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Special FX (several pages, but really good)
Support Group...Prior to our little holiday sabbatical, we began addressing issues that we believe will be important as we look into 2004. From the standpoint of fiscal stimulus, consumers will be on the receiving end of excess cash tax rebates in the mid-to-late portion of the first quarter and early second quarter of this year. The mid-year 2003 drop in marginal personal tax rates that was retroactive back to the beginning of 2003 is responsible for this phenomenon that will clearly support the consumer in the early part of the year. Our view of the consumer in 2004 is one of strength early in the year and then a fade as the year progresses. Absent significant acceleration in payroll employment growth, perhaps a very significant fade beginning late in the second quarter and throughout the remainder of the year. Of course, the markets already know this. In our minds, the important question in terms of the consumer's ultimate influence on the financial markets directly ahead is how much of this near term tax rebate support to the consumer has already been discounted in stock prices? As you can see in the following chart, the S&P retail index recently peaked within about four points of its late 1999 high. A failure to break above that prior 1999 peak ahead will say a lot about a market that has already priced in potential consumption strength in the first and second quarters of this year.
The second important issue for 2004 that we covered a few weeks back was the fact that fiscal tax related incentives for capital spending remain firmly intact throughout 2004. Accelerated depreciation schedules for 2004 and the ability to completely write off the first $100,000 of capital equipment employed will most assuredly pull what might have been 2005 spending into 2004. The question remains just how meaningful this will be to the overall economy. Although we believe these tax breaks will certainly influence corporate behavior in the year ahead, a potentially fading consumer would dampen total corporate capital spending strength regardless of tax incentives. Although tax incentives can be a strong economic motivator, there is no way that a substantial capital spending boom of the magnitude experienced in the mid-to-late 1990's lies ahead. As you can see in the following chart, substantial capital spending booms are separated by decades, not by quarters or years.
Again, the markets know these capital spending related incentives exist and do not sunset legislatively until December of this year. Will the financial markets reward what may be temporary capital spending strength with yet higher stock prices? As we have mentioned a few times now, we believe it will be important to monitor the relationship between the cyclical stocks and the broader equity market as represented by the S&P 500. Cyclical's have been leaders of the market advancement over the past year along with techs and small cap issues. A breakdown in the relationship between the cyclicals and the SPX would
signal that the markets have already discounted the "good news" on capital spending to come in 2004. We're not there yet.
Special FX...There is no question in our minds that another key for the financial markets as we move into 2004 is the value of the dollar. Unlike tax rebates for consumers or tax incentives for corporate spending, the dollar has the potential to influence and shape the total markets in a much broader manner. From stocks and bonds to commodities and precious metals, both perceptions regarding and the reality of dollar movements can have a very profound influence on asset prices. Although we do not have the answer as to what will happen to the dollar in 2004 relative to major foreign currencies, or what will happen to the pricing of various asset classes as a result of dollar related foreign exchange movement, we want to explore a bit of what we see as the current dynamics and characteristics of the US dollar. It's no secret that the dollar has been declining against the bulk of foreign currencies for a good while now. Depending on how the dollar is measured, we see differing rates of decline over the past few years. Against a basket of equal weighted foreign currencies, the decline has been more substantial than has been reflected in the downward trajectory of the trade weighted dollar. As you can see in the chart below, on a trade weighted basis, the dollar is quite near historical bottoming territory of the last three decades.
