Things That Go Bump in My Worry Closet

John Mauldin | Thoughts from the Frontline
November 19, 2004

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!
--Old Scottish Prayer

Coming back from Canada this morning, where the Canadian dollar is on a breath-taking rise, and reading several lengthy (and very conflicting) reports on the international currency situation, I feel compelled to weigh in with a few observations. Basically, the numbers of things that are out of balance in the world are increasing. How long can the current status quo maintain itself? This week, we visit my worry closet. Now, there are numerous writers who would tell me not to worry. Isn't the market going up?

I am perfectly willing to be led into greener pastures. The employment numbers a few weeks ago were quite good. Retail sales seem to be coming along, thank you very much. But I hear things bumping in my closet. Maybe they are simply the ephemeral ghosts of bear markets and systemic shocks past, not yet willing to leave this world. As I tell my children, ghosts can't hurt you. However, the bumping is rather persistent, so I think we should bravely crack the door and peak into my worry closet and see if anything more substantial than a few ghoulies and ghosties reside therein. We will look at several situations and then see if we can make some sense from it all.

If a Trend Cannot Continue, Then it Won't

A large majority of the world now believes that the huge and surprisingly growing US trade balance will mean the further and continued erosion of the dollar. Morgan Stanley believes that despite the falling dollar that our trade gap will widen dramatically in 2005, to as much as 7% of GDP. This is unprecedented, and could only happen because the dollar is the world reserve currency. Can the world really absorb what would be $2 trillion dollars in the next three years? Where do you invest that $2 trillion? We are talking about a monster imbalance.

As I settled into my desk this morning, the following note from Reuters about a lecture by Alan Greenspan in Germany hit my desk:

"The insatiable foreign demand for dollar holdings would eventually fall as investors diversify, U.S. Federal Reserve Chairman Alan Greenspan said on Friday in remarks that landed hard on the dollar. Greenspan told a banking conference in Frankfurt the United States should cut its record budget gap to help narrow the shortfall in its current account and avoid a need to offer higher rates of return to retain foreign investment and painful economic consequences.

"Current account deficits, even large ones, have been defused without significant consequences, (but) we cannot become complacent," Greenspan warned. Greenspan said cutting the U.S. budget gap would be the best way to boost domestic saving and lessen America's reliance on foreigners to fund the huge shortfall in the current account, a broad trade measure that includes investment flows.

"Alternative approaches to reducing our current account imbalance by reducing domestic investment or inducing recession to suppress consumption obviously are not constructive long-term proposals," he said.

Greenspan said an eventual desire by foreign investors to cut the risk of holding too many dollars may lead them away from U.S. assets or lead them to seek higher rates of return. He warned this would elevate the cost of financing of the U.S. current account deficit and render it 'increasingly less tenable.'

"We see only limited indications that the large U.S. current account deficit is meeting financing resistance," Greenspan said. "Yet, net claims against residents of the United States cannot continue to increase forever in international portfolios at their recent pace."

"It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point," Greenspan said. The dollar hit a new four-year low against the Japanese yen after his comments and fell against the euro, pushing the European currency back toward recent record highs. (from Reuters)

Greenspan is only stating what everyone else "knows" and what I have been writing for several years. The trade deficit cannot continue at its present pace. Clearly, the world has absorbed our deficits for many years, and I do not think we will go into surpluses for many, many years. But the magnitude of the surplus has to be brought down. As I said, $2 trillion in three years is untenable.

If something cannot continue then it will stop. The question is will it be an abrupt, over the cliff type of stop or a controlled slowdown?

What I mean by that is summed up well by Stephen Roach. He writes today:

"The day will come when foreign investors simply say 'no' to this arrangement - refusing to fund America's consumption binge without getting a meaningful concession on the terms of financing. That's when the dollar collapses, US interest rates soar, and the stock market plunges. Under such a crisis scenario, a US recession would be all but inevitable. And a US-centric global economy would undoubtedly be quick to follow. Unfortunately, with America's current-account deficit now in the danger zone, that day of reckoning could well come sooner rather than later.

"The only way to avoid this wrenching endgame is for the world's major central banks to move preemptively on the dollar, carefully managing a gradual but significant depreciation over the next several years...

