Volume 1 12 The Dollar's Descent Orderly Or Not October 30 2009

VOLUME   1.12 1.9  VOLUME  OCTOBER 30, 2009   

The Dollar’s Descent: Orderly or Not?

The global economy is operating in an untested

and will, if it continues, become dangerously

and entirely artificial environment.

unstable.

Governments have intervened in every market

The next phase of this cycle will be

from bonds to mortgages; they have even

influenced by the global reaction to the U.S.

managed to keep Chrysler in business.

Administration’s attempt to reflate its way out

Subtracting the effects of stimulus, the real

of the deep recession and export deflation to

underlying strength of the economy is a

other countries via dollar devaluation. Federal

mystery.

Reserve monetary policy has effectively

Near zero interest rates have fueled a

become the global monetary policy. The

speculative bubble as the dollar has become the

willingness of central banks in Asia and the

carry-trade vehicle of choice. People are

Middle East to prop up the dollar enables

borrowing to speculate on assets, not to spend

excessive U.S. credit expansion, while

on production. American labor force figures do

simultaneously transmitting the Fed’s policy

not show any pick up, whether measured by

around the world. This was a fundamental

hours worked, unemployed and discouraged

cause of the parade of bubbles that culminated

workers (16%) or the trend of total

in the 2008-09 financial crisis and we are

employment. The situation is unsustainable

heading down the same path again.

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Despite the Fed’s accumulation of over a trillion dollars of incremental assets, M2

rates and Fed purchases of risky assets will gain traction.

money supply continues to remain weak and business credit is still declining (Charts 1-3). CHARTS 1-3

Money is freely flowing into commodities, stocks of both emerging and developed countries and foreign real estate, but not yet into the real economy in any meaningful way. What lift there is to GDP is entirely related to government stimulus programs, not credit expansion. Peering behind the veil of stimulus provides an ugly picture. Unemployment is still rising and other labor market indicators remain very weak. Subsidies to car and home sales are providing only a temporary boost which borrows from future demand. Mortgage modification programs have suppressed a flood of foreclosures. It is clear the U.S. Administration is propping up the economy with helter-skelter stimulus programs while hoping that the magic of near zero interest

 

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The operation could be time sensitive

the 2001 tech-wreck reversed the flow of

as a quick economic rebound is needed to

capital that had previously been chasing the

contain fiscal deficits. A double dip recession

American based technologies and media

would be a disaster for the already terrible

mania.

fiscal outlook. The U.S. has had no problem

The only major counter-trend move in

selling Treasuries so far, but if the recovery

the dollar happened early this year, as capital

proves temporary, investors may well revolt at

inflows pushed the dollar up by 15%. This

yet a further surge of government debt.

buying has since reversed, leading to a sharp

Therefore investors need to watch Treasury

decline and bringing the dollar back within

bond yields closely.

about 5% of its pre-crisis levels (Chart 4). It is

Investors should also keep a close eye

worth noting that this decline has nothing to do

on the U.S. dollar as this plays out, as it will

with a loss of confidence in the U.S. as some

provide one of the clearest indications of

have argued. If it had, Treasury bond yields

whether the recovery is derailing. If the dollar

would not be stable. Rather it is a function of

breaks down significantly from current levels,

the deployment of capital in emerging markets

it would signal a loss of confidence in the

and commodities, much of it financed with

U.S.’s ability to finance the Fed’s buying

cheap U.S. denominated loans.

spree.

Most indicators are pointing to a kind Despite the risks to the recovery in the

of soft landing for the dollar in the short term –

U.S. economy, and the untenable long term

a gradual petering out of the decline. This

fiscal outlook for the Treasury, our view is that

would allow the U.S. to continue to export

the U.S. dollar will continue a relatively

deflation to countries whose currencies are

orderly decline. This trend originated when

appreciating, helping the U.S. rekindle its

 

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CHART 4

capital flows with a 2% tax on foreign portfolio investment. China recently relaxed capital restrictions to allow more outward foreign investment by Chinese nationals. Canada’s central bank has sent strong signals that it will resist raising rates as exchange rate appreciation is expected to “more than fully

manufacturing base and address global imbalances. Those that are pegged to the dollar, like China, are experiencing rapid asset inflation and economic resurgence. This is good as long as it lasts and that could be for some time. There is no sign of domestic

offset” favorable economic developments since July. This talk alone knocked a few cents off the loonie. International efforts will increasingly provide a floor under the dollar, implying that it will be hard to get the dollar down much from here, at least in the short run.

inflation in the United States. Consumer prices Export and commodity based are falling, TIPS/Treasury spreads are low and economies are faced with a difficult situation stable, and excess capacity abounds. The U.S. as financial flows have driven a massive rally has had no trouble holding down long rates, an in stock and asset prices while export sectors indication that the bond market isn’t worried have been hobbled by rising currencies. For yet. example, so far this year, stock indices in Countries experiencing upward currency pressure against the dollar are becoming increasingly concerned and willing to intervene. Brazil is attempting to control

 

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certain emerging markets have shown some staggering gains relative to the developed nations (Table 1). Note that the table does not account for currency shifts, so the disparity

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between the U.S. and other markets is even

them to tolerate currency appreciation to a

more dramatic.

degree. Short term, almost everyone will be

TABLE 1: EQUITY PERFORMANCE OF SELECTED GLOBAL MARKETS, YTD RETURN

forced to do what they can to keep downward Industrialized Nations United States

%

Dow Jones 30 Industrial Average Standard & Poor's 500 Index NASDAQ Composite Index

Japan United Kingdom Commodity Producers Norway Australia Canada Emerging Markets Russia Peru Turkey China Indonesia India Brazil Thailand Singapore

11.2 17.7 30.6 13.7 14.6

pressure on their currencies, namely accumulating dollar reserve assets. Longer term, this system is subject to a violent reversal of capital flows, causing a stampede out of

53.6 25.9

developing countries that could flatten stock

23.0

markets and real estate for a while. 124.9 112.9 87.6 86.9 73.8 69.5 61.8 56.4 50.4

There are several risks to our outlook for a gently declining dollar: 1.