There is no question that on a fundamental basis, there's a lot to worry about when it comes to the dollar. Assuming that the dollar is a mirror of the collective thoughts and ultimate trust of the global financial community, one should clearly be cautious on the dollar with respect to record US debt relative to GDP, record trade and federal budget deficits, a veritable explosion in the US money supply over the last few years, a substantially levered US consumer of the moment, etc. But it sure seems pretty clear to us that a declining dollar of the last few years has engendered greatly differing responses from various components of the financial markets and real economy. As we explored in a recent discussion, it's pretty clear that at least a meaningful portion of the advance in commodity prices of the last twelve to eighteen months is in good part explained by the declining dollar, as well as strengthening real global demand for raw materials and commodities. As we also concluded in a discussion devoted to gold a month or so back, the advance in the yellow metal has technically paralleled the decline in the dollar over the last few years. Alternatively, it sure appears that the US equity and fixed income markets have given very little attention to the fact that the dollar has been in a very noticeable downtrend. The equity markets have continued to push higher despite the declining dollar really having no positive influence on the US trade deficit for what is going on close to two years now. Likewise, US fixed income markets appear virtually blind to the declining currency. The blinders, of course, being gladly provided by continued foreign investment in US fixed income assets. When it comes to the longer term meaning of a declining US dollar relative to foreign currencies, and the potential for dollar related asset class pricing adjustments as we move into 2004, just who is right and who is wrong? Are the commodity and precious metals markets on the right track in terms of inflating against a punctured dollar? Or are the US equity and fixed income markets correct in their apparent complacency in the face of one of the largest dollar declines since the mid-1980's?
Although only time will tell, we hope taking a quick look back at the dollar decline in the mid-1980's relative to equity and fixed income market action at that time will provide some perspective. Again, it was a while back that we more completely discussed the mid-1980's dollar decline and the Plaza accord that helped accelerate that decline. We won't drag you through the conceptual history of this occurrence again. What we will do, though, is take a look at the numbers related to that dollar decline in terms of the equity and bond markets. Before getting started, it was February of 2002 that the trade weighted value of the dollar hit its latest peak. We are currently 22 months into the decline period so far. As of the end of November of 2003, the trade weighted value of the dollar has declined 20.8% from the February '02 peak. So just what happened to the stock and bond markets during the very significant dollar decline of the mid-1980's and how does it compare with what is happening today?
Cutting right to the bottom line, it was literally years of decline in the trade weighted dollar of the mid-1980's before the stock and bond markets reacted quite negatively. To put it simply, the lag time was more than substantial. As you can see in the following chart, the peak in the 1987 stock market came 29 months and a 31.2% dollar price decline after the peak in the trade weighted value of the currency. Those predicting a stock market collapse shortly after the dollar peaked in early 1985 had a long wait in front of them. More importantly, from the dollar peak to the subsequent peak in the equity market, the monthly SPX rose over 80%.
Although far from being identical to equities, the peak in the bond market of the mid-1980's (as measured by the 10 year UST) came 22 months after the peak in the trade weighted value of the dollar in early 1985. The trade weighted dollar had declined by over 29% by the time US Treasuries commenced their sell off. Of course it was the bond sell off that also helped precipitate the "crash" in stock prices at the time. But, once again, bonds did not immediately sell off once the dollar peaked. There was close to a two year lag period.
When it comes to equity and fixed income markets in the here and now, are we witnessing a similar lag effect? At least as of now, the bond market appears to have topped (yields bottomed) 16 months past the most recent peak in the trade weighted dollar. As you can see in the chart below, the dollar had declined a little over 18% when Treasury yields bottomed last summer. Again, at least so far, neither higher interest rates nor a continued downward trajectory in the dollar has yet dented enthusiasm or prices of equities in the current environment. At least so far, the lag continues.
Although the commodity and precious metals markets appear to be pricing in the influence of a declining dollar of the moment, history suggests that a lag in recognition of a declining currency in both the equity and fixed income markets is perhaps to be expected. At least that's the lesson of the 1980's dollar decline experience. Looking ahead, the simplistic question is, of course, for how much longer can US dollar denominated equities and, in part, fixed income securities continue to ignore dollar machinations on the downside (assuming there is more downside to come, of course)? Again, if history is any guide, it could very well be that this question is answered in mid-2004. Although we saw very substantial rallies in the equity markets during 2003 in dollar terms, that is certainly not the case from an "outsider's" point of view. Through November of last year, the trade weighted US dollar was down close to 13% for the year. Adjusted for the decline in the dollar, the performance of the Dow and the S&P look much less spectacular than is the case in absolute nominal dollar terms. We find the following chart interesting from the perspective of the global equity investor. It's nothing more than the S&P 500 expressed in Euro terms. As is clear in the picture, in Euro terms the S&P 500 is still solidly in a technical bear market. The head and shoulders formation is fully intact and there has been no break at all in the declining tops trendline. This is certainly not the perspective of most bullish stateside commentators. Important from the standpoint that in the long run, the US markets do not stand in financial isolation. This is true perhaps now more than ever.
