollar, and the Pound. The picture almost conjures up the entrance to a “gaping pit” that should be avoided at all costs. Forex hedge fund managers never found their stride in 2011, losing over 3% as a group through November, with its largest fund, FX Concepts, posting a 19% loss for the period. Timing was everything during 2011, and most experts never found the magic formula for success.
The year began with a continuation of the Fed’s second Quantitative Easing program, designed to expand the U.S. money supply by $600 billion, thereby diluting the Dollar and causing the overall negative performance for the year. This program ended on June 30th, and the remainder of the year was spent regaining lost ground as the U.S. economy posted a modest recovery. March witnessed the horrific earthquake and tsunami that struck Japan and devastated the local economy. Central banks attempted to intervene to weaken the Yen to help the rebuilding effort, but to the consternation of all, including forex brokers, the Yen chose to appreciate by nearly 10%.
The “elephant in the room”, however, was the ongoing debt crisis in Europe. Try as they might with summit meeting after summit meeting, government officials could not reach agreement on how to deal with its weaker member states and the potential for default on their various bond offerings. Major export states, especially Germany and France, were unwilling to share the benefits of a currency that was weaker than the Mark or Franc with southern countries where the stronger Euro inhibited tourism and trade. The market viewed each proposal with skepticism while GDP growth for the region was near zero.
As for the coming year, most experts are forecasting more of the same in 2012. No less than six summit meetings are scheduled in Europe over the year, but economists expect the Eurozone to slip back into recession. Emerging markets are in cutback mode, already feeling the weakening demand from Western nations. China has announced that it will focus on internal infrastructure projects and manage growth expectations down to 7.5% from 9.5% for 2011. In the meantime, the hope is that the fragile U.S. recovery will continue to gain strength, in spite of it being an election year and with Europe import demand declining. Uncertainty and volatility will become household words in our daily lexicon.
The lessons learned in 2011 were to be patient, back off overly choppy markets, and adjust your risk parameters to allow for greater flexibility. Hopefully, these lessons will not have to be learned again in the year to come.
Guest post by Axel Merk, Portfolio Manager, Merk Funds
November 30, 2011
Can the euro be saved? Is it possible to stem the flight of money from the periphery into the core? With a botched German auction in mind, investors are now wondering whether it’s possible to prevent a flight out of “all things euro”? We examine the dual challenges of fiscal sustainability and bank solvency in this analysis, with the not-so-modest title “Guide to Save the Euro”.
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Fiscal sustainability
Fiscal sustainability is about revenue and expenses, but also about perception. As the housing bubble in the U.S. proved, what is affordable at low interest rates may become a nightmare when rates go up. Similar rules apply to governments: if there is a perception that obligations won’t be paid back, the cost of borrowing will skyrocket. Spain is the most recent case study. Recent elections kicked out the socialist government, giving an absolute majority to the party of conservative prime minister-elect Mariano Rajoy. You would think that Rajoy would give a speech, declaring how his party will use its mandate to ensure Spain’s obligations will be met, how the rigid Spanish labor market will be opened up, how Spain – with one of the lowest debt to GDP ratios in the developed world – will have a strong comeback. You would expect his team would give an update on how to clean up the Spanish banking system; how his administration will be transparent and give frequent updates on progress. However, in an apparent proof that politicians globally are utterly clueless about all things finance, Rajoy pronounced in an interview that Spain would be unable to come to a sound financial footing if it has to pay 7% on its debt. The market’s response was swift: Spain had to pay 5.1% to sell 3-month Treasury Bills in late November, versus 2.3% just a month earlier. While Rajoy has lined up what some consider extremely competent people, he is not known to make tough decisions. Overlay this with the concern that members of his party are responsible for some of the policies that have led to the current malaise and you can see why the market seriously questions whether there is the determination to make the necessary tough decisions – decisions that will likely step all over the toes of regional decision makers in his own party.
But fear not! The market will bring Rajoy and other policy makers to their knees. By imposing punitive borrowing costs on Spain, the Spanish government will get the message. The question then will be whether the medicine will be too tough to swallow. Regaining market confidence after destroying it is rather difficult. It took former Federal Reserve Chairman Paul Volcker the herculean task of raising interest rates to 20% to convince the market that he was serious about fighting inflation; in contrast, when there is confidence, a Fed official only needs to utter a few words to appease concerns in the market. Similarly, what would have historically been a regular budget battle to balance the books may become a struggle for survival.
To achieve a sustainable budget, the obvious levers are to increase revenue or to cut spending. As Greece has shown, raising revenue through tax increases does not necessarily work; governments can also liberalize their labor market, cutting red tape. They can sell off government property to reduce debt levels, but in the absence of other structural reform, such sales might only be a short-term patch up. The expense side, of course, is where real progress can be made. All governments of developed countries face the risk that they have made too many promises. Some of those commitments can be renegotiated in an orderly fashion, others through default.
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Policy makers believe that if there is some magic elixir – such as an insurance scheme or an unlimited Chinese checkbook, governments will have the breathing room to clean themselves up. However, our dear policy makers have proven that the moment the pressure abates, the willingness to push through tough reforms evaporates. That’s not a European trait, but a universal one: in the U.S., there is no pressure applied by the bond market and, as a result, there is no agreement to tackle fiscal sustainability in the U.S.
