The Tide Is Turning

What’s Next for American Foreign Policy…
and How to Protect Your Money

By Kim Iskyan

Great leaders are born, not made…

Or so goes the “Great Man Theory,” a 19th century hypothesis that says natural leadership is innate… Certain people are born with abilities that set them apart, pushing them to greatness and often empowering leadership roles. And history is defined by a small number of these epoch-defining men, rather than by big-picture, long-term, impersonal forces.

Like him or not, President Trump is a Great Man president… And American markets will be suffering the consequences for years.

In just four years, Trump dramatically changed the tone and tenor of the U.S. government. He made policy U-turns on the environment, regulation, taxation, trade, and international relations. He upended America’s relationship with the rest of the world – forever changing the image of Uncle Sam on the global stage.

One of the many consequences of the Great Man is that Pandora’s boxes aren’t so easily closed. President-elect Joe Biden can repair alliances, change policies, and play a sober, healing president right out of central casting… But markets have a memory like an elephant – and they’re not going to forget what American voters are capable of.

Meet the World’s Biggest Emerging Market

What country is this Foreign Policy magazine excerpt describing?

An incumbent leader refuses to commit to a peaceful transfer of power. While his political allies rail about an attempted coup, he calls for his opponents to be arrested. Expectations of political violence grow as the leader calls for his supporters, who include armed vigilantes, to man polling stations. As investors brace for political and social instability, the country’s financial markets gyrate with each election poll…

It could be any of several dozen scenic developing world destinations, many of which would fall under the American president’s affectionate “shithole country” classification… emerging and frontier markets from Argentina to Nigeria to Turkey, where weak institutions and social unrest – overseen by leaders fueled by conspiracy theories and gut instinct – are periodically interrupted by electoral chaos.

But no, this is of course the United States today.

One of the hallmarks of developed countries is that the institutions of government – including courts, the parliament, the electoral infrastructure, the bureaucracy, and the executive – can stand above the push-and-pull of politics, so that even election losers have sufficient faith in the system to accept defeat.

But as the recent presidential election has shown, that’s no longer true in the U.S. “Welcome to the United States’ first modern-era election as an emerging market,” Foreign Policy said.

In a lot of ways, though, the U.S. was already an emerging market. Political risk expert (and my former boss) Ian Bremmer, who founded political risk consultancy Eurasia Group, defines emerging markets as countries where “politics matter at least as much as economics for market outcomes.”

This means that the usual suspects investors look at for signs of market trajectory – economic growth, inflation, and interest rates for starters – matter less. And in some cases, individual leaders can change institutions permanently.

Not long ago, “emerging markets” referred to fast-growing but politically volatile countries where bad politics – a cataclysmic cycle of political corruption scandals (Brazil over the past few years), a dictator who invades a neighbor on a whim (Russia in 2008), regulators in bed with the sectors they were supposed to be looking over (much of Asia in the 1990s) – could erase years of market gains in a matter of days. Politics mattered in emerging markets a lot more than they mattered in more developed markets.

In contrast – again, this is how it used to be – in developed markets like the U.S., Europe, and Japan, things were comfortable and easy, and there weren’t many surprises. Aside from special situations – changes in regulation or significant shifts in government policy that influenced one particular sector – politics were background noise for investors.

For markets, there’s a big difference between emerging markets (“EM”) and developed markets (“DM”). Since emerging markets are seen as a lot less predictable than developed markets, they’re generally viewed as a lot riskier. So for years, emerging markets have traded at a lower valuation than developed markets.

One of the best ways of measuring market valuations is to use the cyclically adjusted price-to-earnings (“CAPE”) ratio. It’s a longer-term, inflation-adjusted measure that compares price to earnings (that is, the P/E ratio we all know and love) to smooth out short-term earnings and cycle volatilities to give a more comprehensive and accurate measure of market value.

Today, developed markets trade at an average CAPE of 20, compared to a CAPE of 13 for emerging markets. The S&P 500 trades at a CAPE of 31. The discount of EM to DM (that is, how much cheaper emerging markets are in comparison to developed markets) is toward the high end of its historical range. The U.S. market has long had – even before Donald Trump – one of the highest CAPEs of any stock market in the world (Ireland and Denmark are higher).