Before leaving the comparison of the mid-1980's with the present in terms of the dollar and various asset classes, a few more points of interest. Just what happened to the relationship between commodities and a declining dollar in the mid-1980's? Interestingly, just prior to the peak in the trade weighted dollar of 1985, the CRB had already begun to decline. The CRB continued to decline coincidently with the declining dollar for 16 months during 1985 and 1986 before bottoming and moving higher while the dollar continued its southern journey. As you can see, the CRB ultimately peaked in the latter 1980's as the dollar was beginning its own bottoming process.
What is different this go around is that there has been no lag at all between a peaking dollar and a bottoming CRB. So far into this cycle, the CRB bottomed three months prior to the dollar peak and has been ascending almost non-stop as the dollar has continued its decline. Commodities have so far been definitive in their statement regarding the significance of the decline in the dollar for this cycle. To us, if this relationship continues to hold ahead, regardless of where the equity or fixed income markets travel near term, it will be a very telling sign that ultimately the dollar decline will be much more far reaching for the real economy than was the case in the mid-1980's.
Flows And Mo's...What is also meaningful to ourselves in looking at dollar movements and asset class pricing during the mid-1980's and present is to remember that when the dollar peaked and began its precipitous decline in 1985, Greenspan had not yet become Fed Chairman. We were still a ways away from this financial market life-changing event. Certainly one reason why the financial markets (equities and fixed income) have continued to hold up in the face of a declining currency this go around is the incredible liquidity being made available to financial markets these days at what is a negligible cost compared to that of the mid-1980's. From the peak of the trade weighted dollar in February of 2002 until November 2003 month end, the dollar declined by just under 21% while money supply as measured by M3 has magically increased by just over 21%. The US markets are clearly floating on a sea of liquidity. And it's not just the Fed and the Administration responsible for this phenomenon (although they are two of the chief protagonists). The Japanese and the Chinese essentially "printing money" to intervene in foreign currency markets has also helped create an environment of excess global liquidity. As we stand from afar and look at the global markets and real economy we see the following going up in price: stocks, real estate, energy, gold, GDP, broader commodity prices, and bonds. For all of these asset classes to move higher in almost synchronous fashion, we can come up with no other explanation than excess liquidity on a global basis. A massive global reflationary effort. For now, there is really only one thing going down - the US dollar. So although history suggests that at some point a declining dollar will negatively affect US equities and fixed income markets, is excess liquidity holding back or delaying this assumed rational reconciliatory path? As we look ahead into 2004, which of the following three will be the most powerful in terms of influencing the pricing of various asset classes - a declining dollar, excess global liquidity, or foreign flows of capital into US dollar denominated fixed income assets?
So far, the latter two are acting to hold up US financial asset prices in a very meaningful manner. YTD as reported by the US Treasury, foreign purchases of US financial assets totals $581 billion. Academically, this exceeds the like period cumulative US trade deficit. Academically, this suggests that pressure on the dollar would be much, much worse had the foreign community not essentially "recycled" the entire US trade deficit (and then some) for the year back into dollar denominated fixed income assets. Intuitively, this suggests that momentum has also played a perhaps significant near term role in the declining value of the dollar as of late. The reason we bring this up is that we need to remain alert for a potential dollar rally at really any time. Although we firmly believe that as long as US policy makers essentially have no qualms whatsoever about debasing the dollar (untethered money supply growth), the USD is headed lower long term. But in the interim, we have recently witnessed Japan publicly proclaiming that they are upping their Dollar/Yen cross rate intervention war chest. Moreover, although the Euro has advanced against the dollar like a slingshot over the past year or so, we need to remember that fundamentals in Euro land aren't exactly wildly positive. In our eyes, the Euro has been a default currency choice, not a proactive one. In reality, large pools of global capital really have only three choices at the moment - the USD, the Euro and the Yen. The acid in our stomachs are reminding us that the paired short dollar and long Euro or gold trades are getting a bit crowded. Especially given that foreign central banks have accelerated Treasury purchases significantly over the last year. The downward momentum in the dollar and the upward momentum in the Euro could be reversed at any time ahead on a purely technical basis.
