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Insidious Effects of the Dollar’s Decline

The United States is home to the largest and most liquid investment markets in the world. There’s hardly a market one can think of that isn’t exchange listed. This has made the United States the primary destination for excess global capital placement whether it has gone towards the relative safety of government bonds or been more aggressively allocated towards stocks, ETF’s or even the futures markets. The final destination of the investible funds is less important than the singular characteristic that all these investments have in common. They’re denominated in US Dollars and the Dollar’s value may be more meaningful than the underlying asset class.

Investment securities are not protected from the vagaries of their underlying currencies. Therefore, globally allocated investments owned in US Dollars can lose money in a flat market if the Dollar declines. The Dollar peaked in early July and has since fallen by more than 6%. Therefore, if your US equity portfolio hasn’t gained more than 6% since July, you’ve actually lost money. The Governmental shut down has accelerated the recent slide and pushed the Dollar to a new 30 day low for the second time this week. This is only the second time since May of 2011 that we’ve made multiple 30-day lows in the same trading week.

Perhaps more troubling to global investors than the currency-based loss is the fact that the traditional safe haven investments, even in Dollar terms, have not behaved as expected. The primary relationship between the Dollar and the US equity markets since the financial implosion of 2008 has been negative. This has been embodied by Dollar rallies on stock market declines. Very simply, foreign capital gets converted to US Dollars and placed to work through buying declines in the stock market. Conversely, when foreign investors take profits in a rising stock market and convert back to their base currency, the Dollar falls.

We also see this relationship play out in the gold market. Economists on TV tell us to buy gold as a defense against a declining US Dollar. Sensationalists point to the overwhelming debt being created by our country and tell us to buy gold because our country is on the verge of implosion and our currency will become worthless. Speaking of correlations, it’s amazing how many of the people saying this are the ones selling gold investments. Astute investors would notice that the correlation between these two markets has been trending upwards since early June. This means they’re moving in the same direction more frequently rather than opposite each other as expected.

Foreign purchases of US goods have always been Dollar dependent. Every nation and agricultural enterprise within every nation is forced to tie their commodity purchases accordingly. Therefore, it becomes especially disturbing when a weaker Dollar fails to attract foreign purchases of global staples. Beginning in August of 2012 we started to see the commodity markets decouple from the US Dollar. Wheat was the first market to be sated. Corn followed suit in October of 2012 and hogs joined the new normal last November. This means that even base foreign needs have been filled. Therefore, they are more likely to trade in the same direction as the Dollar going forward rather than the typical negative correlation that we’ve seen from bargain hunters looking for inflation in the commodity markets.

The International Monetary Fund (IMF) stated that world Consumer Price Index (CPI) came in at 3.2% year over year for August. This is down from 4.9% a little over a year ago and ties in rather neatly with gold’s last run at $1,800 per ounce early last October. The US unemployment rate is generally believed to be artificially low in the as reported number of 7.3% and Gross Domestic Product (GDP) here in the US came in at a very tame 2.5%. These statistics, combined with a low global industrial capacity usage number suggest that inflation is nowhere near. Furthermore, the Federal Reserve Board’s recent decision not to implement a tapering of the $85 billion per month in economic stimulus reinforces the notion that their primary concern is deflation, rather than inflation.

Many economists believe that we may be near a tipping point in the bull run that has followed the economic meltdown of 2008. The obvious concern now lies in the protection of the wealth that’s been garnered during the recent run. Clearly, the ownership of alternative investments isn’t going to play out the way the pundits have suggested. Therefore, investment vehicles that will profit from a decline in both asset value and currency depreciation should be seriously considered. These include inverse ETF’s as well the futures markets, which will allow the seamless execution of short trades including currencies. Equity futures spreads selling small caps like the Russell 2000 and buying big caps like the S&P500 are also a good idea when expecting volatile, downward markets. Remember that cash is only king as long as the King’s throne isn’t sinking.

