Blog: Spirit of Money, Financial Fluidity
by munificent

Buffett and the U.S.$

Well, are we lucky? Or solid? Who cares as long as life is going our way....hmmmm

Date:   6/16/2005 11:20:54 AM   ( 16 y ) ... viewed 1252 times

How Buffett Tripped Over the Dollar

By Jon D. Markman Contributor
6/16/2005 7:12 AM EDT

Six months ago, the value of the U.S. dollar was on the firing line as it plunged to a record low vs. the euro. Amid fears that a united Europe would surmount the spendthrift U.S. as a safe haven for financial assets in a tumultuous world, investors worldwide -- led by noted Nebraska sourpuss Warren Buffett -- heaped scorn on our currency and scolded U.S. lawmakers to get the federal deficit under control.

But a funny thing happened to all those dollar bears. Their contempt for U.S. economic freedoms hasn't amounted to a hill of beans, and their positions have been smoked. The dollar has rallied massively since the start of the year against all other currencies, reflecting a swift, stunning paradigm shift in the way that global political risks are priced.

Buffett, who reportedly lifted his bet against the buck to a position of $22 billion and counting in the first quarter this year, isn't sounding quite so smug anymore. Normally an equity investor with liberal social views who rarely made forays into the foreign-exchange markets, he has had his head handed to him by more experienced currency players. Although his antidollar attack worked from 2002 through 2004, since then he has been forced to pay for attempting to mix politics and money.

Berkshire Investors Suffer
An uncharacteristic earnings growth setback at his Berkshire Hathaway (BRK.A:NYSE - news - research) conglomerate in the first quarter was attributed to this wrong-way wager against the greenback in favor of other currencies -- including the euro, Swiss franc, Australian dollar and British pound. The second quarter is concluding with an even worse tone for the position. It's not fair to assume that the dollar's rally will continue, but it has shown typical American scrappiness in its comeback against doomsayers and ill-wishers.
Is Buffett likely to be proven right anytime soon, or will his investors continue to suffer from his bearish posture toward the buck? It all depends on your view of the relative strength of U.S. and European economic policies and political structures.

Buffett has told shareholders that he took his original position on the basis of a belief that Bush policies had led to unsustainable twin deficits in the federal budget and the balance of our trade with the world.

But guess what? Due to improved tax collection, higher payroll earnings, a modest decline in overall government spending and better-than-expected corporate earnings, estimates of the U.S. budget deficit are steadily on the decline. The 12-month federal deficit has narrowed to $339 billion, or 2.8% of GDP, according to Ned Davis Research. Receipts have been growing twice as fast as spending over the past 12 months, as both corporate and individual tax contributions have been stronger than estimated.

Although the cutback in spending presents our economy with a fiscal drag, the result has been a positive reassessment of Americans' focus on getting their house in order.

Good News Grows
This week, more uplifting economic news appears to be in store. Economists at ISI Group report that their proprietary weekly survey of corporate results in key sectors is trending much higher than they expected, with particular strength from retailers, restaurants and car dealers. Auto production is much higher on the heels of new incentive programs, and consumer confidence has reversed its decline and is now trending up.
Much of the strength has resulted from the continuing boom in new-home sales. And these sales are themselves a function of the improvement in the bond market that has lowered bond yields, and thus mortgage costs. As for the trade deficit, here's a shocker: U.S. exports were actually up 13% year over year in April. In other words, we may be on the verge of a virtuous cycle that could push U.S. GDP growth back up to the 3% level this quarter.

At the same time, Europe and Asia continue to falter. As ISI analysts pointed out, the past week's news brought word of weaker French industrial production, diminished European corporate finance executives' confidence, the worst Australian business expectations in 14 years, a setback in Swedish industrial production and weaker retail sales, home prices and consumer confidence in the U.K. There are also new reports of a cool-down in Chinese imports, exports, home construction, manufacturing growth and leading economic indicators.

For an exclamation point at the end of this scenario, foreign-currency bears point to a 26% decline in scrap-metal prices last week and another 10% plunge in the Baltic Freight Index, which measures demand for ocean shipping.

A country's currency can be considered in a way to be analogous to a company's stock. When central banks and trading partners are positive on a country and its ability to be an effective store of value, they simultaneously buy its currency and sell the currency of other countries. When they believe that a country's ability to pay its debts is eroding, either because of a loss of vitality or inflation, then they sell the currency.

The bottom line now is that, according to Bloomberg data, holdings of U.S. government debt by international investors and central banks rose by $93.2 billion, or nearly 5%, to $1.9 trillion last quarter. As the dollar has risen in value, it has helped foreign investors retain the value of their U.S. assets. The dollar's strength has also kept inflation down -- further preserving the value of bonds' coupon payments.

Our recent confluence of happy events -- stronger dollar, higher U.S. bond prices, lower bond yields and lower inflation -- has further widened the gap between our economy and that of the disorganized, disrupted and disturbed Europeans. The benchmark 10-year Treasury bond now yields about 90 basis points more than its German equivalent. The average of the spread between the two over the past decade has been 14 basis points, or 0.14 percentage points. To give you some perspective, 10 months ago -- before the recent U.S. presidential election -- there was no difference in yield at all as anti-American paranoia and panic gripped the world's bond traders.

All of this bodes well for the ability of the U.S. to attract the foreign investors who buy our debt and fund our success. Already, foreign banks and pension funds, most notably in China, Japan and South Korea, own nearly 50% of all the U.S. Treasuries that have been issued, or about $1.9 trillion. And the more they want to buy, the lower the yields will go -- supporting further gains in interest-rate sensitive sectors, such as the U.S. homebuilding industry.

The Euro Factor
At the end of the day, all decisions to buy and sell things are made at the expense of some other thing. In the case of the dollar, that other thing is a currency in Europe that may simply not exist five years from now. Influential Italian politicians have begun calling for a return to the lira, a majority of Germans polled say they would like to see a return to the deutschemark, and a leading British editorialist called the euro "a heroic project" whose ultimate failure has become more likely.

What Buffett and his cohorts failed to understand as they thumbed their nose at the dollar was that it's impossible for Europeans to sustain a single currency without a commitment to a single European political and economic policy. And the liberal immigration laws demanded by such integration have proven to be social anathema, as Northern Europeans have freaked out over the prospect of a flood of cheap Eastern European and Turkish labor stealing their good blue-collar jobs.

There will be no credible alternative to the dollar as a store of value until the Europeans decide they can live and work together in peace. While it is a noble and worthwhile goal, there is at least 300 years of recent world history to suggest that it is an unlikely prospect.

For the foreseeable future, the greenback will continue to denominate, and dominate, world trade. And it is only a matter of time before Buffett announces that he is returning to matters he understands better than world currency flows, such as the value of Dairy Queen, See's Candies and Coke.

Jon Markman, writer of Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback; click here to send him an email.

Interested in more writings from Jon Markman? Check out his newsletter, Value Investor. For more information, click here.


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