The Dollar Breaks Out

"Money can't buy you happiness but it does bring you a more pleasant form of misery." - Spike Milligan

This week the dollar (as measured against a basket of currencies, predominantly the Euro) broke out.  As you can clearly see from the chart below the strength in the dollar has been building for some time.  This is predominantly due to the considerable weakness in Europe rather than a show of strength in the United States however what are the implications of a stronger dollar on the world's largest economy?

Typically strength in a country's underlying economy results in a strengthening of their currency.  The attraction of foreign capital to that economy results in a stronger currency but the implications are far deeper.  A stronger currency means lower rates of inflation.  Think about it, as the dollar strengthens the price of imported goods, in dollar terms, falls.  On the commodity front, as most commodities are priced in dollars, the price to the rest of the world increases.  As this price increases the demand for these items falls, once again resulting in reduced inflation to the United States.

So does this dollar strength mean that the united States economy is strong?  Well in relation to the rest of the world we are doing quite well.  Our housing market seems to be bottoming, job growth while still anemic is growing, interest rates are low and should remain low for a long time to come particularly if the dollar remains strong, this low interest rate will start to feed into positive growth and if inflation remains tame things look kind of good!

So why is the market falling if things are looking up?  The market is forward looking and while things appear to be getting better I believe that it has run too far too fast.  In addition the problems of the rest of the world can easily come and bite us right where it hurts and this uncertainty will weigh on the market.  As it looks forward, uncertainty is not a good ingredient for positive market returns.

So as long as the dollar strengthens will the market go down?  In trading these types of correlations occur all the time and are reliable until they are not -  meaning that for the present time if the dollar strengthens the market will fall but at some point this correlation will be broken.  In other words, dollar strength does not necessarily mean that the market will fall, but it does right now.  In the past a strong dollar would normally point to a strong economy which would point to a strong market, but the problem is that the dollar is not strengthening due to a strong economy but due to weakness everywhere else.

The good news is that this strength is buying us a lot of time to repair our damage and insulate ourselves as much as possible from the impending crisis in Europe.  However, as the world economy is so tightly knit it will be impossible to protect ourselves completely from any fallout in Europe (just look at the JP Morgan mess) meaning that the risks in Europe will weigh on the market regardless.  So while it certainly appears that some of the underpinnings of a good economy are being put in place, if there is a hurricane from Europe our tent pegs will not hold down a half erected tent and it seems that it is only a matter of time before that storm hits our shores.

The Market Takes Strain

"I had not, it seems, the originality to chalk out a new road to shame and destruction, but trode the old track with stupid exactness not to deviate an inch from the beaten center." - An except from Charlotte Bronte's Jane Eyre

The above quote is one that a lot of us can use but right now it mostly applies to the global leaders and the central bankers of the world.  Whether they admit it or not we are heading towards a problem the like's of which have not been witnessed for almost a hundred years.  Trying to fix a debt problem by printing more money and increasing the debt level just will not work.  I have repeatedly mentioned this through my blogs but it appears that the central bankers of the world disagree with me and others who think like I do.

Even though we are running a fiscal budget deficit of more than a trillion dollars (and it appears that this deficit will continue to run for years to come) there has been no real expansion to the eeconomy.  I would agree that housing seems to be bottoming and that the stock market has been on a tear however the problem behind all of this is that printing money has not created an economic base that can sustain any growth.  Remove the juice from the Federal Reserve and we crater.  The problem is that when you print money you have no control of where it goes and so bubbles are created in areas that are not condusive to long term growth. We should know, our central bankers have been printing money for more than a decade now and the result is an ever larger problem.

An example of this is the fever associated with the Facebook IPO.  The launch was heralded across the globe and the company ahs raised over $16 billion giving it a valuation of over $100 billion.  The fact that it is trading at a price to earnings ratio of over 100 at its launch brings me back to the heady days of the Nasdaq bubble.  I have heard people rage about how it will be the first trillion dollar company, but how many other social netowrking sites are there out there?  If they have nto realized revenues off their subscriber base by now how will giving them $16 billion today help that endeavour.  It once again seems that the money printing has resulted in money being wildy speculated on a company in the hopes that it is the salavation of every investor.

