Even conservative investors need to take some risks with their investments in an effort to protect the purchasing power of their savings against inflation. At an inflation rate of only 2 percent per annum, the inflation target Federal Reserve Chairman Ben Bernanke would like to see adopted, today's $1 would only buy 55 cents worth of goods in 30 years.
Some say deflation, not inflation should be front of people's minds. After all, if free market forces were left to its own devices, we would have a further contraction in credit. Because of this, massive reflationary and monetary efforts have been put in place. However, these efforts have not been very effective at reaching those who need access to credit. The money does go somewhere, though: asset prices across the board have been inflated, including commodities, stocks and bonds. Singapore recently revalued its currency higher because the threat of inflation can no longer be ignored. Inflation, not U.S. political pressure, will force the Chinese government to allow its currency to rise. When that happens, commodity prices may come down when valued in Chinese yuan, but may rise further in U.S. dollar terms.
Many think of inflation as a tax, but it can also be thought of as a partial default by governments on their obligations. This is the first time during peacetime that the total level of all industrialized countries' public debt exceeds the combined GDP. In that context, we believe there may no longer be such a thing as a safe asset, and investors may want to take a diversified approach to cash. If central banks are diversifying their reserves into baskets of currencies, why should you as an investor keep all your reserves denominated in one single currency?
Some argue that the U.S. dollar may have issues, but that there are no "safe haven" alternatives. Recently, it has been fashionable to bash Europe and the euro. While Greece has serious challenges, we believe the markets will ultimately see Greece for what it is: a struggling country comprising just over 2 percent of eurozone GDP. While eurozone countries may struggle to meet their debt criteria, at least there are incentives to encourage fiscal restraint.
Also note that Bernanke has testified that going off the gold standard (weakening the currency) during the Great Depression helped the United States recover faster than other countries that did not. True, if your purchasing power is taken away from you through currency devaluation, you have a greater incentive to work. We see something similar playing out now: the United States is pushing growth at any cost, whereas the eurozone's growth may lag, but on the backdrop of a stronger currency. Our analysis shows that countries that depend on foreigners to finance their deficits have currencies sensitive to economic growth; the converse is also true: nations who don't rely on foreign financing tend not to require economic growth to drive currency appreciation. Japan is a prime example: Japan does has a current account surplus, and in spite of lousy economic growth, the Japanese yen experienced one of its best periods from the summer of 2007 through the end of 2009. The reason? The government was in disarray, going through seven finance ministers through this time frame, and hence unable to spend money or exert pressure on the Bank of Japan, allowing free market forces to encourage consumer restraint. In the United States, we are far more effective at printing and spending money than elsewhere in the world, a strategy that bears some risks as the United States manages its debt like an adjustable rate mortgage: about one-third of U.S. government debt matures in the next three years, taking the lead amongst industrialized nations.
There may not be a safe place to invest in the world anymore. Gold, considered as the ultimate safe haven by some, is rather volatile when its price is measured in U.S. dollars; even the staunchest gold bugs rarely have all their money in gold. Diversification may help spread the risk of being exposed to any one currency; putting all your eggs in Bernanke's basket is a risky proposition.
Axel Merk is President & CIO of Merk Investments, Manager of the Merk Hard, Asian and Absolute Currency Funds, www.merkfunds.com. He is also a featured contributor on our sister website, www.AdvisorBiz.com. Check out his latest piece on the Greek debt crisis.