Global Glut Going Nowhere

The drop in gas prices over the last month has been a relief to us all. The economic sanctions placed by the European Union, Canada and the U.S. on Iran has simply shifted the flow of Iranian crude oil from west to east. The net result has been more oil on the global market with China, India and Russia picking up cheaper oil from Iran due to the lack of competition from western buyers. One would think that cheaper oil to the BRIC countries would be just the catalyst needed to help them develop their own internal demand for goods and services through the creation and evolution of their own middle class. Unfortunately, we are in an economic phase of global deleveraging and even the stimulus of low fuel prices will not keep their engines turning fast enough to save us from a second half slowdown here in the U.S.

The thesis of those who run our economy has been: If we can just provide enough economic grease to keep our own wheels turning the development of BRIC economies will, eventually, create demand for our goods and services. This is still probably true in the long run and the forward demand projection can be used to our advantage through tracking commercial trader purchases via the commitment of traders report. What a different world it has become when our economic horse has become hitched to someone else’s wagon.

China has been trying to engineer a soft landing for their economy through government expenditures on infrastructure and the attraction of foreign direct investment. The struggle can be seen in their manufacturing output, which has declined for seven straight months. They’ve also lowered their lending reserve requirement to stimulate financing which has dropped by 19% year over year and is at its slowest pace since Q1 of 2007. This may simply add further capacity to an already slack market in the wake of China’s 15-year building boom. This is also a futile attempt to increase home ownership, as home ownership is one of the few ways Chinese people have been allowed to invest their newfound prosperity and therefore, already represents an outsized portion of their personal portfolios. The Chinese result will sacrifice its citizens as the high water mark buyers and lead to further class separation between the builders who profited and the people who got stuck with the bill. This will leave them with little disposable income to buy our Apple computers and Fords.

The Chinese situation looks hopeful compared to India. The trouble in India is as much political as it is structural. Indian politics are confusing even to the Indian newspapers. It’s easy to go from the Times of India to India Press or any one of their nearly 2,000 daily publications and find contradictory information. Foreign businesses find it nearly impossible to find the right agencies for the right permits. Even if one does, it is quite possible that the rules will not only change but, be made retroactive thus, invalidating the entire business plan of the entity that just put the whole package together. This is exactly what happened to Wal-Mart between December of 2011 and February of this year. Permits were voided and taxes created by the new policy were made retroactive. Foreign direct investment is drying up rather than fighting its way through the bureaucratic red tape.

This still leaves Brazil and Russia to save us. Brazil just passed England to become the sixth largest global economy. However, Brazil’s balance of trade slipped into negative territory early this year for the first time since the economic crisis and once again ten years prior to that. Furthermore, their latest GDP readings were just positive enough, 0.34% to escape the technicality of recession. They are battling the decline by cutting interest rates for the seventh time in a row. This easing cycle has seen their rates decline by more than 400 basis points, including May’s cut.

Finally, Russia’s economy is shepherded by the fluctuations of natural resource prices on one hand and Vladimir Putin’s political inclinations on the other. The Russian shadow economy remains one of the largest physical cash exchanges in the world. The government recently limited official cash transactions to approximately $20,000 U.S.  Dollars. The political confusion has led to a flight of foreign capital out of the country. Putin’s sincerest desire seems to be the development of a quasi socialist Russia in which the natural resources are shipped abroad by governmentally monitored, semi state controlled companies. Putin then wants access to these revenues to fund his own programs and basically, become the Arab peninsula of natural resources while triangulating politically with Iran and China.

It doesn’t matter whose horse we hitch our wagons to if we’re all headed down the same path. The global balance sheet expansion experiment that hasn’t worked worth a darn in Japan is now being replicated in Europe just as it has been put to work here in the U.S. The world will pull through it and those countries that have been willing to make the tough choices, either through an enlightened electorate body or, the tight fisted hand of an autocratic leader will be the first ones to rebound. Our future, I’m afraid, looks more like the path of Japan’s lost generation than ever.

Pandora’s Grecian Riddle

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

 

Pandora’s Grecian Riddle

Here’s a riddle for you. What could make the U.S. Dollar and Gold rally while keeping short term interest rates exceptionally low, in the face of a bleak domestic economy?

