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May 12, 2009

Follow the Money... Out of the U.S. Dollar?
by Kieran Osborne

Recently, stock markets appear to have experienced an almost euphoric phase, seemingly shrugging off most negative news flow day after day. Whether or not you believe in the so-called "green shoots" of economic recovery, a significant economic rebound, or a continued decline in economic activity, one thing seems abundantly clear: investors have been becoming less risk averse. The most commonly followed "fear indicator", the VIX index, has retracted (likewise, other commonly followed indicators such as the TED spread has tightened and OIS spreads have reverted to levels not seen since the Lehman Brothers collapse), three month T-bill yields have recently risen and equity markets around the world have rebounded from March lows.

Let's not get ahead of ourselves just yet though. We consider the impetus for the recent stock market rally has been news flow and data pointing to economic stabilization in the U.S., not an economic rebound. Negative news flow and data still seems to predominate, though it appears to be dissipating. As such, we may well be nearing an economic trough, as the rate of decline of economic growth (also referred to as the second derivative of economic growth), appears to be slowing. That said, positive news flow continues to be conspicuous in its absence. Hence, we would caution against misinterpreting current data as a precursor to a looming economic recovery. Indeed, significant economic overhang and headwinds remain, while an economic stabilization, in and of itself, does not portend an imminent economic reboun.

In our opinion, it is unlikely that economic growth will exhibit a "hockey stick" rebound because so many issues must still be worked through, many of which may curtail economic growth for an extended period of time. For instance, numerous mortgage holders who bought homes around the peak of the housing bubble are yet to refinance their loans, the unemployment rate continues to climb, and de-leveraging is likely to continue at both the corporate and personal levels. All of which will constrain consumer spending, the main driving force behind economic growth. Moreover, the ambiguousness of the present administration's intentions and policies creates a heightened level of investment uncertainty, while the inflationary implications of present Federal Reserve interventions is increasingly worrying (please see our previous newsletter entitled (Un)Intended Consequences: Uncertainty, Inflation & Inflexibility).

Nonetheless, we may be entering a phase of lower market volatility and a reversal of risk aversion trades. With the onset of the financial crisis, many investors pulled their money out of investment positions in international markets and into the U.S. dollar in a perceived "flight to safety". We consider this phenomenon transient in nature - most of these funds did not flow to "sticky" long-term asset classes (in light of the capitulation in U.S. stock markets, it certainly doesn't appear much ended up in equities). Just witness the yield squeeze exhibited by short-term U.S. T-bills during the crisis. Thus much of this money may be set for imminent redeployment. We believe a reversal of these positions bodes well for many international currencies.

In our opinion, investor risk appetite will remain at an elevated level relative to those seen at the height of the crisis, in part due to a misinterpretation of current data as "green shoots" of economic recovery (a more apt analogy might be of spring sun counteracting the growing size of an out of control snowball racing towards a village), but also due to the generally held view that the worst is behind us. Indeed, the market recently shrugged off the very real prospect of a global pandemic in the swine flu. While we continue to see challenges ahead, we nevertheless consider present dynamics augur well for many currencies outside of the U.S. dollar. In light of present expectations, we consider investors are increasingly likely to redeploy funds internationally, reversing their "flight to safety" trades. We believe certain countries may be better placed than others, particularly China, which can actually afford its stimulus, and whose growth outlook, in our opinion, appears more favorable. Much of Asia may benefit too, while those countries that benefit from a rise in commodity prices, such as Australia, Norway, New Zealand, and to a lesser extent Canada (we consider its close proximity and inter-dependence with the U.S. economy as a drawback) are also likely to benefit from increased investment flows.

Additionally, we consider gold will be a net beneficiary of current policies and market interventions. As previously noted, we believe present initiatives are creating significant latent inflationary pressures. This inflationary overhang appears to have already spooked the market: the spread between long-term TIPS and equivalent maturity Treasury bonds has widened, and the price of gold has appreciated. We consider that the evolution and transpiration of economic ramifications, brought about by present initiatives, will act as a catalyst in underpinning the strength in the price of gold going forward.

The flip side of all this begs the question - if investors increasingly move towards riskier assets, and away from government issues, who will be left (or, more to the point, willing) to purchase the government bonds required to fund the administration's unprecedented level of spending? Especially given the low yields on these securities, a factor compounded by the Fed's intervention in the market. Indeed, the Fed may have to ramp up purchases of these securities if others abstain, monetizing government debt, and driving the price of these assets further from "fair" market value, compounding inflationary pressures in the process.

In light of these dynamics, investors may want to consider whether a basket of hard or Asian currencies would be a beneficial addition to their portfolios.

We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.

Kieran Osborne
Merk Mutual Funds

Kieran Osborne is Senior Analyst and member of the portfolio management group at Merk Investments; he is an expert on macro trends and currencies and has significant international market experience. Prior to Merk Investments, Mr. Osborne was an equity analyst at Brook Asset Management, where he worked in both the Australian and New Zealand markets. He has also worked in New York for MCM Associates, a U.S. hedge fund.

The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund invests in a basket of hard currencies. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a hard or Asian currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

The views in this article were those of Kieran Osborne as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice. Mr. Osborne is Senior Analyst and part of the portfolio management group at Merk Investments LLC. Merk Investments LLC manages the Merk Hard and Asian Currency Funds. Foreside Fund Services, LLC, distributor.

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