So what does this mean? Valuations fall when earnings rise or the price falls. If U.S. markets were to be valued more like emerging markets – in line with how the U.S. is looking more like an emerging market on the political and electoral fronts – either earnings would need to more than double, with no change in U.S. market share prices… or share prices would need to collapse by more than 50%. (And meanwhile, EM valuations would need to stay still as the U.S. “caught up” to their emerging market brethren.)

That would be catastrophic for U.S. markets. But this isn’t going to happen overnight… if ever. Because luckily for U.S. investors, the United States remains the closest thing to a superpower. It’s the world’s biggest economy… it’s a hotbed of innovation… and in times of trouble, investors around the world flee to the safety and liquidity of U.S. government securities and the U.S. dollar. And for now, that’s still happening despite America being the world’s largest emerging market.

(Will President-elect Joe Biden be able to reverse America’s slide down the slippery slope of emerging markets? More on that below…)

Also at risk is the future of the U.S. dollar as the go-to currency around the world…

The U.S. Dollar Won’t Be the King of Currencies Forever

Almost every country – and person – in the world craves U.S. dollars.

Central banks around the globe hold reserves – in currency or precious metals – so they can trade goods abroad or invest in other countries. Some central banks use it to maintain exchange-rate pegs.

For roughly the past century, the U.S. dollar has served as the world’s primary reserve currency… It’s the global economy’s most important medium of exchange, unit of account, and store of value. Without U.S. dollars, many other countries wouldn’t be able to buy oil or gold, sell toys or cars, or invest in hotels or bridges.

And foreigners use a lot of dollars… It’s estimated that more than half – and maybe as much as two-thirds, though no one knows for sure – of all printed dollars are used outside the 50 states.

Seven different countries use the U.S. dollar as their official currency, while 65 others peg their national currencies to it. And in 2019, 88% of all foreign-exchange trades involved the dollar. (The euro was second, with a role in 32% of all foreign-exchange trades in that span.)

Thanks to the dollar’s supreme status, the U.S. government can borrow cheaply – and as we’re seeing nowadays, seemingly indefinitely – from the rest of the world, which remains hungry for dollars. And the government can defer repaying its lenders by constantly rolling over (and increasing) its debt, seemingly forever…

The U.S. national debt now stands at a mind-boggling $27.3 trillion (up just over 20% in 2020). To put that in perspective, that’s roughly $82,400 in debt for every single American citizen.

The only way the American economy can continue to borrow from everyone else is if the rest of the world continues to covet U.S. dollars. And the whole premise hinges on the faith of the rest of the world in the dollar… and more specifically, the U.S. government.

Faith in the U.S. dollar is linked directly to the credibility of the U.S. government. Just like you need to believe in the management of a company whose stock you own, big holders of U.S. dollars – most global governments – need to believe that the decision-makers managing the U.S. dollar won’t do anything to harm the value of their holdings.

And as the U.S. has devolved into an emerging market, that faith – regardless of who’s in the White House – is going to continue to be tested… by U.S. politics, as well as the U.S. Federal Reserve’s rampant expansion of its balance sheet and the extraordinary and unprecedented printing of new dollars for coronavirus stimulus and other measures.

There’s a limit to how many new dollars can be created until the global economy calls the U.S. government’s bluff. Just because that limit hasn’t been reached yet doesn’t mean it doesn’t exist.

You don’t have to like a country or its leaders to hold its currency… But you do need to trust the country’s economic policy and the people making that policy. A currency is only as strong as the economy – and the country – standing behind it. If you don’t think you’ll be paid back… if you don’t trust the potential products of the structures and institutions of politics… or if you think the value of the paper you’re holding is going to collapse, you’re going to stop lending, and you’re going to want to sell it.

Historically, reserve currencies tend to last around a century, give or take a few decades, before inflation, high debt, bad policy management, and just plain greed end their time in the sun. By that calendar, the American dollar’s time at the top may be within a generation – at the most – of losing its top spot.

Strategists from investment bank Goldman Sachs earlier this year warned that nosebleed levels of borrowing by the Fed were triggering “debasement fears” about the dollar – which could bring about inflation and the end of the dollar’s dominant position. In October, the Financial Times warned that the U.S. has “squandered its exorbitant privilege” as a reserve currency.