What about calling it quits, leaving the euro? We have long argued that it isn’t in anyone’s interest to leave the euro. Take Germany: a currency dragged down by weaker peripheral countries helps German exports. Germany is effectively operating with an artificially weak deutschemark. More importantly, if Germany were to leave the euro, money might be sucked out of the financial systems of weaker Eurozone countries and into Germany, thus exacerbating a collapse of the periphery. Just because this isn’t in Germany’s interest, it doesn’t mean the market isn’t pricing it in: in the third quarter, large Italian and Spanish banks reported double-digit percentage declines in deposits from corporate and institutional clients, although their overall deposit levels only dropped by approximately 2%.
Generally speaking, there are two paths that may lead to fiscal sustainability: surrendering sovereign control over the budgeting process; or, embracing the brutal pressures imposed by the bond market.
Surrendering sovereign control over budgeting process
When a government asks the IMF to help, tough austerity measures are imposed, a de facto handover of sovereign control to an outside agency. Keep in mind that the IMF currently does not have sufficient resources to step in and rescue Europe. It would require Europe and the US to swallow their pride and allow China to chip in. China, in turn, would rightfully demand substantial voting rights at the IMF.
When other Eurozone countries impose terms, the process is similar, except that the IMF has more established processes, i.e. is used to playing “bad cop” when it comes to imposing highly unpopular reforms. The same can be said should a fiscal union be introduced that many are calling for: for Germany to agree on any fiscal union in which Eurobonds are issued, stringent rules are likely to be imposed on beneficiaries of the proceeds of such bonds. The fiscal union is already taking shape. The notable shortcoming is a lack of defined process regarding how money will be deployed – unfortunately this shortcoming in the current setup means that each flare-up in the crisis is addressed with yet another patch.
As part of a more formalized fiscal union, Germany may open its checkbook to bail out the rest of Europe. That’s a tall order, but the market is starting to price in that possibility. The recent botched auction where the German Treasury was unable to place all of its 10-year bonds showed that investors are now demanding higher rates of return to lend money to Germany. Just recently, Germany’s 10-year bonds yielded less than 2%; as of this writing, the yield has risen to 2.3%. While still low, it shows that “fiscal integration” in Europe means that a yield conversion won’t happen at Germany’s cost of borrowing level. Germany will also have to get used to the idea that the German bond may have to give up its benchmark status to a Eurobond alternative over time. To the casual observer, this may appear like a natural step; in a world with large tradition and even larger egos, these are steps on a rocky road.
Embracing bond market pressures
There is an alternative that policy makers must contemplate: embracing the brutal pressure imposed by the bond market. It requires dealing with the reality that low interest rates must be earned. It also means that governments have to embrace the reality that they may have to renegotiate some of their debt, i.e. default. Government defaults are nothing new. However, governments should take great care that a government default does not lead to an implosion of the financial system. Banks hold substantial amounts of sovereign debt – a key reason why select banking shares are under pressure in Europe.
However, banks have one major advantage over sovereigns: they have access to central banks. While sovereigns must go into the market to fund themselves, banks may go to their central bank to obtaining funding. Banks also employ a business model that by nature has substantial leverage. While the leverage makes banks vulnerable, the banking model has two advantages:
- Central banks can keep even a technically insolvent banking system afloat. Just look at Japan in the 1990s. Similarly, the Federal Reserve (Fed) and European Central Bank (ECB) can keep even zombie banks afloat as long as they choose to.
- The reason the U.S. Treasury injected money into the banking system in the fall of 2008 (the infamous TARP program) is because the inherent leverage employed by banks allows any capital injection to support a high multiple of debt. Former U.S. Treasury Secretary Hank Paulson’s bazooka was effective because it was applied to bolstering bank capital rather than buying toxic securities outright; the latter would have turned the bazooka into a water pistol. Similarly in Europe, the focus must be on making Eurozone banks strong enough to stomach sovereign defaults.
The implication, however, is that by strengthening Eurozone banks, the sovereigns are weakened. In the U.S., while it was a gargantuan task to convince Congress to authorize TARP, a central treasury allowed swift action. The U.S. is simply better at spending and printing money than Europe. The downside is that the U.S. example proved so effective that no real reform took place (and executives were able to reap large paychecks).
A bazooka works when one has a bazooka to shoot. The reality is that in Europe, many of the sovereigns are now so weak that a bazooka may save only the banking system, not necessarily the sovereigns. Policy makers need to address this reality: in the case of a government default, it should be managed in an orderly fashion. Avoid a run on the banks by making bank deposits as secure as possible.
More practically, it also means that France, for example, must sacrifice its AAA rating in order to bail out its banks. It’s not really a sacrifice, as that rating will be stripped in due course anyway, but politically it’s a tough sell. That’s where the practical limitation of the self-sacrifice approach lies: sovereigns will be most reluctant to intentionally blow a big hole in their own shaky balance sheets to save the banking system.
As a result, expect a muddled combination of increased IMF support, increased fiscal convergence, increased focus on strengthening bank balance sheets, increased involvement to keep banks afloat (the ECB is already debating providing multi-year unlimited credit lines), and increased cost of borrowing for Germany. However, this is likely to remain a drawn out process and the tail risks that European policy makers mess this up cannot be ignored, either. We come back to our initial argument: a lot depends on perception. Perception is a function of leadership and a credible path that is likely to lead to results. The prime minister-elect of Spain wasted his first opportunity to make a good impression. The German psyche has been badly wounded by the botched auction. In typical European fashion, another summit has been announced to discuss closer fiscal integration. In case anyone wonders why this process is so painful, it is because the right decisions are politically so incredibly difficult to make.
