3/27/13 – A Smaller Piece of a Bigger Pie—And Getting Smaller

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 27, 2013 11:11:59 AM

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Looking at the effects of Cyprus echoing around the financial markets, one thing that’s become apparent is that it really isn’t all about the U.S. any more. Even as the U.S. economy continues to recover, the international press doesn’t care that much. We are a much smaller piece of a much bigger pie. Still the largest piece, still important, but not what we were.

Some of the perennial questions I get from clients arise from our diminished place in the scheme of things. What happens, for example, if the dollar collapses? Given the central role the U.S. occupies in the world financial system, the standing answer has been that it won’t happen any time soon. World trade is denominated in dollars, the world’s low-risk reserve currency. Under current conditions, there is no alternative.

That answer stands, but the logical follow-up question is “What would have to change to remove the U.S. from its central role?” The first thing that would need to happen is a relative decline of the U.S., which, as noted, is underway. The second is the development of an alternative financial infrastructure for the world economy, and that may have started as well.

The nations known as the BRICS (Brazil, Russia, India, China, and South Africa) agreed at a recent conference to start exploring the creation of a currency exchange mechanism and a development bank, with China and Brazil agreeing to swap up to $30 billion with the express goal of allowing firms from the two nations to trade without converting assets to U.S. dollars. This is a big step, particularly as it involves two large and very fast-growing economies.

It’s not the first time such a plan has been tried, and there is no guarantee of success. Previous attempts have either been one-offs, such as using gold to buy Iranian oil, or attempts to work through existing institutions to create a new artificial currency, such as SDRs through the International Monetary Fund. None of these ever got far.

What makes this plan different is the explicit nation-to-nation agreements being developed, as well as the group involved. By bringing together the fastest-growing nations, and ones that have relatively low influence on existing international financial institutions compared to their current economic heft, this idea pairs the political and economic desire to upend the current structure with the potential economic ability to do so.

This is back-page news for now, and a lot of hurdles remain—not least that the U.S. is well aware of the plan and will be doing what it can to place obstacles in the way. Many of these nations and others that might join have disputes that go well beyond the economic. Nonetheless, this is a sign of things to come as the relative economic position of the U.S. in the world economy continues to decline. If this one doesn’t work, another will be along shortly.

What this means for investors with a long-term horizon is that, more than ever, diversification should be as comprehensive as possible. American investors have a very bad home bias, overweighting the U.S. in their portfolios, and that has actually been smart over the past several decades. Looking forward, it may not be as wise.

This is not a “this time is different” moment either, because multi-polar worlds have been the norm rather than the exception throughout history, and the signs of a reversion to the mean are something of which we should be very aware.

Upcoming Appearances

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

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