What happens when the rest of the world gets tired of the U.S. dollar? The value of it will drop. Again, that’s not happening tomorrow… There’s nothing that’s about to replace it. But markets have a way of figuring things out… creating solutions where one doesn’t exist. And the time of coming up with a solution to the U.S. dollar might be sooner than anyone thinks.

‘Hard Power’ Isn’t Made for Endurance

On the global stage, the United States has become a bully. And that matters for your portfolio… in a way you might not think.

Under Trump’s “America first” approach to dealing with the rest of the world, the U.S. has ignored or abandoned long-held security and multilateral arrangements and commitments – such as pulling away from allies in Europe and from NATO, leaving the critical Treaty on Open Skies for arms control, and suspending funding to the World Health Organization in the midst of a global pandemic.

The government also weaponized trade deals and adopted a transactional (instead of partnership-oriented) approach to economic relations with both allies (like European countries) and adversaries (such as China). And it’s used the dollar payments system for political purposes to punish countries and individuals – including Iran, Venezuela, and people and institutions in China and Russia – by denying them access.

In other words, in recent years, the U.S. has relied on so-called “hard power” – military might and economic heft – to get its way. And it’s been destroying its huge reserves of “soft power” – powers of persuasion and influence to win hearts and minds by demonstrating leadership and values – along the way.

A bully might get his way today, but he doesn’t inspire loyalty. It’s the charismatic and smart soft-power-savvy kid who everyone likes, who manages to win others to his side for the long haul because he’s a leader of people.

The trick to an enduring power is to have a broad and deep reserve of the “soft power” of influence – and to be able to back it up with hard power when necessary.

But with Donald Trump, it’s been hard power all the way. And if your only geopolitical tool is the hammer of hard power, everything looks like a nail… even if hard power alone might do more damage than good.

It’s been a sharp turnaround from the post-war era of Kumbaya-join-hands of American hegemony. The so-called liberal international order championed democracy, trade, and human rights – generally with American leadership and heavy funding – via an alphabet soup of transnational institutions, like the United Nations, NATO, the International Monetary Fund, the World Trade Organization, and many others.

With the U.S. at the head of the table, these organizations weaved together the disparate, and often conflicting, national military, economic, and political interests of the countries of the world.

Meanwhile, American do-good interventions in dozens of countries around the world have often dominated the country’s foreign policy agenda, despite the absence of any self-interest… beyond wanting to make the world a better place for all, and (of course, until the 1990s) keeping the world as free as possible from the stain (or is it a virus?) of communism.

Are we going back to that with Joe Biden? Not so fast.

It’s easy to forget, though, that the post-Cold War period up until Donald Trump – a time during which most living American adults came of age – was historically anomalous. As a recent article from Foreign Affairs magazine – subtitled “Why This Could Be an Illiberal American Century” – explains…

Trump’s ‘America first’ approach to foreign policy has deep roots in U.S. history. Before 1945, the United States defined its interests narrowly, mostly in terms of money and physical security, and pursued them aggressively, with little regard for the effects on the rest of the world. It espoused liberal values such as freedom and liberty but applied them selectively, both at home and abroad. It formed no alliances besides the one it signed with France during the Revolutionary War. Its tariffs ranked among the highest in the world. It shunned international institutions. The United States was not isolationist; in fact, its rampant territorial expansion inspired the envy of Adolf Hitler. But it was often aloof.

Slow-moving demographic changes that benefit the U.S. – and put the economic growth of most other countries at risk – combined with greater automation of the global economy may reduce the reliance of the United States on other countries. A slow realization that a lot needs to be fixed in the U.S., from race relations to infrastructure to education, may accelerate the “America first” agenda regardless of who’s president.

What does that do to stocks’ prices? No country – not even the United States – is an island. Global supply chains are global, and consumers are all over. Until recently, trade was a centerpiece of global economic growth. If the supremacy of hard power leads to a reversal of these trends and a reversion to a permanent “America first” mentality (even if it’s a “PG” rated version rather than Donald Trump’s “R” rated iteration), companies and markets will suffer.

How to Invest in Our Current Reality

But what about Joe Biden? The new president-elect will be an evening mug of warm milk predictability compared with the Day-Glo Tequila Monster Triple Headache that has been Trump’s swamp-upending, ally-insulting, incompetent-authoritarian, explosive impulsiveness and volatility.