The first quarter of this year is a case in point.  While the governemnt reported that the economy grew at a rate of 2.2% most if not all of that growth came from the automobile "sales".  I say "sales" as digging into the numbers reveals that most of these "sales' were just pushing product onto the dealerships floors rather than to the consumer.  Stripping this out takes growth down to around 1.0%.  This is the number that I believe is an accurate reflection of our growth prospects as long as the large government debt looms above our heads.  Not that the number in and of itself is a problem but as a percent og GDP it is.  Add to this massive budget deficits of more than a trillion dollars a year and you can see why we will rapidly blow well past debt of 100% of GDP in the years to come.

Now that is bad enough (and is the only reported number), but when you add in the problem of the aging population you then have to factor in the drains of the baby boomer population on Medicare and Social Security.  These holes take our total debt to $200 trillion.  This number is supported by a GDP of $14 trillion so in balance sheet terms we have leveraged ourselves 1,400 percent.  Try doing that as an individual and see what happens to your credit rating!  Also try doing that and then try getting another loan!

This is the problem that desperately needs to be fixed and it needs fixing now.  European problems are allowing us the time to get our economy in order as no matter how much money is printed the dollar remains strong.  Looking across to Europe it appears that we have a number of years before anyone looks our way, but believe me when they do they will not be happy with what they see.  If interest rates suddenly spiked, the bleed on the Treasury would consume most of the revenues to the government and would result in a continued deficit.  This is why it is imperative that the Federal Reserve keep interest rates low for the foreseeable future.  Keeping these down allow them to leverage the balance sheet to buy time to repair the damage to allow continued confidence in the US economy.

It is a conundrum and not one that is new however, with all the world's problems it is rapidly being exposed as the problem that it always has been and it will require a leader with vision to turn it around.  Looking therefore at the political landscape, our coming options are not good which means at least four more years of the same.  Cutting taxes will not work.  How can you cut your revenue to pay down your bills?  To take this to an extreme if you pay no tax how does the government pay its bills?  This idea that lowering taxes creates jobs and stimulates an economy looses merit at these levels of deficit.  Increasing taxes also does not stimulate growth.  So raising taxes is not the best policy either.  Cutting spending will become harder and harder to do as a smaller and smaller piece of the budget is going to actually running the government while almost 90% is being used up through Medicare, Social Security, interest payments and defence.  What is needed is to take a long hard look at our obligations, bring them to the forefront of debate and take them head on.

To do this requires a visioanry that can get the public to understand that pain must be felt all around in order to protect what we have created.  Pushing the can down the road has not worked.  In fact it has resulted in the current mess.  Socialism has seen its flaws revealed, communism with an open market will not work and while democracy is under attack the clear point is that free markets have not been the order of the day but rather a manipulated market has been tried and has not worked.  We are treading the tried and true path to massive problems and the rolling over of the stock market is beginning to show the cracks.

What are Commodity Prices Telling Us About the Future?

"Advice is the only commodity on the market where the supply always exceeds the demand." - Unknown

Having traded commodities for years I love to refer to them to get a few clues about where inflation and global growth are headed.   As commodities are the raw materials required by all economies of the world, their prices reflect as pure a demand and supply curve as can be found anywhere.  Obviously there is also a lot of speculation and at times manipulation of commodity prices but by and large the globally traded commodities of gold, copper and oil provide a very good insight as to inflation and global growth prospects.

I will start with a look at the price of gold.  Gold is thought to offer a hedge against inflation and is used in as a wealth protector in times of fear of global armegedon.  At present it appears that with fear of a global meltdown subsiding that most of the price is reflecting expectations of inflation.

The chart above shows clearly that gold has broken down giving a clear picture that the prospects of global inflation are muted.  I know, I know, the price at the pump and the price at the grocery store and on your insurance premiums are going up quickly, but that is not what comprises the entire basket of products that you consume.   So if inflation is muted that must mean that the input prices are coming down in price.  Well one of the main contributors of inflation is oil and the following chart will show you one of the major reasons why gold is falling in value.

The crude oil chart, while not completely broken is on the verge of breaking down.  This should translate into reduced prices at the pump and this will also, in time, feed through into other prices.  The caveat with oil is that prices can spike at any moment due to unrest in the middle east or any one of the oil producing states.  As there always seems to be a high probability of this happening prices can spiral higher at any time however what this does point to is the potential that demand does actually exceed supply and this could only be the result of weakening demand as the supply of oil is relatively stable.  So let's look at global growth prospects and there is no better guage of this than my old friend doctor copper!

High grade copper is used in everything and its price directly reflects global demand and this demand is based on global growth.  No economic growth and the price drops quickly, resume global economic growth and the price rises.  As you can see it appears that the price of copper is coming under strain and this points to a global economic slowdown.  This also confirms the above presumptions that point to lower inflation and hence lower prices in gold and oil.