Please make sure you sign up for our newsletter to be informed as we discuss global dynamics and their impact on currencies. We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com.
Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com
Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.
The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.
The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.
The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.
The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.
The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.
This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.
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Guest Post by Axel Merk, Portfolio Manager, Merk Funds November 22, 2011 The worst-case scenario for Greece, should it be unable to secure further bailouts, might be that it would have to live within its means. Presently, spending only the money coming in is considered unbearably brutal. If Greece could only leave the euro, it could install its own printing press, inflating its sorrows away. Any economist will object: it’s complicated. But it isn’t: Greece could introduce a high-flying New Drachma, quite literally. First, please note that any country may default on its debt. The trouble is that the day after a default it might be difficult or impossible to obtain a loan at palatable terms. As such, any country considering a default must conduct a risk / benefit analysis. A country that has a primary deficit, i.e. a budget deficit before paying interest expenses, faces the challenge that such deficit would be eliminated overnight (because the deficit could no longer be funded), causing a massive shock to the economy as government spending would come to an abrupt holt. To mitigate such a shock, it is usually the lesser evil to beg for leniency from creditors, in return for austerity measures. It is in Greece’s interest to promise the stars to get yet another loan. In contrast, once a primary surplus has been achieved, Greece may well find a default attractive to cut its overall debt burden; the shock from being shunned from the credit markets would then mostly be a shock to the creditors. It’s because of these dynamics that countries tend to default only after an agonizing period trying to cut expenditures. Some succeed: look at Ireland. The country appears to be regaining the confidence of the markets. However, political realities may make it difficult for Greece to ever get on a sustainable fiscal path. However, if a country defaults without first eliminating its primary deficit, policy makers may be tempted to repeatedly default without ever getting the house in order. If creditors are dumb enough to provide another lifeline, good luck to them ever being repaid. In such a situation, credit is more typically provided through the countries’ own printing press, in the case of Greece by introducing a new currency. Introducing a new currency in a debt-laden country that has been unable to eliminate its primary deficit may be doomed for failure, but since when has bad policy stopped politicians from trying to implement it? There are logistical and legal challenges, such as what obligations would remain euro denominated and what obligations will now be New Drachma obligations. More importantly, if Greece were to introduce its own currency, odds are that those that can, would reject it; as a result, the euro would remain the default currency for business.
In contrast, pensioners and government employees might have no choice but to accept the New Drachma as payment. Quite likely, these groups would cry foul that their new currency is worthless, demanding to be paid more. Not long thereafter, and with a media friendly Greek drama playing out on the streets, the government might relent, printing more money to appease the protestors. Inflation and hyperinflation may well take hold, in turn relegating the New Drachma to the history books. Some policy makers may suggest capital controls and a variety of oppressive tools to force the adoption of the New Drachma. Unfortunately, the little money left in Greek banks may evaporate faster than policy makers can act, as savers would likely take their money abroad. While it may cause a complete collapse of what little public infrastructure is left, the upside of a dysfunctional government is that the black market may fill the void. After all, it’s only money we are talking about, and some ingenious entrepreneurs will always find a way to keep life moving along. Anarchy, however, might well be used to describe the situation if things turn sour. Optimists that we are, we believe it doesn’t have to be that way. No, we do not expect the Greek to learn German and adopt their habits. But Greece might have an opportunity to turn the crisis into an opportunity. The government should embrace reality and recognize that swapping the euro for the New Drachma in some forceful fashion would be a non-starter. The Greek Government would have the exclusive authority to issue Drachma Points (DPs). In order to get government services, DPs would have to be paid. The government would set the price of government services in DPs. The government would, in turn, estimate what portion of the typical government employee’s and pensioner’s consumption is comprised of government services. That portion would have to be paid in DPs; remaining expenses would continue to be paid in euro, until DPs receive wider acceptance. Axel Merk will race to cure cancer in 2012! The government should make DPs transferable. As such, a market would be created that creates an exchange rate between euros and DPs. We know that, without a doubt, benefits of government employees and pensioners will have to be cut to be sustainable. Rather than forcing almost the entire economy into an underground economy, the rest of the economy could continue to embrace the euro, while the public sector would embrace DPs. If a Greek government were to introduce price controls, shortages would be created. By limiting DPs to the public sector, should the DPs be mismanaged, there would be a shortage of public sector services. That, in turn, may not be the worst outcome, as the private sector would then have an opportunity to make up the shortfall. A way to balance income and expenses may be for the government to collect revenue in (strong) euros and pay expenses in (weak) DPs. Government employees and pensioners can be paid partially in DPs, but creditors should be paid in euros (possibly after what is becoming a customary “haircut”) – at least until DPs are well established in the marketplace. So, would this idea work? It ultimately depends on how exactly it is implemented. Odds are that Greece would inflate this new currency away anyway, just as it is likely to do with a New Drachma. However, if Greece wants to leave the euro, the new currency should be introduced while still allowing business to be