Crackup Currency

The British pound has performed phenomenally well against the dollar of late. But our world traveler, Dan Denning, doesn’t see too much more upside…Asia is where the action will be, he says…

"You’re under quarantine. Stay where you are. Don’t move."

The cops (bobbies/anti-terrorist police/agents of the warfare state) were in the lobby of the offices here in London, at the Sea Containers House, on the south side of the River Thames. A package with a white, floury powder had been sent to the office and opened by the receptionist.

He opened the package and found himself in a puff of white cloud. Police were called. Doors were sealed. Fire engines showed up. So did men in white biohazard suits. Those of us in the office were taken down a back stairway and sequestered behind police tape with the words "Do Not Cross" printed on it. "Wait here. Don’t go anywhere. You’ll be told what to do shortly."

So it is in today’s warfare state. Do what you’re told. Don’t ask questions. Accept the power of the state. Fear for your life or your death at the hands of sophisticated terrorists using direct mail response envelopes as weapons of mass disruption.

Seriously, London, circa August 2004 reminds me a lot of New York circa September 2001. It’s the capital city of the country with the world’s strongest currency. The economy appears to be booming. The housing market is soaring. And you’d have a hard time thinking of a single good reason to buy the British currency today.

Pound Strength: Asian Currencies

Why start with the British currency when the task of this (delayed) report is to talk about Asia? Specifically, the task of this report is to look at all of my Asian trip in currency and resource terms first, and equity terms second. I’ve said, after all, the next great bull markets of our investment lifetime and the greatest investment story of our lifetime (the Money Migration) are taking place in Asia. But there are lots of questions to answer before investment decisions can be made.

What currencies are worth owning in Asia, and how do you value a currency absolutely (instead of relatively versus other currencies)? What are the underlying trends in commodity consumption in Asia, and which commodities do they support? And are there any fairly valued or, dare I say, undervalued equities in Asia worth owning -WITHOUT a lot of risk? If not, can you still get Asia profits without the Asia risk?

But before we get to those questions, you have to roll back the videotape for a moment and ask a more basic question. As we sit here sipping our cocktails on the deck of the USS Dollar, the world stands poised on the edge of a great currency realignment. As I’ve said here before, the world has too much dollar risk. With its Twin Deficits each nearing half a trillion dollars, it’s hard to see the United States achieving a much sounder currency footing anytime soon.

The problem if you’re looking to diversify your dollar risk is what else to buy (other than gold). First, let’s look at what NOT to buy. Once you see what currencies are not likely to go higher against the dollar in the coming months, it narrows your choices (and, not coincidentally, brings us squarely to Asia).

When you’re looking for currencies to appreciate against the dollar, the obvious place to start with is the currencies that have already been tanning the dollar’s hide. The British pound and the euro have both beaten the dollar soundly since midsummer 2001.

Pound Strength: A Good Draft Beer

Having lived in both the eurozone (Paris) and now in London, I can tell you personally that the pound strength hits visiting Americans more than euro strength. It might just be that the cost of living in London is higher than it is in Paris. A good draft beer in Paris costs about $4. In London, it’s about $6.

The question now is will my beer be getting more expensive in dollar terms this fall? You can answer that question by going at it logically. Let me explain.

First, how likely is it that the U.S. dollar will suffer more weakness in the next six months? Or is it possible the dollar will actually rally off its recent lows? Well, if you look at the U.S. Dollar Index (a trade-weighted index of other currencies) you can see the Dollar Index is still trading below its 200-day moving average at 90.

It IS up from its lows of around 85. But since making a high in 2002, the index has treaded consistently under its 200-day moving average. Since then, it’s only seriously challenged that MA three times, once after the big reflation rally in March 2003, and two times earlier this year, as the hint of rising interest rates pricked speculative bubbles all across the globe and all across asset classes.

Having bounced off its long-term moving average and failing to break out to the upside, the dollar faces a crossroads. Will it retest its all-time lows again? Or can it mount a charge?

For the dollar to gain ground against the euro and the pound, we’d have to see an improvement in the U.S. trade deficit, which happened to roll in about $55 billion in June – yet another record. A falling U.S. deficit would take some pressure off the dollar. But a falling deficit would also mean reduced consumption of imports in the United States and slower GDP growth, neither being dollar bullish.

Let’s assume, then, that the dollar is not going to strengthen on its own merits. Does that mean it will fall? And if so, fall against what?

Pound Strength: Why Buy the Euro or Pound?

