On behalf of my teammates here at Hedgeye, I'd like to thank all of you - our subscribers, partners, and friends - for giving us all of the research feedback that you do. Today, we would like to share with you some interesting and well-thought out feedback on the U.S. Dollar’s long term outlook from one of our subscribers, as well as our responses to that subscriber.
We remain long the U.S. Dollar via the etf UUP in the Hedgeye Virtual Portfolio.
To: Darius Dale
Subject: Long Term Outlook for the U.S. Dollar
JEFF: “You guys do great work and are providing a fantastic service to the investor/wealth manager marketplace.
Question for you, has Hedgeye considered doing a longer term prognosis for the USD and what that entails from an investment thesis perspective? You have been very adroit at calling short term inflection points and directional changes in the USD, but what about longer term? The reason I ask this is that despite the recent fall off in correlation between the $$ buck and commodities and metals, hasn't it typically been a higher correlation (since all this "stuff" is dollar denominated?) Longer term, so goes the dollar, so goes (inversely) oil, gold, silver, PGMs, most agriculture, etc. Is that truth or myth?”
HEDGEYE: We have done a great deal of longer-term work on the $USD, none more powerful than our August Monthly Strategy Call – Should U.S. Government Debt Be Rated Junk Status (email us if you need a copy of the replay and presentation materials).
It’s true that commodities have historically moved inversely with the $USD (see chart below).
JEFF: “Not to come off as overly cynical, but for all the rhetoric by politicians on cutting government spending and fiscal responsibility, we have heard this before. Deficit spending in and of itself isn't disastrous, but long term sustained and growing deficit spending eventually is, and that's the situation the U.S. is in. I couldn't tell you precisely when the US began it's sustained deficit spending binge (aside from WW2), but my sense is that it has been going on at least since Ike and has been virtually unabated, except for a year or two during the Clinton administration, for the better part of 50 years.
At this point I would venture several observations: 1) 50 years is a long time, 2) it is both a republican and democrat problem, both parties are guilty of it, so simply changing the political guard is not a solution, and 3) it has been aided and abetted by a willing electorate, of which 45% of households now pay little to no income taxes (WSJ). To think that the U.S. will suddenly find the "new religion" of austerity and fiscal responsibility on the heels of half a century of spending beyond it's means, one would have to suspend one's faculties. People have gotten too used to getting free stuff, and politicians have gotten too used to giving stuff away to get re-elected, and government has gotten too big and bloated and wants to sustain itself and the populace, like the proverbial frog in the slowly boiling water, has grown to increasingly think we actually need this government. And with enlarged government, comes the need to spend, and spend the U.S. has like no government before it in the history of the world. Obviously, this has major implications for where we find ourselves and equally major implications for where we go from here.
And this is where I come to the crux of my question(s) for Hedgeye.
The Reality on U.S. Deficit Spending
First, ignoring unfunded liabilities (or maybe not?), if you graphed annual U.S. government deficit spending since the 60's I think you might find pretty quickly that deficit spending was a structural problem in the U.S. All rhetoric to the contrary is simply that: rhetoric. The question in the U.S. is not "will there be a deficit?" It's how LARGE the deficit will be? I believe I am correct in saying that if you look at the data, one would have to believe in elves in the forest to believe for a moment that the U.S. is capable of balancing a budget. "Fiscal restraint" is political code for running smaller deficits. It just doesn't seem do-able.”
What's the Run-Rate on U.S. Debt (where are we going?)
With Washington essentially gridlocked for the next two years, what is the run-rate on U.S. Government Debt? David Stockman has said that we are adding $1T to the national debt every 15 months. That actually seems low to me. Today we are at $13-$14T national debt, by end of 2011 where will we be? $15T ? Where will we be by the end of 2012? $16T + ? With a slowing global economy and the U.S. economy with more drags on it than a farm tractor (housing, high unemployment, de-leveraging, major state level budget issues, banks with huge loan impairments still sitting on their books, etc.), what is your outlook for US GDP to government debt? Looks like we are getting ready to flip upside down with government debt soon to exceed GDP. Maybe that's already happened. It used to be that people justified spending as long as economic growth exceeded it. "It's not how much debt you have, it's how much GDP you have." Now the runaway train of debt appears to be getting ready to race past GDP (isn't this a historical and somewhat foreboding event?) and while it's hard to grow an economy by $1T of GDP in a year, our run-amuck government doesn't seem to have any problem exceeding that in debt creation (year after year). In fact the US is now buying it's own debt . This all seems to be pushing us to some kind of tipping point.”