conducted in euros; the banking system could accept both euros and DPs. With a gradual introduction and the currency value linked to government services (rather than nothing as is the case with a fiat currency, or gold as in the gold standard), such a transition may be feasible. Ultimately, holders of Greek debt have a choice: accept a restructuring with a 60% “haircut” or accept a New Drachma that’s worth only 40% of the euro (or less)? Either way, losses will have to be taken by creditors. Moreover, any short-term loss may simply be a first step towards further losses down the road if Greece cannot devise a sustainable budget. While we ponder about Greece, the market has obviously moved on to worry about bigger economies. Greece’s policy makers may dream about the benefits of their new high-flying mileage program and how to market it to the people, but policy makers in the rest of Europe should focus on the health of their banking systems. We cannot prevent sovereigns from defaulting on their obligations, but they can make banks strong enough to stomach potential losses. Governments should get used to the idea, as supporting banks may cost them dearly, including their ratings. The alternative for governments is to go down the road of doling out frequent flier points. It might just work – being the first in line for having accumulated more points than your peers may make them appear priceless; until you notice that the premier status lines are just as long as the lines for everyone else. Thought of from an American perspective: if you are a good citizen accumulating DPs, you get to skip the line at the DMV! Subscribe to Merk Insights to be informed of our analysis as this crisis evolves. We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com. Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability. The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand. The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes. The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500. The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com. Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest. Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses. This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor. |
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Guest post by Axel Merk, Portfolio Manager, Merk Funds
November 1, 2011
Axel Merk |
Greek Prime Minister Papandreou is throwing in the towel: by calling for a popular vote on austerity measures now, we believe he is almost assured a no vote. This allows Papandreou to say that he tried everything he could to avoid a default, but the people have spoken. Having said that, as we write this analysis, Papandreou appears to be changing his mind and may cancel the idea of a referendum as quickly as it came about. Still, the message is clear: a default is coming.
The sad part is that Greece has not been able to eliminate its primary deficit (the deficit before interest payments), so that it could have the potential to bounce back upon a default. On the contrary, Greece may fall into chaos or anarchy. The threat of such a scenario, in turn, may prompt European policy makers to instigate a Marshall Plan to rebuild Greece. While we can ponder about the Greek drama, it’s paramount to contemplate the consequences for the rest of Europe and the euro.
First, the good news: market pressures should accelerate reform. Specifically, we expect bank recapitalizations will both be accelerated and increased in scope; if you can’t save the sovereigns, at least make the banking system robust enough to absorb defaults. That’s better than any insurance scheme policy makers can come up with.
Expect dramatic actions by policy makers, akin to those seen in October 2008. Just as policy makers did not initially heed the markets then, the pressure is now on to follow through with substance after last week’s sketchy plan to save Europe, and ostensibly, the world. Specifically, pressure on Italian Prime Minister Berlusconi is mounting rather dramatically to engage in real pension reform. In comparison to both Spain and Ireland, which have seen relative market improvements, the markets have scolded Italy. While it is possible to turn the tide, the longer the wait, the more the market will demand.
What would alleviate the pressure is a commitment by the European Central Bank (ECB) to be the lender of last resort for Italy and Spain. However, that’s unlikely to happen, at least not in the short term. As of today, the ECB has a new leader, Mario Draghi. As an Italian, he will be under pressure to be rather hawkish. His first press conference is this Thursday. He could announce a program to buy unlimited Eurozone debt, and sterilize such activities. However, such a move would take the pressure for reform away. And a central bank’s role is not to make the life of policy makers easy. If Draghi were to pursue the route of least resistance, he could easily be labeled as, well, Italian, in his approach to central banking.
Any revised bailout fund for Italy is likely to cost France its AAA rating. France itself also has lots of homework to do. The lesson here is that policy makers always wait until the last minute to engage in reform; some day down the road, the market will focus on the U.S.; at that stage, the U.S. dollar may be under severe pressure: the U.S. dollar is more vulnerable given the significant current account deficit.
So for now, the drama continues. To summarize, expect more on bank recapitalization and reform. A wild card is whether the European Financial Stability Facility (EFSF) is going to be bolstered in earnest. For those politicians that still believe Greece can be held afloat: stop believing in fairy tails and move on. The market will.
As far as our positioning is concerned, we had increased our euro holdings ahead of the summit last week. We have since reduced it. We had also substantially reduced the yen ahead of that summit. Our outlook calls for substantial volatility in all currencies, except for possibly the yen; as such, our risk assessment is currently favoring the yen disproportionally. As October 2008 has taught us, though, rational investors may be forgiven for changing their view of the world on a daily basis… Stay tuned and subscribe to Merk Insights.
Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds
This report was prepared by Merk Investments LLC, and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any investment security, nor provide investment advice.
Guest post by Axel Merk, Portfolio Manager, Merk Funds
October 27, 2011
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Axel Merk |
The markets appear euphoric about the ability for European policy makers to deliver on new promises. Low market expectations were met. We, too, have a positive takeaway, but only because of one detail of the grand plan; actually, let’s call it a “grand sketch,” as many details are still unknown.