Let’s ask the question more directly. What would make the euro or the pound a "buy" at current levels? Things that make a currency a buy: high interest rates, a stable central bank, low inflation in domestic prices, a growing economy. Things that make a currency a "sell": high government debt-to-GDP, low economic growth, inflation, an unstable central bank, a stagnant economy.

The three-year weekly chart shows the British pound resting just above its 20-week moving average at 1.81 to the dollar. Note that the 20-week moving average went flat early this year and that since then the pound has fluctuated at the 1.81 level. This chart shows a currency that has peaked and should now be sold (certainly not bought).

The Bank of England (BOE) was one of the first central banks in the world to begin its tightening cycle and put the brakes on the tide of easy money that drove everything up in price in 2003. Rising interest rates on government bonds in England made the pound a great "yield" play – especially with U.S. interest rates at 45-year lows. The BOE has hiked the yield on its key interest rate five times since November.

It’s not a coincidence that it was about November of last year that the pound began its big rally from 1.55 to 1.81. The flood of money into UK bonds strengthened the currency. But the rising rates have also taken their gradual toll on the economy. The housing market has begun to slow down. And the strong currency has driven up the trade deficit to 1.9% of UK GDP.

It’s possible that the BOE may hike again. But so may the Fed. And so the likelihood is that the yield trade is over. With the trade-off, expect to see the pound make a correction.

Regards,

Dan Denning
for The Daily Reckoning
September 2, 2004

P.S. Sterling is not a currency likely to benefit from further dollar weakness. But neither is the euro. In fundamental terms, the euro is just as awful as the dollar. Instead, I’ve come up with an indicator for valuing currencies. I call it "net resource wealth." I still have to back-test the results and iron out some of the kinks in my adjustments, but so far, results look good. I should have it ready for my Strategic Investment readers by the end of September.

The end of summer has put us in a thoughtful mood. In the early morning, the whole earth seems to give off a soft, warm vapor like the breath of a dying man. Sweet, steamy mists rise from the Thames…a subtle fog collects in trash bins and alleyways…

What is surprising in the financial world now is its remarkable lack of anything worth talking about. Something new must be born; we are ready for it. But something old must pass away first to make room for it. The world inhales and exhales. Things go up…and then down. In with the new, out with the old.

And yet nothing seems to want to die. Nothing happened yesterday. Nothing happened the day before. Nothing has happened all year.

Nothing cannot happen forever…or to put it another way, nothing goes on forever, especially not nothing, if you see our meaning. What is now seems to want to be forever. The here and now feels eternal.

But never before has something so much needed to happen. Never in the history of the world have the accounts of one nation – the United States – been so out of balance with those of the rest of the world, particularly Asia. Every day, the U.S. economy tilts $2 billion more into the hole. And never before has the whole world economy depended on the spending power of people who ran out of spending money years ago…and now these big spenders depend on the kindness of strangers in strange places in order to keep going. Most of these skinny strangers live in what used to be called the Third World…where American foreign aid was supposed to help rescue them from starvation and poverty.

It is all very strange and remarkable when you think about it. But what people seem unable to imagine is that someday soon it may be remarkable in a completely different way. Something has to give, in other words. Some gotta win, some gotta lose…and the most sure losers, in our humble opinion, will be holders of expensive U.S. stocks. They are priced for a world that doesn’t breathe.

More of the latest news from our financial newshounds…

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Eric Fry, from downtown New York City…

– Lacking any birthdays, baptisms or bar mitzvahs to celebrate yesterday, your editor decided instead to celebrate the spectacular late August weather – the venue: Splash, an outdoor seafood restaurant in Westport, Conn.

– The three-part celebration began with a few games of beach volleyball – your editor’s one and only athletic pastime – then continued with cocktails at sunset and concluded with a delightful meal from a table overlooking the Long Island Sound. The evening was utterly perfect…almost.

– Your editor set out for the restaurant last night in the company of three females: his girlfriend, his girlfriend’s daughter and his GPS system (the sultry female voice inside his dashboard tells him how to find his intended destination). By the end of the night, he would become very disenchanted with one of his female companions…(Hint: It would not be his girlfriend’s daughter)…

– Technological advances are a wonderful thing. Most of us adore our TV sets, cell phones, high-speed Internet connections, iPods and innumerable other 20th century innovations. Some of us also love our GPS systems. But no gadget is perfect – cell phones sometimes go dead, TV sets sometimes deliver a fuzzy picture and GPS systems sometimes select a suboptimal route.

– Your editor knows the route to Splash – he could almost drive it blindfolded. WITHOUT a GPS system to show the way, the drive to the restaurant takes about 30 minutes. WITH GPS, the trip took about 45 minutes.