"In the end, a lopsided world needs a jolt to find this healthier state of balance. A weaker dollar is the functional equivalent of a major shift in the world's relative price structure that could well lead to greater balance. Given America's gaping and rising balance-of payments deficit, dollar depreciation is all but inevitable. There are two options for the world's financial authorities - remain in denial and get blindsided by a dollar crash or move ahead of the markets and manage the downside....

Iwata-san Speaks, the Yen Trembles

Can the world central banks actually cooperate on this level? I am not talking theoretically. Of course they could in theory. I mean practically. When Asia central banks have been using competitive currency devaluation as a major marketing tool, what would make them want to stop before everyone else does? Who will start the process? Going to the other side of the world from Germany, in what might be a more important speech, can we find a glimpse of the answer?

Note above that I ended with the tag-line on the Greenspan comment that the yen hit a four year low against the dollar. Can we lay that at the feet of Greenspan? Maybe, but the stronger reason might be comments from Bank of Japan Deputy Governor Kazumasa Iwata.

Iwata-san said today that "price stability means more flexible currencies." This simple statement may be huge, gentle reader. Flexible is not a word that is normally used by Japanese central bankers. It seems like he is saying that Japan might allow the yen to rise.

Even apprentice currency chart mavens cannot help but notice that Asian currencies as a group have only risen modestly during the last three years, an average of 3-4%. But against the euro, it has been a different picture. The euro has been rising almost as strongly against Asian currencies as the US dollar. If you are a European exporter, you are not pleased.

Although that has meant Europe gets to buy the inputs for it products, as well as its imports, at a much cheaper price, it is a hard price to pay for an already weak European economy. You have recently heard solemn pronouncements from various highly placed officials over concern about the strong euro. What they are really griping about is that they have had to do most of the heavy lifting of watching the dollar drop. They would prefer it if the rest of the world, especially Japan, China and the rest of Asia would lend a hand and allow their currencies to rise.

I find it interesting that on the same day Greenspan speaks that you get a major Japanese official talking about "flexible currencies." It was only a few years ago that we would read of major Japanese financial leaders talking about the need for a cheaper yen. I searched my old letters and found this note from February 22, 2002:

"Eisuke Sakikabara, former Japanese government financial guru, was known as Mr. Yen in Japan's heyday. Like Alan Greenspan, his musings would move the yen up or down.

"Listen to his quote from a few days ago: 'What we are in this moment is an economic crisis. Economic crisis eventually reach the financial sector. It is not unlikely for the yen to reach 150 or 160 before the end of this year.' Later I noted 'Other Japanese leaders would clearly prefer the yen to be at 130.' "

This was indeed the mindset among the Japanese then, and I expect a lot of the Old Guard industrialists now. The yen was then at 116. Today it is at 103 and change.

But the remarks by Iwata do not square with that position. Have the Japanese indeed now decided to allow the yen to gradually rise? If they do, my strong guess is that the rest of Asia will follow.

Note that it is not only Japan which is using the word flexible. Look at what Germany's Finance Minister, Mr. Eichel, said yesterday when asked whether current developments in the foreign exchange markets might have increased the pressure on China to allow the Renminbi to fluctuate more freely: "More exchange rate flexibility is generally desirable to make the process of global adjustment easier... [and] in this respect, I welcome efforts by China to create the conditions for more exchange rate flexibility, especially through reform of the banking sector." (The Gartman Letter)

There's that word again: flexible. Is there a pattern here? Could we actually see cooperation?

But let's be careful what we wish for. We might just get it. "Whoever you are, I have always depended on the kindness of strangers." (Blanche Dubois from Tennessee Williams' A Streetcar Named Desire.)

The hope of course is that higher prices would lead to the US consumer spending less and saving more, US exports becoming cheaper and therefore would increase and the trade deficit would drop. Also, since foreign currencies would be stronger, it would be nice if their consumers would spend a little of that stronger currency, especially the Japanese.

Of course, that does not get rid of the ugly fact that someone will have to finance the US budget deficit. Right now, the personal savings rate is at a rock-bottom 0.2% of disposable income. It was 7.7% in 1992.

But one man's spending becomes another man's savings. The world is saving what we are spending. And by spending I am pointing mainly at our government deficit. We are currently absorbing about 80% of the world's surplus savings. (Morgan Stanley) As Roach noted, not only are we outsourcing our production and labor, we are outsourcing our savings as well.

