Portfolio Adjustments For A Changing World Reserve Currency Basket

Since long before most investors took their first breath, there has been an unequivocal king of the financial world. Locals call him Buck, most call him King, and those he shuns call him the Devil. King-to-be Dollar ran away from Cranky Old Gold in 1914, claimed the throne in 1920, and put Uncle Sterling off to pasture under the Bretton Woods Agreement in 1944.

Prior to the agreement, there was a peg of 4.03 US Dollars per Pound Sterling. The ratio was then immediately adjusted to 3.5, with a requirement that the currencies would float freely versus one another within 2 years. Decades of continued negotiations saw pegs of 2.8 and 2.4 before the currencies finally floated freely against one another in the early 1970s, resulting in a dip below 2 for the first time. In 2022 the two currencies came within 7% of reaching parity.

China’s Yuan (CYB) is the consensus pick for next top reserve currency, but her neighbor to the south may be even better positioned to gain. The reserve currency basket is more diverse than ever, making changes more fluid and potentially more volatile overall.

Investors do themselves no favors by choosing sides in geopolitics. They do, however, either benefit or suffer greatly based on positioning when structural changes occur in the global economy. From 2009-15, countless macro guys and gals made the mistake of thinking QE would be the “straw that broke the camel’s back” in a global economy where King Dollar had taken too many liberties. A rising tide lifts all boats and, despite the United States’ economy benefiting the most from QE in an unbalanced and obvious manner, “money printer go brrr” was in fact a strong dollar strategy in that it maintained the status quo rather than allowing a collapse that would have sought new leadership.

The U.S. dollar rallied in 2022, as the Fed led reserve banks worldwide to fight inflation that plagued most currencies far worse than it did King Dollar. Despite inflation slowing as 2023 gets underway, prices remain elevated and consumer savings have been depleted. While the Fed focuses on its balance sheet and lagging domestic indicators, many economies are dealing with catastrophic recessions.

What seemed like weak dollar policies 10 years ago turned out to be strong dollar policies, and what is currently being touted as a strong dollar policy will prove to be ol’ Bucky’s demise. The United States has gone from fearless leader to cowering penny pincher in the eyes of the observing world. It’s not necessarily to say that the Fed raised rates too far, too fast, or for too long, but more so that reign atop the currency ranks means structural change is needed to maintain balance. Hyperinflation and slowdown were the Fed’s two choices, neither a winning hand. Unsurprisingly, it chose to save itself.

Many consider India’s government, led by Modi, far and above the most diplomatic of any major world power. India plays both sides in the growing East vs West trade war, which was ignited in 2018 by the most intentionally undiplomatic leader the free world has ever had. India gets favorable terms from both East and West, part of the reason the Nifty 50 and Bombay Stock Exchange performed better than any other stock markets their size in 2022.

My contrarian nature makes me more prone to seek underappreciated names rather than to jump on the Bombay Train near all-time highs. Investors may very well be served best to buy and hold the iShares India ETF (INDA) or individual Indian companies at current levels. I’m compelled to start a small long Rupee vs Dollar position near these levels, as I fully expect the Rupee to enjoy a substantial growth in market share within the world reserve currency basket by the end of the decade. Unfortunately, the Rupee ETF (formerly INR) was delisted, so investors have to use forex markets or currency exchanges to buy the Rupee.

China’s currency, the Yuan, broke out to all-time highs against the U.S. dollar in late 2021 before equity markets turned south. With China’s consumption levels and share prices highly correlated to the United States economy for the time being, China’s currency is my preferred way to own exposure to the soon-to-be largest economy in the world. My plan is to initiate small positions in each of the Rupee and Yuan, and roll into equities when I feel more comfortable with valuation in India and growth prospects in China.

At current market prices, the most glaring value proposition I see is set to benefit from the Americas becoming a level playing field.

Canada’s Trudeau garners the role of top diplomat in the Americas, indeed considered a “soft” playing field. Canada is in the top 5 globally for energy exports and gold mining, making it far more resource rich relative to both national debt and GDP than the United States. Gold (GLD), which I own, has been a beacon of stability throughout the tumult that has defined the last few years, and many call for its official inclusion in the currency reserve basket. Currencies from gold rich countries, China being the world leader, are likely to experience outperformance going forward versus others, all else equal. The Canadian Dollar, already well established within the reserve basket, stands to grow its share. If that is the case, dividends to be paid in Canadian Dollars, or Rupees or Yuan for that matter, are extremely appealing.

Citi (C) and Bank of America (BAC) have recently downgraded U.S. equities in favor of European ones based on valuation. The war in Ukraine alone makes me consider Europe a greater risk than South America, which offers much lower valuations. Canada offers similar valuations to Europe, with significantly better growth prospects and a better risk profile by many magnitudes. Canada’s resources and standalone currency make for unique positioning among Western economies. The entire population of Canada is less than that of California. Climate change is making the equator, once the planet’s most prized location, repel humanity. More and more of Canada is becoming appealing to develop, be it for resources, tourism or other commerce. The immense size of Canada combined with its low population density offer growth prospects no other Western economy can claim.

Utility companies in Canada, much like the USA, have been the market’s top performers in the risk off environment defined by rising interest rates. My preference is to add shares of Canadian banks in the near term, with an eye on utilities to add on weakness in the future. The iShares Canada ETF (EWC), with strong financial and yield components, gets a buy rating from me and will be on my watch list.

Largely due to lower oil prices, both earnings and yields are expected to fall near term for Canada’s banking sector. Still, reserve currency changes will soon make investors in shares of United States banks and utilities run for the exits and stampede into shares of companies that transact in better positioned currencies. There are quite a few New York listed Canadian banks that offer attractive valuations and high dividends. Their operations vary substantially, making the banking sector landscape quite different to that of the United States. Bank of Nova Scotia (BNS) has a substantial presence in the Caribbean and Central America. Valuations in those regions are generally substantially lower than in more developed economies, making BNS very pricey relative to Royal Bank of Canada (RY), Bank of Montreal (BMO), Toronto Dominion Bank (TD) and Canadian Imperial Bank of Commerce (CM). RY garners the same type of leadership premium JP Morgan (JPM) does compared to other U.S. banking shares, again making my preference to look elsewhere for better value.

CM is my top pick, as it caters to higher net worth clients, offers the lowest price to book of the stocks listed above, and similarly high profit margins and returns on equity to the leader RY. Decreased deal making since 2021 make the current P/E just over 8x and yield of 6% appear overstated on a forward basis, as is the case for all Canadian banks. Still, CM has an excellent dividend growth history, including increases each of the last 7 years.

There are impending changes economists see well underway that investors have generally failed to account for. Unfortunately, analysts at Citi and Bank of America are looking backwards to Europe rather than forward to tomorrow’s leaders. Equity markets are starting to crave U.S. dollar weakness, with recent equity bounces coinciding with substantial USD declines. “Petroyuan” usage has gone parabolic, as the war in Ukraine has resulted in polarization away from US dollar transactions. Once the world reserve currency basket has fully shifted away from dollar dominance, there will be exactly zero going back.