Kuta Beach

Kuta Beach

Sunday, 15 March 2009

Why Australians Should Hold US Dollars

The chart above shows the performance of the US economy (measured by the S&P500 index, labelled GSPC) and the Australian economy (measured by the All Ords index) compared to the performance of the US dollar relative to the Australian dollar.

What I find interesting is how the Australian economy is pretty much following the US economy. An Australian who holds Australian shares in his super fund won't get much diversification by investing in US stocks since the two seem to copy each other.

Interestingly, the strength of the US dollar seems inversely related to the performance of the stock markets. Even stocks go up, US dollar goes down. When stocks go down, US dollar goes up. This then provides an excellent tool we can use to smooth out the volatility of the stock market.

I have always said that one easy way for Australians to be being exposed to US dollars is simply to make microloans via Kiva. The company is based in America, so any Australians lending money need to convert their Australian dollars into American dollars.

The chart above only goes back two years. Let's look at the performance of the stock markets versus the US dollar over the last five years.

What I think is interesting is that the Australian economy has outperformed the US economy over the last five years. Our economy has done about two times better. The US dollar would be bad for diversification if it were exactly inversely correlated to the stock market. For example, if half your portfolio is in an S&P500 ETF and the other half in an S&P500 inverse ETF then you are wasting your time because you pay fairly significant management fees to hold on to these ETFs and the net effect is a portfolio that mimic holding 100 per cent US dollars.

The chart above shows that the US dollar is not exactly inversely related to the stock markets. Until mid-2006, the US dollar remained flat while the stock markets boomed. Then the US dollar started to fall as the economy keep booming. Scared that the US dollar was collapsing, everyone invested in oil and raw materials, sending prices of petrol, food, metals, etc through the roof. Then three-quarters of the way through 2008 the stock markets tumbled sharply and the carry trade unwinded, which resulted in a boom in the US dollar.

Growth in the economy can be real, e.g. if an oil company invents a cheaper way to extract oil from the ground then they become more profitable, oil is cheaper for consumers, etc. This has benefits for everyone. Company profits are higher, dividend payments should rise, and thus stock prices should go up. The US dollar should remain the same. Nothing is really happening to it. If the technology is invented in the US and many people want to buy it from Americans, perhaps the US dollar will rise slightly.

In contrast to real economy growth, we can have fake growth caused by an increase in the money supply. If there is more money in the economy then this can stimulate economic activity. It is the principle behind all the recent stimulus packages given by central banks around the world today. More money in the economy simply increases the price of everything, including stocks. While people who hold on to stocks may think that they are richer because stock prices have gone up, in reality they are no richer because the currency is depreciating. What is the point of seeing your stocks go up 5 per cent when the price of milk (and everything else) goes up by 5 per cent as well?

This is why people should hold US dollars in their portfolio. When there is real economic growth, the US dollar seems to stay relatively flat while the stock market booms, allowing you to make a net gain. On the other hand, if there is fake economic growth because of more money in the economy, the US dollar seems to be almost exactly inversely related to the stock market, which allows you to preserve your wealth during inflation or deflation. If there is an increase in the money supply, the US dollar falls, which is bad, but companies can charge higher prices and the stock market should rise. However, if there is a massive contraction in the money supply then stocks will plummet but US dollars should go up because of the dollar's increasing scarcity. Holding currency then is the best way to ride out what is looking like a period of deflation or, as one person calls it, stagdeflation.

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