Dollar Weakness: Double-Shot Endgame

James Ferguson explains the effects of the Weakness of the US Dollar — good and bad — and recommends we keep a very close eye on it in the future.

 SO FAR, dollar weakness has been good for the US. It’s made exports cheaper, and started to cut the value of the record trade deficit.

But the falling dollar also threatens US Treasury prices. Falling bond prices would result in rising yields – and higher interest rates usually prove disastrous for a debt-fuelled economy. Witness what’s happening to UK retail sales, for instance, now that mortgage equity withdrawal has slowed.

If such a slow-down triggered an increase in precautionary savings, a full-blown recession would be on the cards. But equally worrying for investors, higher US interest rates also justify a lower stock market valuation.

The price/earnings ratio (P/E) of the S&P500 will have to fall to reflect higher bond yields – exacerbating any earnings contraction that takes place as US consumer spending falls.

The enormous US trade deficit sucks in a mind-boggling 80% of the world’s savings, yet America itself has only a 1% national savings rate. Who funds this debt-fuelled spending binge? The Bank of Japan has been especially happy to recycle export-earned dollars back into US Treasury bonds. Keeping the dollar pumped up, and pushing US bond-yields lower, has kept Japan’s major export market humming. But the consequent weakening of the yen also helped at home in Japan, by minimizing the impact of imported dollar-denominated deflation from the rest of Asia.

Dollar Weakness: A Three-Way Danse Macabre

Japan’s policy has tied the yen to the dollar only slightly less effectively than China, which has had the Yuan formally pegged to the dollar since 1994. Thus the dollar has not only stayed unrealistically strong against the Asian currencies but long-term US interest rates have been kept too low. The American consumer’s understandable reaction, year-in and year-out, has been to borrow yet more artificially cheap money to buy yet more artificially cheap Asian imports.

Had this three-way danse-macabre not transpired, the dollar would now be coming off a much lower peak. US interest rates would have much less upside, and it would take much less of a wrench to bring the US trade account back into balance. For Euroland it’s time to re-learn an old lesson. As John Connolly, Richard Nixon’s Treasury Secretary in the early ’70s, once famously remarked: “The dollar is our currency but it’s your problem”. And Europe’s carmakers are already feeling the pain.

Volkswagen’s US sales fell 14.1% in the nine months through September, compared with the year before. Deutsche Bank calculates that the dollar’s fall in the past two months could subtract one-half of a percentage point from Europe’s growth rate next year. President of the European Central Bank, Jean-Claude Trichet has declared that the rapid descent of the dollar is “not welcome from the standpoint of the ECB.” He has called on the US to boost its savings rate as an antidote to the budget and trade deficits.

Of course, the only two ways to boost your savings rate are to hike interest rates, and/or have a recession – which increases precautionary savings. Neither approach is going to appeal to the US.

Besides, American industry is now starting to benefit from the weaker dollar. A typically unsympathetic US Treasury Secretary, John Snow, put the onus back on the Europeans when visiting the Eurozone last month. He told the ECB it needs to carry out structural economic reforms, and address the region’s own “growth deficit”.

So whilst the immediate and direct impact of a weaker dollar on Eurozone stocks can be quite brutal, the effect on the US stock market is, if anything, mildly positive, as recent strength in the S&P has implied. However, that will only last as long as dollar weakness remains quarantined from the US debt markets. If recent currency falls trigger – or even worse, reflect – a loss in confidence by Asian T-bond investors, the contagion could spread to the entire bonds market, and yields would surge.

In fact, this might already be happening. Malcolm Moore, writing in The Telegraph, notes that: “the steep rise in Treasury yields in the last two sessions [occurred, rather ominously] without any material news.” The consequences of higher bond yields for US equities could be immediate and catastrophic.

Looking at forecasts for earnings per share (EPS) in the S&P500 index, we can see that the bubble started as early as 1996, before finally hitting the dot.com peak in 2000. Since the crash wasn’t deep enough to bring the market back in-line with EPS, the subsequent 50% over 2003/04 was a real surprise for many analysts.

Today, with the S&P’s P/E ratio still high at around 21x, many professional investors believe the market is too expensive compared to historic norms. On this view, the bubble never fully burst and is now nearly a decade old.

Dollar Weakness: Not Much Economic Follow-Through

But things aren’t quite that simple. In the run-up to the US election in November, George Bush’s administration threw a huge amount of stimulus at the economy, including 50-year low interest rates, huge tax cuts, and massive government spending – not least on Iraq. The economy boomed, but companies felt uncomfortable about the tenuous nature of such a debt- fuelled recovery, so their hiring plans have been famously reticent this cycle.

Without more new and better-paid jobs, there’s unlikely to be much economic follow-through. Profit growth into 2005 will undoubtedly slow and probably peak out.

The consequence of employers keeping their hands in their pockets is that corporate after-tax profits are now at a near record high 7.6% of GDP. Profit margins too have most likely reached their zenith. “In the early 90’s, after-tax profits were less than 5% of revenues,” notes John Mauldin. But now “the S&P 500 has profits of 9.2% of revenues – in short, it doesn’t get much better than this.”

Yet Wall Street analysts think US earnings will grow a further 18% from the end of this quarter to the third quarter in 2005. This seems unlikely given the size of the earnings rebound since the third-quarter of 2001, plus the absence of further policy stimulation. Also consider that the 10-year average earnings growth rate has averaged just 5.7%.

If projected targets for earnings-per-share prove too optimistic, the only thing left to support the US equity market will be low bond yields – and that depends crucially on the value of the dollar.

“Up until now, it has been a win-win from a US perspective,” says Cazenove economist Eric Lonergan “but if a weak dollar starts to be bad for bonds, the US will start to care about it.”

One possible solution to this domino-effect would be a US dollar rescue mission. “Intervention on a massive scale could occur at any time” economists at ING reckon. Malcolm Moore reports that “the heads of four central banks – ECB, Japan, Switzerland and Poland – suggested intervention to strengthen the greenback was imminent.” But even the ING economists admit intervention is likely to provide only “a temporary reprieve.” And it would prove very costly.

So the real risk now for US stocks – and by extension, UK equity prices as well – is that they end up facing a dollar-induced double-whammy. By sapping Asian investors’ appetite for Treasury bonds, the weak dollar could trigger a bond market collapse, driving interest rates sharply up. This would choke off the cheap credit that has driven both America’s private and public sector spending sprees…thus putting the brakes on GDP growth…causing an inevitable deterioration in corporate earnings…which would push the US price/earnings ratio even higher than its current 22x.

Secondly – and more insidiously – as US interest rates push above the 5% range, they will no longer support price/earnings at 20x…let alone 22x or above. If Treasury yields drift up towards 6% or so, the sustainable P/E falls below 17x. Yields up at 7% imply a market P/E of just 14x.

In short, stock market investors should keep a very close eye on the US dollar – and an even closer eye on bond yields.

Regards,
James Ferguson
for Whiskey & Gunpowder
December 15, 2004