There is an enormous amount of

speculation occurring in the financial system. Commodities and emerging market equities

Only two countries have raised rates to

have risen seemingly well beyond their

deal with overheating so far: Australia in early

fundamental value. Any reversal in this

October, and Norway on Wednesday. Each

money-fueled bull market could unleash

raised rates by 25 basis points, exacerbating

another financial scare so long as the recovery

upward pressure on their currencies. Unlike

is so fragile. Confidence in the ability of the

the export industry in most nations, neither is

U.S. to mount another large scale bailout and

heavily dependant on U.S. markets, allowing

stimulus package is far from guaranteed and the dollar could fall victim. Although this

 

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scenario is a risk, we believe that is a relatively

temporary phenomenon in the absence of a

low probability event for the foreseeable

strong and sustainable recovery in the real

future. But clearly, the dollar must be watched

economy. Until then, consumer price inflation

closely along with foreign central bank action

(CPI) will not occur.

(as opposed to what they say). 2.

In our opinion, all of the above risk

It is possible that China may allow the

scenarios are unlikely. However, they

Yuan to appreciate against the dollar by

highlight that there is a great deal of

diversifying its reserves, particularly if asset

uncertainty ahead. Policy makers are walking

price inflation continues to accelerate. There

an impossibly thin line between frothy asset

has also been some talk about OPEC looking at

markets and persistent deflation and

pricing oil in a basket of currencies, a rumor

deleveraging. There is the clear risk that the

which OPEC predictably denied. Again, we

authorities will either do too much too soon, or

believe this talk is unlikely to materialize into

too little too late. But whatever they do, it is

concrete action for the foreseeable future.

likely to be the wrong thing.

3.

A major spike up in commodities,

No one has experimented in peacetime

particularly energy and food, would be a major

with global stimulus and credit creation on the

blow to the global recovery, scaring bond

scale we have seen over the past year, and the

investors and consumers alike. However, we

telltale signs of bubbles and emerging

still believe that deflation is the main problem

imbalances are revealing themselves.

and that speculative or financial demand for

The dollar reserve system is well past

commodities should not be confused with

its expiry date, but there are no realistic

industrial demand. Speculative demand could

alternatives for at least another 10-20 years.

well drive prices higher, but this would be a

Pressure for change will continue to intensify

 

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as the Federal Reserve will continue with its

have to keep in mind that there are plenty of

fire hose monetary policy to support domestic

things that could go wrong quite quickly.

employment at the expense of international

Yields fell in the Treasury auction this

credibility. A shift away from a dollar

week, with the 10 year notes falling 17 basis

dominated global economy over time will

points over the week. We expect Treasury

undoubtedly bring great volatility, uncertainty

yields to remain stable for at least the next few

and new challenges in the transition.

months.

INVESTMENT CONCLUSIONS

Corporate bonds continue to provide

The bull market in global stock markets

good value, although spreads could begin to

and commodities remains intact. In particular,

open up again next year if the economic

the U.S. has lagged far behind all other world

recovery falters after the stimulus effect has

stock markets since the lows earlier this year.

abated.

Some catch-up should be expected. However,

The gold story is very well known and,

we do feel that it is time to start building

at this point, it may be pretty well played out.

liquidity and take a more defensive posture.

Any recent gains in gold have been due to the

Equity indexes in all markets are well above CHART 5

their moving averages and vulnerable to a near term technical correction. Looking out 6-9 months, the possibility of another major downleg is increasing. Conservative investors should begin to reduce exposure on market strength. Aggressive investors may wish to play the momentum for a while longer but they

 

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falling value of the U.S. dollar. Priced in Euros or Canadian dollars, gold has been flat for the past 6-7 months (Chart 5). Easy money, very low carrying costs and fears of future inflation could well keep the market frothy and push prices somewhat higher. Pending a surge in physical demand for gold, financial flows into the metal could reverse swiftly. In summary, asset price inflation and rampant speculation are creating an uncomfortable environment for long-term value investors. Whether you are investing in real estate in China, equities in Peru, or indexing the S&P 500, you are putting your faith in the ability of the U.S. Government to pull off a miracle. Expectations will be tough to meet, and the risk of the Administration Tony & Rob Boeckh losing a handle on the situation is a constant threat. Over the next five years, investors should focus on capital preservation and avoid getting swept up in the inevitable credit-fueled

October 30, 2009 BoeckhInvestmentLetter.com [email protected] *All chart data from IHS/Global Insights and may not be reproduced without written consent.

bubbles.

 

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STOCKS

 

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COMMODITIES

 

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CURRENCIES

 

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INTEREST RATES

 

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