Normally, a falling currency means inflation and rising interest rates. And inflation is starting to show up in the data. Rising interest rates will not be far behind. The typical pattern for the Fed once they start raising rates is to do it for far longer and go far higher than anyone thought they would at the beginning of the rate increasing process.

Greenspan's comments on our US budget deficit were quite clear, and maybe more than a little threatening, although I wonder if most of congress can understand what he was saying. If the government does not act, rising US rates will be a natural consequence as foreign investors will not buy US government debt. Rising interest rates are not good for the stock market or for housing values. Nor will a falling dollar be helpful.

(As an aside, I openly question whether the Fed would allow rates to rise too far, too fast because if mortgage rates rose to 8%, it could cause a serious softening, if not sell-off, in the housing market. That would precipitate a serious recession. Consumer spending and sentiment is far more closely tied to housing values than anything else, including the stock market. But the affect of holding down long term rates and buying US debt (monetizing the debt) would be inflationary. Indeed, in the current world it would be stagflationary, to coin a word. Not a good environment.)

I expect Congress to start the process of getting spending under control, and soon. A falling dollar would actually help in a few areas. Let's say we fall another 10-15% against the euro and 20-25% against Asian currencies. Our agricultural products, one of our main exports, would be far more competitive and thus the need for price supports and those huge farm subsidies would go away.

It would make it easier to promote free trade agreements and those have always been good for our economy.

The Chinese Currency Conundrum

There is a growing international call for China to revalue their currency. Much of the speculation about the Chinese revaluing the Renminbi focuses on the large trade deficit they have with the United States. If they buy all the dollars from the various Chinese companies who sell to the US, giving them Chinese currency, it is inflationary and can spark a bubble, which would result in a crash, much like the Asian crisis of 1997-98.

But that's not really the case anymore. China is running a deficit with many of its other trading partners. In fact, it is now running a small negative trading balance as a nation. They are simply recycling our dollars to other countries. Further, they have been using some of their past surplus at least in part to buy euros, as their central bank's holdings of non-US assets has risen by $100 billion in the last four years. This has probably been one of the hidden factors in the euro's rise. (BCA Research)

Given that the Chinese will only act in a manner which will benefit them and at a time which they will determine, what can we guess about the timing of when they will allow their currency to float?

First, they have to allow their currency to float by 2007, assuming they will live up to the document they signed when they entered the World Trade Organization, and I assume they will. But waiting until the last minute does not make sense. They, like all other central banks, like slow and steady.

If the Japanese are truly signaling that they are willing to let the yen rise, which will mean the rest of Asia is likely to follow, I would speculate (and that is all this is) from all the sources I have read, that the Chinese will allow their currency to float in a measured way. They will initially allow the currency to float within a certain range and gradually broaden that range.

They are taking the steps they need to be taking to start such a process. We are beginning to see some verbal movement from their financial leaders as well as practical steps. Take note that this has been done after the election so as to not be seen as meddling in US politics, or worse, to seem like they were bowing to US pressure.

Who Really Controls the Dollar?

Roach is right. The dollar is going to be devalued. Whether it is in a crash or a controlled downward glide path is not in the hands of the US or the Fed. So, let the games begin. We will see if there is a coordinated movement to allow the dollar to drift down, especially in Asia. Such an effort would be a major policy shift for Asian central banks.

The irony is that it is foreign central banks that have far more interest in the value of the dollar, and far more control over it. Secretary Snow can talk all he wants about a strong dollar (and he once again did yesterday). The Fed and the Bush Administration will do nothing. They clearly want and need a lower dollar.

The Things That Go Bump in My Worry Closet

OK, the dollar is going to go lower. As I pointed out a few weeks ago, that is not the end of the world, unless you want to vacation in France. The dollar dropped over 30% and then rose in the 80's and 90's without great upheaval. So far, other than our European trips and products costing more, there has been little adjustment on the part of America. In a growing economy, rising interest rates and a falling dollar is something we can deal with.

Remember the old western movies, where the trusted scout leans over to the captain and says, "It's quiet. It's TOO quiet." This is usually just before a 1,000 Apaches come screaming over the hill. I get this eerie sense that it is too quiet.

