Avoiding the Calamity
Smart investors are abuzz these days over what they call the “Calamity” — shorthand for a set of potential catastrophes to U.S. markets in the next few years. Scenarios include a dollar collapse, financial system failure, or a combination.
Triggers might include:
- Central banks of east Asia stop supporting the dollar.
- Interlocking web of derivatives contracts between major U.S. financial organizations could contain an unforeseen concentration of exposure in those firms, causing a cascade of failures as one fails to meet its obligation to others.
Among the doomsayers are big names like Warren Buffett, the world’s most successful investor. Recent statements by Buffett and his vice-chairman, Charlie Munger, imply that their holding company, Berkshire Hathaway, is holding over $60 billion in cash and short-term instruments, both directly and through subsidiaries. This amounts to more than half its market capitalization. Berkshire is voting with its pocketbook.
Yet avoiding the Calamity may not be so easy for small investors. At the 2004 Berkshire annual shareholders’ meeting, I heard Buffett mention in passing that “anyone” could hedge against the dollar by investing in conservative non-dollar-denominated issues. I decided to check whether this was as easy as he suggested.
For this experiment, I resolved to purchase French “OATies” — inflation-indexed bonds issued in euros by the French treasury — in the secondary market, for my own account. The logic was that these would provide a hedge against all components of The Calamity: inflation, a dollar collapse, and a U.S.-based financial crisis.
It turns out that, while easy for a billionaire with a staff of 20, this kind of hedge is operationally complicated and expensive for individuals, for a number of reasons.
- U.S. brokerages generally do not allow you to hold securities denominated in foreign currencies.
- ADRs (American Depositary Receipts), the usual vehicle for holding foreign securities in dollars, do not appear to exist for basic conservative investments, such as the government bonds of other countries.
- There exist no mutual funds that simply hold portfolios of conservative foreign government bonds.
- There exist no mutual funds that invest in inflation-indexed foreign government bonds.
Faced with these limitations, the individual investor’s simplest path is to open a foreign bank account in, say, euros; transfer dollars into it, paying exchange fees; open a foreign brokerage account; transfer the euros into that; then buy securities via the foreign brokerage.
While on this journey, I did discover a few items for the wild and wooly speculators out there:
- Brokerages would love to sell you derivatives that bet against the dollar, e.g. forward contracts. However, no reasonable person could call these conservative; most successful investors would not even call this an investment. It’s a speculation on a currency direction in the immediate future. By contrast, buying quality government bonds or shares in well-financed companies, at reasonable prices, constitutes an investment regardless of the currency. (Note also that, if you believe Buffett and Munger about derivatives exposure, you have to ask yourself whether the issuer would be able to pay you if the dollar actually did collapse.)
- There are lots of mutual funds invested in dubious foreign bonds, such as government issues of Russia, Brazil and Mexico — all of which have defaulted on obligations in the past 20 years. Moreover, they generally have long durations of 6 to 8 years, which exposes you to rising interest rates, which are likely. In most counties, interest rates certainly aren’t going down from here.
So what’s left for the individual investor? There are a few short-term international bond funds that come close to filling the bill. For example, Payden Global Short Bond Fund (PYGSX) doesn’t hold AAA bonds, but is diversified and short-term, which limits exposure to both interest rates and defaults.