The Good
Just as the U.S. bailout fund “TARP” was used to bolster U.S. banks as opposed to buying toxic securities in the market, the most effective tool to bolster confidence in the Eurozone is to ensure banks are able to stomach losses on their sovereign debt holdings. The movement to focus on banks in earnest started earlier this month. On October 5, 2011, German chancellor Merkel embraced the notion that bank capital must be bolstered; we turned significantly more positive on the euro that day. Her change of heart came after the market had provided ample “encouragement,” in the form of widespread selling of bank shares and debt; the process had been enabled by European stress tests that disclosed sovereign debt holdings in detail.
This is real money that banks will need to raise. The financial system, as a result, will be substantially more robust. Relevant for the euphoria is that there is a focus on bank capitalization. Regulators have started to embrace market value assessments, another huge positive.
Just like many, we would like even higher capital targets. One has to be realistic, though, that bank capital alone will not unfreeze interbank lending markets. Banks with a tier one ratio of 9% must still finance 91 percent of their balance sheet. We must move away from myopic bank regulation coercing banks to favor domestic sovereign debt to a pan-European approach where corporate debt (the interbank lending is lending amongst financial institutions, which are corporations) is valued on its merits rather than regulation.
The Bad
Greece. A debt write-off before a country has been able to achieve a primary surplus (budget deficit before interest payments) is counter-productive, as it takes away a powerful incentive to invest and engage in further reform. Having said that, this is mostly bad for Greece; financial institutions have now been warned that they must have adequate buffers going forward. We avoided a 60% write-off, and may end up with two 50% write-offs. Consider, though, that 18 months ago pundits called for an implosion of the financial system should Greece default. Then, the euro was trading around 1.20 versus the dollar. Now Greece clearly defaults (even if it is possible to avoid the triggering of credit default swaps), but the euro is trading at over 1.40.
The Ugly
The European Financial Stability Facility (EFSF) that’s touted to protect one trillion euros is a scheme where even policy makers don’t yet know what exactly it is going to look like. It is not a “bazooka,” as it cannot refinance itself at the European Central Bank (ECB). Indeed, gearing it up appears to be done through the back door, by making it an insurance scheme. Even so, it only has a fraction of the capital paid-in of what its commitments are going to be. As such, it’s a smokescreen, albeit a very powerful one. In a leveraged world, appearances count for a lot. However, it would be far healthier for policy makers to finally realize that de-leveraging is the answer, not to put up ever-greater commitments that –particularly in the case of Greece – may well be called upon.
The good news is that the markets will be vigilant. When the current euphoria is over, the bond market will have little mercy with those ducking from their responsibilities. And that’s a good thing that should continue to prove wrong those that have called for the demise of the euro. Long live the euro! Starting November under new leadership at the ECB. Talking about leadership: Has anyone noticed that the Federal Reserve might be paving the way for QE3?
Axel Merk
President and Chief Investment Officer, Merk Investments
Merk Investments, Manager of the Merk Funds
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Occupy Wall Street: A Threat to the Dollar?
Guest post by Axel Merk, Portfolio Manager, Merk Funds October 26, 2011 On its face, suggesting that the Occupy Wall Street movement may threaten the U.S. dollar may appear like a tall order. However, simply dismissing Occupy Wall Street as a fad may be a big mistake, just as it is a mistake to dismiss the Tea Party movement. Regardless of your political stance, and with no offense intended to supporters of either group, we believe they may be two sides of the same coin – quite literally. To determine where policy makers and with it, the U.S. dollar, may be heading, it is important to understand that the driving forces behind both movements have common roots. Axel Merk will race to cure cancer in 2012!
The short explanation is that rising costs coupled with stagnating real wages breeds an environment of social unrest. While the above movements are the face of this “unrest”, it helps to dig deeper and analyze the root causes to better understand and assess the ultimate implications of these protests. The movements have been years in the making and are – in our assessment – the result of a highly intoxicating cocktail of policies that have driven recent global dynamics. The alcoholics are our policy makers; the protesters, though, are the ones stuck with the hangover. Unfortunately, it does not look like anyone is going to sober up anytime soon. With the movements embracing an array of goals and complaints, we shall focus on a common thread: sustainability of personal and government finances. However, there are diametrically opposed views on how to achieve these goals. In the late 1980s, former Federal Reserve (Fed) President Greenspan embarked on a long journey to make the U.S. economy more “efficient.” In those days, consumers may have had a mortgage, possibly a loan/lease for their car, but credit was not so pervasively used as it is today. Since then, we have learned to buy just about anything on credit. The upside: your monthly paycheck allows you to acquire greater goods and services, since you don’t have to save to buy that dream mattress or exercise machine, but get to enjoy them for a “low monthly payment.” The downside: you become more interest rate sensitive, less shock resistant, meaning that if you, say, lose your job, you are still stuck servicing your debt. Without debt, losing your job requires belt tightening; with debt, you are at risk of becoming a modern slave, at the mercy of your creditors.