– Your editor – a GPS neophyte – is still intrigued by this sexy navigational system in his new Toyota. So just for kicks, he switched on the GPS system before heading to the restaurant and decided to follow its directions slavishly. Initially, he was charmed by the gentle voice of the techno-dominatrix inside his dashboard. She told him where to go and when to go there (he liked that)…and she corrected him ever so sweetly if he strayed from the path.

– "I think you’re in love with her," your editor’s girlfriend complained.

– "Nah," he lied.

– "You would like it if I behaved exactly like her, wouldn’t you?" she insisted. "That’s it! You want me to behave like the GPS woman, don’t you? Sorry sweetheart; that’s not me."

– "No, I don’t want you to act like the GPS woman…but she is very sweet, don’t you think? She never argues, never complains, never has a bad day…there are worse dispositions, you know."

– Your editor’s girlfriend laughed…fortunately.

– Unfortunately, like so many budding passions, this one was destined to die in its infancy.

– The woman inside the dashboard led your editor astray…For starters, she selected a route that no local would ever choose – geographically flawless, but functionally flawed. No local would have ever selected the traffic-clogged avenues that the GPS gal preferred. Worse, during the course of our short ride, she sent your editor and his companions on two senseless mini-detours and then directed them into a cul-de-sac.

– "See! She’s not really so sweet," your editor’s girlfriend (her name is Rose) declared with smug satisfaction. "Look how she’s treating you! I think she’s passive-aggressive."

– "Yeah, I cannot disagree with you," your editor replied. "It’s too bad, really. For a while there, I thought we had such a good thing going."

– Technology had led us astray…the sweet siren’s voice of technology that had seemed so alluring and so certain had led us astray…so the siren song of Wall Street analysts.

– Last winter, as the new year was approaching, most Wall Street analysts were certain that tech stocks in general, and semiconductor stocks in particular, would lead the next leg of the wonderful bull market that had vaulted the Nasdaq Composite more than 90% from its October 2002 lows. The tech crowd in Silicon Valley was giddy and confident.

– "We ended the year on a high note," gushed Intel’s CEO, Craig Barrett, last January, "as ongoing strength in emerging markets, coupled with improving demand in established markets, drove revenue to record levels…In 2004, our focus will be to drive double-digit growth through technology leadership and global market expansion, and by pursuing adjacent opportunities in communications and the digital home."

– So far, Barrett has lived up to his promise by delivering double-digit revenue growth during the first two quarters of 2004. Unfortunately, Intel stock has delivered a different sort of double-digit performance – down a whopping 33% year to date.

– Alas, technology – and its implied promise of rapid growth, lush profits and hyperbolic share prices – did not deliver investors to their desired destination. Barrett, along with the mellifluous chorus of tech bulls on Wall Street, led investors down a volatile path toward capital losses.

– Interestingly, now that Intel and most other semiconductor stocks have tumbled substantially from their recent highs, Wall Street analysts are rushing to downgrade stocks throughout the semiconductor sector.

– After Intel’s sharp decline Tuesday, numerous analysts weighed in with negative opinions about the chip maker’s prospects. Smith Barney cut its price target on the shares, while UBS, First Albany, WR Hambrecht, Janney Montgomery Scott and Piper Jaffray all issued downbeat comments about one or more semiconductor stocks.

– Might the Wall Street guidance system be sending the wrong signals once again? Will semiconductor stocks soon begin to outperform the rest of the stock market? …At least the GPS woman guided your editor to his desired destination eventually…

– Yesterday, the Dow Jones Industrial Average dipped 5 points, to 10,168.46, while the Nasdaq Composite Index added 12 points, to 1,850. The gold price retreated $1.60, to $410.80 an ounce.

– The stock market might have kicked off September in a more impressive fashion, but the oil market stood in its way. Stocks froze like a raccoon in the headlights, as the price of crude oil jumped $2.13, to $44.25 a barrel. The robust rally started after the American Petroleum Institute and the Energy Department reported respective declines of 8.1 million and 4.2 million barrels in U.S. oil inventories. The nation’s oil supply now sits at its lowest level in nearly six months.

– Also weighing on stock prices was the report around midday of mass sickness at a Washington, D.C., office building. The story turned out to be a kids’ prank. The only actual mass sickness besetting the nation is the mild nausea that afflicts millions of investors every 30 days when they open their mutual fund statements.

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Bill Bonner, back in London…

*** When respiration finally resumes, it will come with more than a sigh from U.S. stockholders. Expect a few coughs and sputters as well…

"’Never again,’ the Texas oil baron and corporate raider T. Boone Pickens announced this month, ‘will we pump more than 82 million barrels.’" And so begins a wonderfully absurd article in the UK’s Guardian newspaper about a group of tree-huggers who decided – 10 years ago – to live without combustible fuel.