The answer: bigger troubles overseas finally finding their way into the light.

I have said for the last 6 months that there is big trouble brewingin Old Europe and the Mediterranean. Many of you who absorb information fromsources other than CNBC and Fox Business channel are already aware that Greeceis on the verge of catastrophe. Members of the EU met in Brussels yesterday,February 15th for the primary purpose of discussing what to do withGreece’s inability to bring their budget in line with national their nationaldebt expenditures, currently totaling about 300 million Euros. They will alsoneed to secure financing of more than 50 million Euros to maintain operationsthrough the end of this year. Currently, their deficit represents about 12.7%of GDP. Jean- Claude Trichet and the rest of the EU policymakers want thisnumber to be brought down to 4% for 2010. It is my understanding that there isa tacit agreement among members of the EU that deficit financing cannot accountfor more than 3% of GDP for EU members.

To put this in perspective, our debt levels here in the U.S. arerunning at approximately the same percentages as Greece. This would be theequivalent of the U.S. cutting its budget deficit, currently around $1.3trillion by more than $550 billion both this year and next. Can you imagine thecivil unrest this would create or, what it would mean to Medicare, welfare orsocial security? How about schools, police forces and the postal service? Thisis what the approximate proposal by the EU would cause in Greece.

Obviously, the next thought is, “its Greece. So what? How badcould it be?” Remember that we’re talking approximately 300 billion Euros.According to John Mauldin, this represents 2.7% of European GDP. Remember BearStearns? They held less than 2% of U.S. banking assets. The issue here is thatthe other members of the European Union would not have the collectivecoordination to operate swiftly and decisively in the event of contagion.Russia in 1998 had a very clear operating system. Decisions were made anddirectives were carried out. Argentina in 2002 was also able to implement thedefault, restructure, revalue and grow procedure within less than a year.However, according to yesterday’s meeting, as reported in both “The Guardian”and the “Telegraph,” there is virtually no consensus among what should be done.The mandate to cut debt was issued but, what enforcement power is there tocarry it out? How long will the other nations allow the European Union as awhole to be seen as impotent in the world financial markets?

Of course, Greece has choices. Most plausibly, they agree to EU concessions and implement them fractionally – like the teenage child that whose completion of the chore list is underwhelming, to say the least. Secondly, they could default on their debt. This would throw the country into a depression.However, unlike Russia and Argentina, who both had a wealth of natural resources to fall back on, over 75% of Greece’s GDP comes from the service sector and less than 4% comes from natural resources, which consist mainly ofagriculture. Therefore, they will not be able export their way to economic recovery the way the Russia and Argentina have. Finally, they could vote to remove themselves from the European Union. The benefits would include a devaluation of their debt and an instant competitive edge in labor pricing.Unfortunately, any savings – monetary or land (mark-to-market), left in Greece would be devalued immediately and it would leave them unable to securefinancing on the open market for quite some time.

Going back to where we started, I asked the question, “What would make the Dollar and Gold rally while keeping short term U.S. interest rates low?” As of this morning, (2/16/10), European Union leaders have broken offtalks with Greece over what to do. A Grecian default would place a huge strain on Germany, Switzerland and France, the three primary holders of Grecian debt(Mauldin). Great Britain and Spain are stuck dealing with their own problemsand the Swiss won’t get involved. If the EU were to bail out Greece, what wouldIreland say? Here in the U.S. we arbitrarily chose to save some firms and letothers fall by the wayside. Think Bear Stearns versus Goldman. The fallout was substantial. I can’t imagine the political chess game that involves picking which country to save and allowing which one to fail. From a tradingperspective, and this is about trading – not political rhetoric, this eventwill create uncertainty in the financial markets. Holders of Euros will diversify. Whether they buy U.S. Dollars directly or, simply move money out ofthe Euro and into other currencies, this action will devalue the Euro. Furthermore,this uncertainty will attract more money to Gold. Finally, uncertainty in theEuro Currency will reassert the U.S. debt markets as king, thus keeping short term rates low for the foreseeable future.

Any questions, please call.Andy Waldock866-990-0777