Now these commodities are not necessarily linked together, in fact there is often a time when they are not moving in tandem, but looking at these charts shows that on the commodity front that the future points to lower inflation and anemic global growth and this is further confirmed by weakness in Europe, China and the United States.  Until these commodities point to global growth it appears that the slow grind to economic health will continue for a long time to come.

So if global growth is anemic and inflation is coming down there is no reason that interest rates will rise any time soon and furthermore there is no reason that stock prices will continue their march north.  There is a high probability under this scenario that stock prices bumble sideways for a long time or, if Europe cannot contain their problems, that they are met with a large downdraft.

China An Economic Superpower?

"If basic economic, political and legal reforms left undone since the 1980s are not addressed....China's onward march will be hobbled, and the world as a whole will feel the consequences as the snake tails wrap themselves around the tiger's head." - Hindustan Time

There is much debate about China's rise to supremacy particularly when it comes to being an economic superpower.  This has been highlighted by their taking the number two spot from Japan, their massive global reserves and their dauntingly large population.  The theory goes that it is not a matter of if China will become the next economic superpower but when?  Some say that this will happen by 2020 but I have to admit that I find that hard to believe and in all honesty I do not see them as an economic threat for at least the next 20 years.  My reasons are numerous and in this blog I will list what I see as sufficient hurdles to becoming an economic superpower that will hinder any meteoric rise into the world's premier economy.

Certainly they have the population size and drive to get it done.  They also have a vast pool of cheap labor and this too will allow growth however underneath this large population is a very troublesome issue - the one-child policy.  This policy was introduced in 1978 and has remained in effect through today.  According to reports this has reduced China's population growth by more than 400 million.  The main problem with this limitation is that by 2020 China will have a baby boomer style population with more of the population in the 35 and above age category than below.  This starts to become really top heavy by 2030 as you can see in the chart below and we have all seen the problems associated with supporting a large ailing population with a smaller younger population.

 
For an example look no further than the stresses that are being placed on social security and Medicare in the US and you can see that this will result in the first problem to China's financial resources in the relatively near future.  This will also have a large effect on the wage rate as less workers will be required to do the same amount of work and pricing power will start to shift to the labor force creating a problem for their manufacturing machine.  Already wage rates are creeping up and, based on this demographic shift, look to continue to accelerate into the future slowing the mainstay of their growth - their manufacturing competitiveness.

The next issue is the lack of economic transparency.  The press is full of reports of trademark and intellectual property theft.  Until this and the laws of the country are cleaned up and considered protective to the investor there will not be enough trust to become a global superpower.  Sure plenty of money is being poured into the country to take advantage of the country's burgeoning rich population, but that cannot translate into an economic superpower until the laws protect investors and there is a safety net of transparency.

Investing in Europe or the United States comes with risk but there is a level of trust that while certain individuals may try to swindle the investor that overall the market is honest and regulated plus there is a vast amount of transparency particularly when it comes to government debt.  Do not get me wrong, I still believe that a lot of the numbers are manipulated on either side of the Atlantic but at least there is some form of accountability and liquidity to the market whereas there is always a fear in China that the market will be closed at any second should something untoward happen.

The next issue is that to become an economic superpower you need a large and liquid debt or bond market.  This does not exist in China at present.  In order to become an economic superpower you need to have your currency widely distributed around the globe.  Look at the dollar, it is everywhere and is often used as the local currency during times of crisis.  It is stable and readily available and this is due in large part to the massive bond market and government debt market.  Through this medium dollars can easily be exchanged in vast quantities around the globe.  Second to the dollar is the Euro and then the Yen while due to the closed market economy that China prefers at present there is little in the way of Renminbi in global circulation.  There really cannot be any significant circulation until the currency peg is released and the markets open up.  I cannot see this happening any time soon as the Chinese government continues to control all aspects of the market with an iron fist and as far as I can see they will continue this trend for the foreseeable future.

Finally while there is no requirement to be a democracy there has never been a closed political body with an open economic environment that has lasted and become a global economic superpower.  Russia tried it and failed and the cost to their economy was horrendous and I just cannot see it working in China.  Something has to give.  With the handover of power coming soon there is a chance that the new leadership will promote a more open political and economic environment, but the time that it will take to implement all of the requirements to become a global economic superpower I believe will confound even the might and desire of the Chinese for years to come.  So while I agree that they are an economic force to be reckoned with, the step to becoming an economic superpower is a long way off.