After the tech bubble burst in 2000 and after 9/11, policy makers sought to keep consumers spending by lowering taxes and interest rates. In 2004, when the Fed started raising rates, consumers kept spending despite predictions of the demise of the American consumer. Consumers continued to spend by creating their own money, using their homes as ATM machines; financial institutions joined the frenzy by increasing their leverage, amongst others by creating off-balance sheet investment vehicles (“SIVs” and “SPVs”, amongst others). But that’s only part of the equation. A little over a decade ago, China and other Asian countries kicked their efforts to join the world stage into high gear. Driven by a desire to foster social stability, as millions migrated to cities, Asian policy makers promoted economic growth, amongst others boosting exports by keeping Asian currencies low versus the U.S dollar. What happens when both U.S. and Asian policies promote growth at just about any cost? When too many gadgets are produced, the cost of such gadgets – all the stuff consumers buy at WalMart but don’t really need – is low. Low interest rates and taxes in the U.S combined with pro-Asian growth policies are a key reason why the Consumer Price Index (CPI) has been so tame. However, the things we cannot import from Asia: education and health care, to name but two, are bound to rise at a faster pace. Notably, too, prices of commodities will likely rise, as policy makers push for global economic growth with all the levers at their disposal. Where does that leave corporate America? On the one hand, corporations have no pricing power because of a flood of imports and consumers that are too indebted to afford to pay more; on the other hand, high commodity prices, as a result of global overproduction, squeeze margins of corporate America. So what does a rational executive do? Executives will strive to maintain margins by lowering variable costs; in the U.S., labor is the one variable cost that can be reduced through outsourcing. As with so many policies, the best of intentions (low interest rates and taxes) have contributed to accelerating the outsourcing trend of corporate America. These pressures are primarily responsible for why real wages have stagnated. But what happens to those laid off? Because many of them have debt, and lots of it, they must find a new job. As jobs are hard to come by, they may start home-based businesses. 9 out 10 of these will fail, but the 10th might become the next big success story. The beauty of the American work force is that it is so flexible; the downside is that policies imposed on them have transformed society at a much faster pace than would have taken place otherwise. The American work force adjusts, but is increasingly dissatisfied. It doesn’t stop there. The artificially fast pace of transformation in the U.S. is embraced by young, new economy companies. But old economy companies – think General Motors – are not agile enough to keep pace. The economy is merciless to these firms that act like ocean freight ships. Mistakes in the case of GM were more than minor, paving the way to failure. Those forces, in turn, pushed more folks into the labor market… Keep these pressures up for a full decade and you shouldn’t be surprised that citizens are starting to revolt. As the credit bonanza came to an end, policy makers did not want to accept it. First billions, then trillions, were thrown at the financial system to stem against the tide that might have thrown the economy into another Great Depression. Both Tea Partiers and Occupy Wall Streeters say this is all crazy and must stop – albeit they have different prescriptions. However, rather than stopping, policy makers are ever more engaged. Once again, the best of intentions are creating yet another avalanche of unintended consequences. Voting with their feet to get their voices heard, the Twitter revolution won’t stop with the Arab spring, but sweep across America in it’s own incarnation: we believe social networking is the perfect catalyst to enable ever more populist politicians to cater to the growing dissent. While the reality is that the issues are complex, the answers appear so easy; we don’t want to belittle the movements, but see a trend that fosters politicians capable of distilling their political message into a tweet. The implication is that at upcoming elections, ever more polarizing politicians will be elected. It is no coincidence that Republicans and Democrats cannot find common ground, but a consequence of the dynamics as they have been playing out. What about the link to the US dollar? A couple of observations:
Subscribe to Merk Insights to be informed of our analysis as this crisis evolves. We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com. Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies. The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability. The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand. The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes. The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500. The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com. Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest. Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses. This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor. |
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Guest Post by Axel Merk & Kieran Osborne, CFA, Merk Funds
October 19, 2011
With so many global dynamics playing out, and the world’s financial markets fixated on the political process (or lack thereof) in the Eurozone, driving market sentiment around the world, it may be a good time to take a deep breath, take a look back at where we’ve come from, and assess the likely implications going forward. Specifically, what are the implications for the U.S. dollar and currencies globally?
Firstly, let’s look at what we’ve done this year. We made a number of macro investment decisions for our Merk Hard Currency Fund strategy, based on our assessment of how the global economy would play out. With deteriorating economic fundamentals in the U.S. and globally, we decided to reduce the strategy’s exposure to the Canadian dollar, given the high levels of interdependencies between the Canadian and U.S. economies. Furthermore, we have been disappointed with the ongoing reticence displayed by the Bank of Canada to raise interest rates.
Weakening global fundamentals were largely driven by elevated concerns over the contagion effects of the periphery nation crisis in the Eurozone, and the apparent lack of a ready solution to satisfactorily tackle the issues. While we maintain a positive long-term outlook on the euro, we nonetheless decided to reduce the currency’s allocation during the year, largely driven by our assessment that there was an increased likelihood of the European Central Bank (ECB) pursuing more expansionary monetary policies. (We have subsequently become much more optimistic on the outlook for the euro – discussed below.) We also decided to reduce the allocation to the Swiss franc this year, based on valuation fundamentals and increased intervention risks. In our assessment, substantial amounts of speculative money had rushed into the currency, resulting in an overvalued franc. At the same time, the Swiss National Bank (SNB) became evermore vocal, threatening currency intervention, which ultimately culminated in the SNB intervening to peg the franc to the euro in September. We also took the opportunity to take profits in our gold holdings, given it had experienced considerable price appreciation through the first half of 2011.