And the potential for unwinding of many a short dollar position could easily cause a nice pop in the dollar over any short term period. As of last week, the very large commercial futures traders were significantly short foreign currencies such as the Euro and Yen. They are clearly betting on a dollar rally. Again, as we look into 2004, we need to ask ourselves which will have the more meaningful influence on the US dollar - flows or mo's? (Foreign flows of capital into US dollar denominated assets or simply currency price momentum?) Longer term, it's foreign flows that count the most with us. But over any short term time frame, changes in price momentum can be powerful. A meaningful or multi-period dollar rally could easily take a bit of the shine off of the precious metals or broader commodity complex. If this should happen in 2004, we'd view it as a buying opportunity for both precious metals and commodities. To be honest, we're hoping for a temporary dollar rally.
The Long And Short Of It...Although we believe the dollar is a huge key to the future of the US financial market, drawing simplistic conclusions regarding shorter term dollar and global currency movements is anything but shooting fish in a barrel as we move ahead. Factors offsetting the academic ramifications of a dollar decline are both many and powerful at the moment. Massive global liquidity creation and the continued significant flows of foreign capital into US dollar denominated assets have largely offset the negatives for US financial assets at the moment. And of course the Catch-22 is that our large trade deficit accounts for the flows of foreign capital back into US dollar denominated financial markets. As crazy as this may sound, if our trade deficit were truly to contract meaningfully ahead, we would expect foreign flows of capital into the US to likewise contract, clearly pressuring US fixed income prices. But we're not there yet. Certainly the foreign community could also decide to place their capital elsewhere in the global sphere, but foreign purchasing of US financial assets has much less to do with investing than with promoting and sustaining their export driven economies. We need to remind ourselves that over the short term, anything can happen when it comes to currencies. But we see no way around a continued dollar decline as long as the US continues to "create" an unlimited supply of dollars. Quite simplistically, it seems pretty clear that the US is simply creating more dollars than is being demanded by the global financial community at the moment. We believe this simple comment explains a lot of the near term dollar decline as the foreign community is doing anything but shunning US dollar denominated assets as of now. But to everything there are limits. As we look ahead, if the rate of change in foreign buying of US financial assets slows, the impact of a declining dollar at that time will have serious consequences for US financial assets. In our minds, the flow of global capital is one of the major keys as to when a theoretical orderly decline in the dollar becomes something much more ominous for US financial markets and the real economy. Until that time, it's simply a good bet that current imbalances will continue to grow. Lastly, another clue as to when the foreign community will have "had it" with the dollar decline is when import prices start to rise quite noticeably. So far, the foreign community has eaten the profit eroding decline in the dollar as they export into the US. Low cost global sources of labor have been a big factor behind this ability of foreign exporters to conceptually ignore the dollar decline, but that only goes so far. At some point the declining dollar will cut into the foreign corporation profitability bone.
How low could the US dollar ultimately go? We have nothing but history for suggestive ideas. IF the current decline in the trade weighted dollar replicates the top to bottom price trajectory of the mid-1980's dollar drop, the following chart tells us that a near 65 value on the trade weighted dollar would be in the cards. At that level it would be setting new multi-decade lows. We've produced the Fibonacci sequence simply for perspective. But as was the case post the dollar top in 1985, the bottom was seen a decade later. True and significant bear markets play out over time, whether it be equities, bonds or currencies.
Year End Squaring Or Year End Scaring?...Just as FYI more than anything else. The big commercial futures traders have become much less short the SPX and have actually gone long the NDX for the first time in many months. Just what are these folks expecting as we tip-toe into 2004? By the looks of it, they're not expecting any big downside soon. In fact maybe quite the opposite as it applies to the NDX. Is this just year end position squaring, or has the power of the rally (especially in December) scared these folks? Although the big commercial futures traders certainly don't walk on water, we just wanted to make sure you were aware of these positions.
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