"As we are pumping 82 million barrels of oil a day at the moment, what Pickens is saying is that global production has peaked," continues the Guardian. "If he is right, then the oil geologist Kenneth Deffeyes, who announced to general ridicule last year that he was ‘99% confident’ it would happen in 2004, has been vindicated. Rather more importantly, industrial civilization is over."

"Not immediately, of course…"

*** A note from our Pittsburgh-based kibitzer, Byron King:

You will be pleased to learn that, at least in one locale of this fair land, consumers are not spending more than they earn. But even this news is not as happy as it may seem at first glance.

I recently traveled to Detroit, Mich., on business. I breezed through a relatively empty Northwest Airlines terminal, passing departure gates labeled with destinations ranging from "Amsterdam" and "Tokyo" to "Seattle" and "Miami." I noticed the paucity of passengers waiting to board the very large jets parked and awaiting their respective pushback times. Not many people seem to be traveling. But whether people fly or not, Detroit and Northwest Airlines still have this wonderful new airport terminal and those shiny Boeing and Airbus jets parked on the ramp, filled with trained aircrew and attendants. And it is all overhead, from the standpoint of getting people from point A to point B. Hmmm…

Driving north, I pulled off of I-94 and stopped for dinner at a national franchise that promotes itself as a purveyor of fine steaks. The parking lot was mostly empty, as was the inside of the restaurant. The hostess was positively thrilled to see me, and the wait staff could not do enough to treat me well. The place was clean, and there were no obvious postings from the Health Department, but I wondered about the lack of patronage. More overhead….

I arrived at my hotel and saw one of my colleagues in the parking lot, who invited me to join him for his dinner. Having previously dined, I tagged along just to keep him company. It was the same story: another national franchise restaurant, clean and tidy, but also almost empty. We were greeted by another happy hostess and a wait staff eager to please these two travelers. More overhead. Something did not seem quite right….

The next night was the same sort of tale. A group of four of us went to a restaurant with a well-known name in the community. The parking lot was filled with cars and pickup trucks that appeared to belong to the employees. The seating area was wide open. The place was clean and the food was good, but it was a quiet experience except for the very friendly staff. "We have a table for you right now, but would you like to stop at the bar?" asked the lovely hostess. Standing behind the bar was an attractive young lady who appeared to be one of the loneliest bartenders in Sterling Heights. She looked like she needed to pour a few beers and earn a tip or two. Being the gentlemen that we are, we obliged, of course, but the silence of the restaurant during our stay was deafening. Still more overhead….

And there we were the next night, at another eatery right across the road from the front door of the DaimlerChrysler stamping plant, just down the road from the General Motors Technical Center, near strip malls and residential areas, in an all-but-empty restaurant. Same story: clean, fully stocked bar, nice salad bar, good food (even a low-carb Atkins menu) and a polite and well-trained staff. Aside from an older woman who was taking her daughter and granddaughter out for a birthday meal, we had the place all to ourselves. If any establishment ought to be packed to the rafters on a Saturday evening, this was it. But no. Something was wrong.

The manager came over to ask if our visit was all right. I said that things were fine, but I was wondering why there were so few patrons in his nice restaurant. He was pretty straightforward and listed a variety of reasons. "There are just too many restaurants chasing the same people. Things are overbuilt. And it is back-to-school time and people are spending their money on the kids. People are paying more for gas. And it seems like a lot of people just run out of money before the end of the month." Yes, apparently so. There is too much month left at the end of the money.

Am I reading too much into my few days in the industrial regions north of Detroit? Did I just happen to pay my visit during a slow period that is normal for the end of the summer? I do not know. I have visited old ghost towns of the American West, such as Silver City, Colo., and the suburbs of Detroit are a long way from that state of vacancy. But I have to wonder if we are reaching the crest of at least this wave of the consumer-driven economic culture. "Things are overbuilt," said the restaurant manager. And incomes are down, and other costs of goods and services are rising.

Back in another time, it must have seemed to be a good idea to somebody to invest their funds in airplanes that are now flying almost empty, or restaurants that are now surrounded by vacant parking lots. For many years, the economic tides have advanced, rivet by rivet and brick by brick. And credit by credit, not to put too fine a point on it. Now comes the economic retreat.

When I think of the tides of the economy receding, I am reminded of the old military axiom that an orderly retreat is the most difficult field maneuver for even the most brilliant generals to plan. It is not uncommon in military history for a retreat to turn into a rout. It is not uncommon at all.