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We decided to redeploy much of the currency exposure into the Japanese yen, given the backdrop of deteriorating global economic fundamentals and the fact that the Japanese banking system appeared to provide relative safety (which in itself is a sad commentary on the state of the global finance industry). The SNB’s intervention to peg the Swiss franc to the euro effectively constrained the supply of “safe haven” currencies, and on net, we believed this would benefit the yen, given its traditional “safe haven” status, particularly with a backdrop of ongoing heightened market volatility. Japan’s leadership structure also remains weak, and we therefore considered the Bank of Japan was unlikely, in the near term, to embark on any substantial expansionary measures that could undermine the strength of the currency. We also increased the New Zealand dollar and Norwegian krone exposures, on our assessment that the U.S. Federal Reserve (Fed) may be forced into more expansionary monetary policies, which in turn may be positive for those currencies highly correlated to commodity prices and expectations for global growth. Notably, the outlook for interest rate increases in New Zealand remained positive while expectations for many other currencies declined substantially throughout the year.
The market’s focus, for the majority of the year, was Europe. Specifically, the periphery nation sovereign debt crisis and concerns surrounding global contagion. As a result, we witnessed heightened levels of market volatility and general selling of perceived risky assets, as evidenced by the decline in the S&P 500 Index (-8.7% YTD through Sep 30th, 2011). Policy makers in Washington didn’t help appease market concerns: leaving the decision to raise the Government’s debt ceiling to the last minute only exacerbated market fears of a U.S. default and further degraded investor’s view of policy makers; the whole situation could best be described as a debacle. Indeed, Standard & Poors subsequently downgraded the credit rating of the U.S. government, citing the inability of the political leadership to come together and agree on a plan to sustainably rein in the deficit over the long term as a key reason for downgrade. We consider these developments have further eroded the safe haven and reserve currency status the U.S. dollar has held for so long, and continue to view the outlook for the U.S. dollar negatively over the medium to long term.
Despite the downgrade, U.S. Treasuries have strengthened recently, largely driven by the risk aversion exhibited in the market, and further compounded by the U.S. Federal Reserve’s (Fed) decision to instigate “Operation Twist” – selling Treasuries at the short end of the yield curve and reinvesting the proceeds in longer dated Treasuries. Thus, flattening the yield curve by artificially depressing yields at the long end. It appears there was a great deal of debate surrounding this decision – indeed, three voting members of the Federal Open Market Committee (FOMC) dissented to the decision (Fisher, Kocherlakota, and Plosser). On the other hand, minutes from the meeting show there was support for further expansionary monetary policy, or quantitative easing, which would constitute “QE3”. It is our assessment that the likelihood of the Fed instigating QE3 has risen significantly, in part due to the weakening economic outlook, but also because of the composition of voting members next year. All three dissenting voices will be replaced in 2012 and the average monetary policy stance of voting members will become much more dovish (only one voting member is considered a hawk – Jeffrey Lacker, the Richmond President)1. With inflation expectations declining, we consider Fed Chairman Bernanke may again present the need for further easing, arguing deflationary risks have become elevated, or at the very least, that further easing will not generate significant inflationary pressures. We believe the impending FOMC composition may consider this argument compelling, and is likely to err on the side of overstimulation.
All of which leads us to believe that the outlook for the U.S. dollar remains to the downside. With continued expansionary monetary policy likely here in the States, and an apparent lack of such policies elsewhere, we believe the divergence in monetary policy is set to resume and likely conspire to further erode the value of the U.S. dollar. When a central bank prints money to finance its quantitative easing purchases, whether that is Treasuries or any other asset, that central bank increases its balance sheet and in so doing, increases the supply of the currency. Without an offsetting increase in demand, increases in the supply of any asset naturally puts downward pressure on the price of that asset – these dynamics are thus likely to put downward pressure on the U.S. dollar. However, there’s an opposite side to this trade: because currencies always trade in pairs, currencies of countries not following such expansionary policies are likely to appreciate relative to the U.S. dollar. It is within this context that we believe the euro, amongst other currencies, may offer strategic value.
With all the market concerns surrounding Europe, we would be remiss not to mention why we hold a contrarian, optimistic view on the currency over the medium and long term, relative to the U.S. dollar. Europe certainly has problems, but in an odd way, it is the inflexibility of its political make-up that may lead to a stronger euro over the foreseeable future. With no central Treasury to decide on fiscal policy for the Eurozone as a whole, the political process to agree upon almost anything is convoluted and time consuming. We have seen it time and again, and it has caused no end of consternation regarding sovereign bailouts and the European Financial Stability Facility (EFSF) in particular. Many individual countries find themselves with very weak political leadership, but interestingly, have instigated, in many cases, very strict austerity measures with opposition support. The issues facing the Eurozone are significant, and there is no simple, easy solution; it’s likely to be a drawn out process rectifying years of malinvestment brought about by unconscionably low funding rates for periphery nations (Greece could borrow at rates similar to Germany for years leading up to the crisis). In turn, economic growth may be restrained over the foreseeable future. Note, however, that economic growth is not necessarily a precondition for a strong currency; it is not incompatible to have poor economic growth on the back of a strong currency – just look at Japan.
We believe two key reasons have contributed to Japanese yen strength – weak leadership and a current account surplus. Weak leadership meant that Japanese politicians had little influence on the Bank of Japan, thus monetary expansion was constrained and the supply of Japanese yen remained relatively stable. In fact, the Japanese were one of the only central banks not to drastically increase the size or composition of its balance sheet in reaction to the financial crisis in 2008. On the other hand, a country with a current account surplus does not require investment from abroad to underpin strength in its currency; it essentially needs investors to sell its currency to stop it from appreciating. The opposite is true for the U.S. – the present current account deficit requires purchases in U.S. dollar denominated assets every single business day just to keep the dollar from declining.
