Will The Circle
Be Unbroken?
(Don't Bet On It)
9/5
The Wheel Is Turning And You Can't Slow Down...The US economy and financial markets can currently be characterized as a virtuous circle. Some would call it a positively self reinforcing circle. Others, a self destructive spiral destined for financial collision. On one side of the equation, investors believe that an assumed new era of technology has propelled economic productivity to a possibly perpetual nirvana like state. (This of course assumes that reported productivity figures actually approach economic reality.) Couple this with a now enlightened Central Bank who has learned to master the business cycle and inflation through new age zen monetary policy. The result is the perception of an economy ever moving forward. Gains in productivity ultimately creating gains in wealth that are recycled in new technology which create further productivity enhancements leading to ever higher levels of wealth creation, and so on. A self regenerating economic fuel cell.
The other side of the equation is the dark side. It is an economy characterized by a large foreign trade imbalance, dependence on foreign capital, lack of internal savings, dependent on ever increasing ponzi-like financial asset prices, addicted to ever larger amounts of credit creation, and ultimately trusting that a greater power (the Fed) will protect the delicate spiral at all costs.
And Everywhere The Dollar Went, The Lambs Were Sure To Go...We see the US dollar as one of the outward manifestations of "the wheel in motion" being in for a bit of a bumpy ride at some point in the future. Unlike consumer confidence readings, the value of the dollar is not some random poll taken by a survey group. The value of the dollar is a result of a continuous on-line global voting mechanism whose participants control global wealth as we know it. It is a reflection of what people are actually doing with their capital as opposed to what they are thinking about doing. No survey could be more pure, more accurate, or more timely in terms of measuring confidence. Although the value of the dollar can be effected by central bank intervention on a short term basis, no central bank or group of central banks can force a sustainable directional move in the dollar over longer term periods of time. Only the force of global capital (the collective we) can do that.
In any event, we place a tremendous amount of current importance on the US dollar as possibly the indicator reflective of the health or direction of the US financial markets. In all honesty, given current rapid fire movement of global capital, the US dollar as a coincident indicator of financial asset market strength has our clear and present attention.
The votes are in and here are the current results:
The longer term record:
You Can't Let Go And You Can't Hold On...The dollar is an important component of the virtuous circle we find in the current financial market environment. In our minds, the dollar is a bit of a conundrum. Has a strong dollar precipitated a strong financial market? Or has a strong financial market caused a strong dollar? We would posit that the US dollar is a component of a set of circular influences and reactions, maybe a bit out of step currently with what has been historical experience. A circle we believe is unsustainable over any reasonable period of time.
As can be seen from the long term chart of the dollar above, the dollar has been ascending against global currencies since approximately the time where the markets began to move beyond Greenspan's comments on "irrational exuberance". Let's look at a few of the other components of our assumed virtuous circle that have put the dollar in the position of strength we see today.
Collapse
of the Asian and Latin American Economies In the Mid-To Late 1990's: Again,
as can be seen in the LT dollar chart above, the dollar really began to
strengthen significantly during the 1997 to mid-1998 period. The exact
time of currency and financial market turmoil in Asia and Latin America. Scared
Asian and Latin American capital fled naturally into the assumed safe
haven. Under the law of unintended consequences, it was these twin foreign
crises that also sent global commodity prices plummeting and initially sparked
the beginnings of the massive trade deficit the US was to develop in the years
ahead. The US ended up flooding the world with trade dollars ultimately
destined for some type of reinvestment.
The
Stock Market Itself: As is not too hard to recall, foreign
money flooding into the US dollar during 1997 and 1998 met with the competitive
and voracious appetite of the US domestic mutual fund investors, helping fuel an
explosion in stock market gains. The US market was already a few years
into having achieved double digit market gains and this confluence of ignition
caused the turbo rockets to fire. The ultimate result? The simple attraction
of more foreign investment in US financial assets. More foreign investment
driven demand for the dollar as US financial asset prices moved higher.
The
Bellyflop Debut Of The Euro: To top off the program, the Euro
debuted in early 1999 to a chorus of Bronx cheers. As you know, it's been
downhill ever since. The result? Once again, more investment demand
for the strong currency ($) at the expense of the weak sister (the Euro).
More Euro country exports to the US in return for dollars that necessitate
either conversion or reinvestment.
Today these factors are still very much in place. Clearly the Asian and Latin American economies are not in the state of crisis witnessed during 1997 and 1998, but are seeing their economies revive in large part due to strength of exports to the US.
You Can't Go Back And You Can't Stand Still...So far we've quickly looked at a few components of the "dollar circle" that largely result from non-domestic influences. Yes the strength of the stock market is domestic in nature, but the increased foreign demand due to past performance and perceptions of future riches lies outside of US market participant control. Let's look at the domestic components of the circle of influence and reaction:
The
Trade Deficit: The current account balance and the trade
deficit are major issues despite the rather light treatment they receive in the
current financial press. Self obvious, isn't it?