The problem, though, is that the toothpaste is out of the tube… The U.S. has shown what it can be and what it’s capable of. Once you’ve experienced Dr. Jeckle’s Mr. Hyde, you know he lurks under the surface, and it’s just a question of time before he’s back again. Four, or eight, or even 20 years of calm, predictable decency won’t put to bed the notion that the United States is one election away from bringing back a Mr. Hyde.

So the U.S. stock market derates to emerging market valuations… the sun sets on the dominance of the dollar… and “America first”-style hard power is the only currency of American power: It sounds like a tough time to be an investor in the United States.

Or… maybe the United States and its investors continue to be extravagantly lucky – like an old-timey movie’s blindfolded drunk who miraculously misses getting flattened by a falling safe, weaves through traffic untouched, and doesn’t misstep when he’s on a tightrope.

The equivalent of that would be the chasms that divide the American electorate miraculously heal, allowing for sensible legislation and quiet elections, and the de-politicization of much of the American economy… a restoration of faith in the global leadership of the United States and the U.S. dollar… and a return of a more benign and less dog-eat-dog global environment.

But it probably won’t unfold like that. The Great Man has changed the course of the supertanker of state. Whoever is the American president, we now live in a different reality.

And you should also have a financial Plan Z in place for whatever American foreign policy or the U.S. dollar brings to your door. That should include…

Gold It’s the best long-term store of value of any asset. It’s fantastic disaster insurance – when bad things in the world happen, the price of gold rises. Gold benefits from the Federal Reserve printing lots of cash. When the value of the U.S. dollar weakens relative to other currencies, the price of gold tends to rise. It’s a great way to diversify a portfolio that’s full of stocks, bonds, and real estate. There are lots of ways to own gold (click here for the best gold stock to own right now per Bill Shaw, Stansberry Research’s gold expert)… but however you do it, be sure you own some.

China It’s only a question of time – and mathematics – before China is the world’s largest economy. There is a massive wall of Chinese domestic money going into the country’s stock market… And meanwhile, foreign money is also increasingly buying Chinese shares after years of largely ignoring the stock market of the world’s second largest economy. The Chinese stock market on a CAPE basis is about half the valuation level of the U.S. stock market. Since China’s economy is still growing fast (6% per year pre-coronavirus), corporate earnings have the wind at their back… and that’s great for share prices. If there’s a global stock market correction, Chinese shares will fall as well… But over the long term, you’re missing out if you don’t have some money in China.

Cash It’s no good if you’re land- (or asset-) rich, but cash-poor. Owning real estate is great – and necessary – for you on that 1,000 times-in-waiting little crypto. But make sure you always have enough crisp Ben Franklins – the most spoken language in the world (for now, at least) – nearby, for whatever might happen. It’s far better to have them and not need them… than to need them but not have them.

U.S. stocks For now and until there’s a viable alternative, the American stock, bond, and currency markets are the world’s biggest and most important. They’re a magnet for capital. Continued stimulus from the Fed will prop up valuations. And there are pockets of safety within U.S. markets where the challenges we’re talking about here will matter a lot less… in capital-efficient companies, in free cash flow powerhouses, in dividend kings, and in other bulletproof stocks where you’ll be insulated from the changes of coming years. Dr. Steve Sjuggerud, who has been in the pages of American Consequences many times before, recently shared a game plan for how to preserve your wealth heading into 2021.

Let Time Work for You…

OK, so it’s all right to be concerned about the direction of the world… But it’s not all right to act that way with your money. When you find an investment that you’re comfortable with that will survive the noise of politics and macro instability over the long term, stick with it so that the magic of compounding can work for you.

Compounding, which Albert Einstein called “the greatest mathematical discovery of all time,” is simply staying invested and reinvesting your returns, instead of taking them out of the market. And it’s probably helped more people build wealth than all the other investment strategies in the world put together.

In challenges, there are opportunities… but you have to see both to thrive.

Kim Iskyan is editor of the Chaos Chronicles at American Consequences. Kim is one of the most experienced and well-traveled financial writers in the world today. From covering Iran’s emerging stock market… to landing in Ukraine in the middle of a war… to booking a flight to Thailand as soon as martial law was declared – Kim has been there and helped investors figure out the risks and the opportunities in these “blown out” markets.