I worry about what happens as the dollar drops and we do not have a growing economy. The Index of Leading Economic Indicators has now fallen for five straight months. Usually, but not always, that means a recession. The index fell for five months in 1995, but the conditions then and now were different. Our debt levels were nowhere near as high, interest rates and inflation were still on the demise and budget deficits were shrinking.

Oil, while likely to retreat somewhat in price, is likely to stay uncomfortably high, at least until a world recession reduces demand. It is a drag on the economy. The fact that long term interest rates have not risen much seems to suggest to me that the bond market is telling us things are weaker than we think.

As I noted last week, I do not think earnings will be anywhere close to the forecasts currently made by analysts. In fact, they have not been as good across the board as the numbers might indicate. Bill King writes:

"...the energy sector is contributing much of the increase in S&P 500 earnings y/y and the sector has a much lower PE (~13) than the S&P 500. Ergo, investors are placing a higher multiple on the index due to the energy earnings for which they have little enthusiasm.

"As usual, an examination of the details shows the situation is even more dramatic. The energy production sector and the energy equipment sector produced $5.95B of the $13.03819B increase in earnings for the S&P 500 in Q3 y/y. S&P earnings growth is 11.9% y/y. Ex-energy earnings the growth is 6.45%.

"Inflation impacts S&P earnings. Metals contributed $1.486B and Tobacco $3.120B (inelastic demand, assume little unit growth; it was -$837B Q3 '03, so the change is ~$4B y/y) of the y/y earnings increase. Add these to energy and we get $10.556B. Ex-these sectors, S&P earnings growth becomes 2.26% y/y.

"Let's look at two more inelastic demand sectors - healthcare and pharmaceuticals. Healthcare provider earnings increased 67.7% or $1.68B y/y. Pharmaceutical earnings increased 34.5% or $2.8856. If we add these sectors to the sectors mentioned above, the earnings gain is over $1B more than the total earnings gain in the S&P 500 y/y. The aggregate of all other sectors had lower earnings y/y... Ironically the above mentioned sectors have low PE's because investors don't think the earnings are stable.

"The multiple expansion of an aggregate due to the increased earnings of a much lower PE component is a principal that fueled the blow-off top in the late '60s to the long bull market that commenced in 1949."

Earnings disappointments are typically a trigger for the beginning of a bear market. A retreating stock market and a slowing economy, coupled with rising rates is not good.

I worry that we will enter the next recession too soon - before the Fed has time to "reload" its conventional recession fighting weapons and with the dollar in clear retreat.

Why the Dollar May Rise

Now, after all that, let me tell you why we could see the dollar rise in the near term. Everybody (well, most everybody) and their dog expect to see the dollar fall. That is the way the bets have been made. But when "everybody" is on the same side of the trade, there is no one on the other side, and you can get some violent corrections. While the trend may still be there, we could see a nasty "adjustment" or two. Indeed, if the central banks of the world actually do coordinate a gradual fall in the dollar, expect to see them "reverse" policy from time to time, just to jerk the chains of the speculators and hedge funds. If you play this market, expect volatility and lots of it.

For those who want to invest in foreign currencies, I would point you to Everbank (www.everbank.com) in St. Louis. You can buy an FDIC insured CD in almost any currency. Call Chuck Butler at 800-926-4922 and tell him I sent you. (Note: Everbank is a sponsor of my publisher.)

Canada and Home Again, Home Again

I spoke three times in Toronto to different groups, had more meetings and great dinners, but it was as exhausting a trip as I have had in many years. My daughter, who works with me and is starting to travel with me, is learning that business travel is not quite as exotic as it sounds. Worth every minute, though. But it was fun, and I want to thank the people at Canaccord, and especially the partners at McKenna, Gale and Stuart McKinnon at Pro-Hedge for being such great hosts. We are looking for potential partners to establish a relationship with Canadian firms so we can work with the many Canadians who have called or written. The rules are pretty complex, but we will get them figured out.

Next week is my favorite holiday of the year. I love Thanksgiving. Family and friends gathering, and calories don't count. Smoked turkey and mushrooms. It's hard to get better than that. Thanksgiving brings back such pleasant memories of large extended family gatherings as a kid, and creates new ones. We have a lot for which to be thankful. I know I am thankful for all of God's grace and blessing on my family and this country.

I am not sure whether or not I will write a letter next week. I will just wait and see what my mood is. I hope you enjoy your week.

Your always thankful for His abundant blessings analyst,

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