In an ancient time far, far away, a massive imbalance in trade used to be a real danger signal for a currency and an economy. No more. In fact, in a perverse manner, the trade deficit seems to reinforce the upward bias to the dollar (at least dollar denominated investments) in today's environment. The largest US export of the moment is the dollar. The massive holdings of trade related dollars on the part of Europe, Japan and China (the big three US imbalance cohorts) need to find a home. One possibility is a sale of the trade dollars on the open market and reinvestment in domestic currency (all of which are relatively weak against the dollar at the current time). A second possibility is domestic reinvestment in capital assets (again necessitating potential dollar conversion). And lastly, good old fashioned US financial assets. After all, stocks have climbed precipitously in the last few years. For a foreigner, even this year's bond market has been heaven on earth - capital and currency appreciation. Yipee!
We've shown you the following chart before:
Foreign holding of US dollar denominated debt has almost doubled since the experience of the 1980's.
The
Boomer Consumer: It's not just consumption of foreign goods, as
is self obvious in the effect on the trade deficit and ultimately the exporting
of US dollars. It's more that the US consumer is both consuming material
goods and financial products at a voracious pace. In fact faster
than ever before. For the sake of the current US economy, and in turn the
global economy, the US consumer simply cannot turn back and cannot stand
still. The perpetual motion machine has to stay in motion. But can
it forever?
Don't adjust your screen. Your computer is fine. Welcome to the Outer Limits? The off a cliff fall in US savings again coincident with the global economic crises, the rising rate of change in relative dollar value, and the acceleration in the trade imbalance is striking (to say nothing of the mushrooming US equity market since 1997).
What discussion of the US consumer would be complete without the following two aerial views:
Dizzy yet?
The US consumer has perversely added to dollar strength over time by consuming foreign products and putting more investable dollars into foreign hands, and also by voraciously consuming US financial assets thereby driving prices higher and heightening foreign attraction to these assets. By helping to force US financial asset prices higher, demand for dollar denominated US financial assets has coincidentally grown. How has the US superconsumer accomplished this? The charts above are pretty clear. In a sense, US consumers have helped finance dollar strength (whether knowingly or not) by taking on personal debt. Now that's what we call national pride! The BOJ and the Fed can move over in terms of dollar intervention, the US consumer is on the job!
Selfless
Corporate Benevolence: Who would have thought that corporate
America would have also picked up the torch in terms of tangentially trying to
support the dollar? Well it's true. They have taken on tons of debt
in the past few years just to buy their stocks and run the prices higher, thereby
enticing further foreign demand for US denominated financial assets - most
specifically the very stocks of those doing the buying back of shares. And
who said corporate America had stopped giving.
In 1990, corporate America was borrowing to save itself from falling flat on its back. Now it's borrowing to save the dollar from falling flat on its green back. Despite rumors to the contrary, we're quite sure the corporate demand for US equities has nothing to do with the current use of stock options as compensation and everything to do with enhancing dollar demand.
In all sincerity, another example of the law of unintended consequences. In this case, a backdrop support to financial assets and the dollars demanded to buy them.
If The Thunder Don't Get You Then The Lightening Will...Don't be fooled. The dollar value support circle encompassed by both domestic US and non-domestic forces has been created by a series of circumstances that are characterized by interdependence. These need and feed off of each other. Without a voraciously leveraged US consumer, there would probably be no massive trade imbalance or runaway domestic financial asset market. Without a trade imbalance or perception of an attractive financial market, foreign demand for US dollars to fund financial asset purchases would not be as strong as is currently experienced. If domestic demand in foreign economies were stronger, foreigners would not be so economically dependent on the US import market and would be redirecting excess capital inward, not outward to the US.
The factors that make up the support mechanism for the value of the dollar were born of imbalance. Imbalance in foreign economies. Imbalance in the financial condition of US consumers and corporations in the aggregate. Imbalance in financial market valuations and capital allocation. The circle of interdependence is fragile. A "crack" in any one of the components could be the spark that ends the strength of the dollar.
Lastly, by default, the dollar is a vehicle backed by confidence. It won't all of a sudden collapse simply because it is a fiat currency. That is already known and theoretically priced into the asset. The fact that it is a fiat currency will ultimately accelerate a fall, but that is a discussion for another day. In our minds, confidence in the dollar (and resultantly US financial assets) will ultimately be broken by a change in any one or more of the interdependent components that make up our little descriptive "circle" of support factors. At some point, the circle created and supported by imbalance will be broken. By and by Lord, by and by.
Copyright 2000, ContraryInvestor.com