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Investment strategies geared to protect against the mammoth U.S. deficits

by Wayne Cheveldayoff, 2003-09-13

The enormous U.S. budget and trade deficits are already having an impact on investment portfolios through the decline in the U.S. dollar (and appreciation of the Canadian dollar and European euro), a rising gold price and a recent upward adjustment in longer-term bond yields.

But it is not too late for investors to take protective action in their portfolios.

With the U.S. deficits continuing to grow, it is likely that there will be more and bigger shifts in currencies, gold and interest rates in the same direction. In addition, while there will be short-term winners and losers in the stock market, the probable eventual outcome--namely more U.S. inflation--will not be good for equities.

Those who have not been keeping track may be surprised to learn that the U.S. government deficit is now forecast to be US$600 billion in the fiscal year beginning Oct. 1, 2003. This is approximately 5.5 per cent of U.S. gross domestic product, which is approximately the same as the peak level reached in the early 1980s and higher than the more-recent 5.1 per cent peak in 1991. Many are warning that the U.S. deficit could stay high for a number of years.

The current account goods and services trade deficit has also widened to approximately US$40 billion a month, or close to US$500 billion annually.

The world’s largest economy now needs about US$1.5 billion a day in foreign capital to fund this trade deficit.

As many countries, including Canada, have learned through tough experience, when current account deficits get this extreme, either interest rates eventually have to rise, or the currency exchange rate has to fall, in order to attract sufficient foreign capital.

With the U.S. Federal Reserve recently flooding the system with money and keeping short-term interest rates low, the burden of adjustment has fallen on the U.S. dollar, which is down against the euro by around 30 per cent over the past three years.

While the expected spurt in U.S. economic growth in the third and fourth quarters of 2003 may attract enough foreign capital to keep the U.S. dollar stable in the short run, the deficit fundamentals are pointing to another ratcheting down for the dollar in the months and years ahead.

While the decline so far against the euro may seem sizeable, it is still modest when compared with past episodes of exchange rate depreciation, and nobody is talking yet about overshooting, which happens a lot when currencies start to move. When the U.S. trade deficit was high in the mid-1980s, the U.S. dollar depreciated more than 60 per cent against the German mark over a number of years.

The expectation of continued high budget deficits is supported by the reality that politicians everywhere would much rather try to grow or inflate their way out of a deficit than take the harsh medicine--spending cuts and tax increases—otherwise needed to deal with it.

As the deficits pile up and the U.S. reflation effort turns into actual inflation, this will eventually have a major impact on longer-term U.S. interest rates. With business investment slack at present, the huge amount of government borrowing is not pushing up longer-term interest rates much. But when business investment does kick in, there will be a crowding-out effect in the capital markets that will almost certainly mean higher longer-term interest rates.

Here is what the International Monetary Fund said in August 2003 about the ballooning U.S. budget deficit. “The worsening of the longer-term fiscal position, including as a result of the recent tax cuts, will make it even more difficult to cope with the aging of the baby boom generation, and will eventually crowd out investment and erode U.S. productivity growth.”

Canadian investors trying to steer clear of the fallout would do well to consider a shift within their portfolios towards:

· Companies with little debt (that won’t be hurt by rising interest rates)
· Gold and other precious metals stocks
· Less exposure to the U.S. dollar and more to the Canadian dollar and euro
· Canadian companies and income trusts that won’t get hurt much by a rising Canadian dollar
· U.S. companies that will benefit from a falling U.S. dollar
· Stocks that will benefit from higher inflation
· Short-term bonds (avoiding longer-term bonds until yields rise significantly)
· Real return bonds (because the total return will be enhanced by inflation)
· A healthy amount of cash (to be able to take advantage of extreme overshoots in the markets in the coming turmoil)

If, as is likely, the U.S. government sticks to its reflation policies and inflation makes a comeback, overall stock market performance in the coming years will probably be tepid, and those relying on index investing are likely going to be disappointed.

History has shown that with inflation on the rise, the stock market has a much tougher time going up, as future earnings streams get devalued.

This is particularly true in the technology sector, where current valuations depend disproportionately on projected cash flows (as opposed to current dividends). A rise in interest rates will mean a rise in the rate used to discount future cash flows, resulting in lower present values and stock market valuations.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.


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©2003 Wayne Cheveldayoff