HEDGEYE: It’s downright frightening to consider that the U.S. government debt will soon exceed GDP – especially when you consider the seminal work of Reinhart and Rogoff, who have shown empirically that debt > 90%/GDP structurally impairs economic growth by nearly half in advanced economies. We could blow by 100% debt/GDP much sooner than consensus thinks, as our deficit/GDP projections for the next two years are significantly greater than the likes of the CBO and OMB (see charts below).
JEFF: “What's the Historical Correlation of U.S. Debt Growth to the Decline of the USD?
Seems like a pretty clear correlation, not every year, but over time. You out-spend your economic growth, you run structural deficits year after year, you pile debt upon debt. You ultimately create a drag on economic growth and de-base your currency. Is this the case with the USD? “
HEDGEYE: The $USD has responded as you would expect to long-term debt buildup and structural deficit spending.
JEFF: “What are the Implications of all this?
IF deficit spending is a structural problem in the U.S. with a lengthy history going back a half century (I think the data suggests it is); and
IF little progress can be made over the next 2 years due to Washington gridlock, in any case, the current deficit run-rate is a complete runaway train regardless; and
IF there is a longer term correlation between growth of public debt and devaluation of the USD
Then what are the longer term implications for investing in things that are denominated in the USD?
HEDGEYE: One would think up, but the likelihood that the USD gets replaced as the world’s reserve currency grows with each passing day (see recent SDR adjustments). Why not crude oil denominated in Chinese yuan? It’s not that far of a conceptual leap as it was even five years ago. This is a very long term call, of course, so there will be a lot of volatility to weather from here to now. That’s why we proactively manage risk on a duration-agnostic basis.
I know this is a complicated question. It's actually a bundle of questions. On one hand, in the context of history, it seems quite simple: you run up unsustainable debts, you ultimately hammer your currency, maybe create a crisis and put a drag on economic growth (Japan). But on the other hand, currencies are baskets of other currencies, it's all relative. In the short term what matters is how you stack up relative to everyone else and Europe clearly has significant problems, but it seems like our time is coming, perhaps a couple of years down the road. Perhaps it's just a question of duration. The SS United States is sinking more slowly, taking longer, but sinking nonetheless.”
HEDGEYE: You hit the nail on its head here, particularly with your points on duration. Duration Mismatch gets a lot of super-duper smart investors ran over because they don’t realize the fundamental difference between investment research and actually investing. Japan and one/all of the PIIGS could blow up before the U.S. has its day of reckoning.
JEFF: “Does US debt (excluding unfunded Liabilities) now exceed GDP? Will that be a seminal event in U.S. economic history? Does it matter?”
HEDGEYE: No, not yet, and yes, this will be a seminal event in the U.S.’ economic history. Whether the markets lend the appropriate focus to it or not will be another story. At any rate, anyone who understands the effects of leverage on the way down will arrive at the conclusion that piling debt upon debt will always matter and it is a negative thing once the Rubicon of 90% Debt/GDP is crossed.
JEFF: “While the dollar may be breaking out to the upside in the short term, what is your longer term take on the USD in light of mounting U.S. debt problems?”
JEFF: “What is your take on the run-rate for U.S. debt? Do you see a tipping point? Even if we waved a magic wand over Washington and political contention ceased and harmony and singleness of purpose suddenly prevailed, isn't the best case that we run $500-$600B annual deficits? Is the US debt a runaway train at this point even under better circumstances?”
HEDGEYE: Yes, the boat has left the dock. As we uncovered in our call w/ Peter Orszag, former director of the OMB, we can only cut so much – perhaps to the tune of just 1% of GDP. To really rein in the deficit, we need a revenue adjustment – and a major one at that. Whether or not there will be any political spine to implement such a solution is, at best, up for debate and, at worst, unlikely.
JEFF: “If this is the case, what is the investment implication for usual suspects like oil, gold and other commodities?”
HEDGEYE: We are bullish long term on both crude oil and gold – but not at every price. There will be alpha to uncover on both the long and short side of all three (USD, gold, oil) over various durations within the context of the long-term structural decline of the USD.
I could be totally wrong here and some of the comments I put forward as facts may not be fully accurate and may in fact be pseudo-facts (I think they are substantially accurate, but I may be wrong), but this overall question on debt, the dollar and it's implications for investing seem like the "elephant in the room". Hedgeye has proven itself quite skilled at making macro calls and you certainly aren't afraid of calling BS when you see it. It seems like "having a take" and being positioned for where we are headed a few years down the road, would be an extremely worthwhile endeavor. Food for thought.
All the best to Hedgeye,