On the above two factors, the Eurozone is not so dissimilar to Japan: the Eurozone has a broadly balanced current account, fiscal union is disjointed at best, and many individual nations have very weak political leadership. Furthermore, the ECB has a sole mandate of price stability, and is reticent to provide any direct bailout funding or directed asset purchases to the financial industry, or specific sovereigns, for fear of overstepping its bounds (or being taken to court by the Germans). The ECB is also fiercely independent. As such, there is little political influence to follow expansionary monetary policies. If anything, the opposite is true, given the criticism leveled at the ECB from Germany. Contrast this with the Fed, which has a dual mandate to foster maximum employment and price stability, which inherently creates conflicts between its two objectives, and arguably lends itself to more expansionary policies. To this point, whereas the Fed considers inflationary pressures to be transitory, the ECB is taking inflation very seriously, and likely a key reason why it did not cut interest rates at its most recent meeting in early October. Indeed, with inflation running around 3% in the Eurozone, combined with the ECB’s sole inflation mandate, there appears to be strong fortitude to maintain interest rates at present levels. As a result, we consider the euro can appreciate on the backdrop of weaker economic growth and continued divergence in monetary policies.
Turning to Asia, we continue to see upside potential in the Chinese renminbi and believe policy makers will continue to be incentivized to allow the currency to appreciate to tackle domestic inflationary pressures. We do not think China will allow its currency to appreciate because the U.S. Senate passes a bill aimed at pressuring the Chinese. If anything, this act simply creates greater political risk and protectionist pressures, ultimately leading to lower levels of global investment and efficiency. (Incidentally, YTD through Sep 30th, 2011, the Chinese renminbi was one of the only Asian currencies to appreciate, returning over 3.5% during this time frame). Inflation is running above 6% in China, with food and labor cost inflation running substantially higher than that. Moreover, actual inflation is likely to be somewhat higher than the reported figures. In our opinion, the prime motivation for the ruling Communist Party to stay in power is to foster social stability; inflation causes a destabilizing effect on social stability – it should come as no surprise that the Chinese attempted to contain news coverage from the “Arab Spring”, which was, in large part, caused by rising levels of inflation and lower standards of living. Interestingly, these inflationary pressures in Asia are having an effect in the U.S. through imported inflation. Recent import price inflation has been running well over 10%; the last time we saw these levels was in the spring of 2008 when oil was approaching all time highs.
Elsewhere in Asia we favor Asian countries that produce goods and services at the mid to high end of the value chain: higher end producers have greater pricing power, whereas low-end producers compete predominantly on price. It is for this very reason that we see the stronger Asian countries, like China, having the ability to pass on increased costs through exported inflation, or U.S. import price rises, described above.
With so many global dynamics to play out, we believe numerous opportunities are evident within the currency asset class, and continue to believe that currencies may provide valuable portfolio diversification benefits and upside potential.
Subscribe to Merk Insights to be informed of our analysis as this crisis evolves; please also sign up to our Webinar on Thursday, October 20, 2011, to provide a live analysis on global dynamics, the U.S. dollar and the Merk Funds. We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund. To learn more about the Funds, please visit www.merkfunds.com.
Axel Merk & Kieran Osborne, CFA
Manager of the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund and the Merk Currency Enhanced U.S. Equity Fund, www.merkfunds.com
Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.
Kieran Osborne is the Director of Research and Co-Portfolio Manager of the Merk Absolute Return Currency Fund and the Merk Currency Enhanced U.S. Equity Fund, part of the Merk Funds.
The Merk Hard Currency Fund (MERKX) seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.
The Merk Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.
The Merk Absolute Return Currency Fund (MABFX) seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.
The Merk Currency Enhanced U.S. Equity Fund (MUSFX) seeks to generate total returns that exceed that of the S&P 500 Index. By employing a currency overlay, the Merk Currency Enhanced U.S. Equity Fund actively manages U.S. dollar and other currency risk while concurrently providing investment exposure to the S&P 500.
The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds’ website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
Since the Funds primarily invest in foreign currencies, changes in currency exchange rates affect the value of what the Funds own and the price of the Funds’ shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, emerging market risk, and relatively illiquid markets. The Funds are subject to interest rate risk, which is the risk that debt securities in the Funds’ portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities, such as for- ward contracts, which can be volatile and involve various types and degrees of risk. If the U.S. dollar fluctuates in value against currencies the Funds are exposed to, your investment may also fluctuate in value. The Merk Currency Enhanced U.S. Equity Fund may invest in exchange traded funds (“ETFs”). Like stocks, ETFs are subject to fluctuations in market value, may trade at prices above or below net asset value and are subject to direct, as well as indirect fees and expenses. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds’ prospectuses.
This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.
1Generally speaking, a central banker may be considered a hawk if his or her monetary policy stance is perceived to focus more on inflation and less on expansionary policies; generally speaking, a central banker may be considered a dove if his or her monetary policy stance is perceived to focus more on stimulating employment and economic growth and less on inflation.
