FYI | Oct 12 2009
(This story was originally published on Wednesday, 7th October 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).
Let’s concentrate on the stimulus that is keeping global share markets into positive territory this calendar year.
I am not referring to the “Cash for Clunkers” program in the US, the massive infrastructure incentives in China or the much-debated handouts by the Rudd government in Australia. All these stimulus programs, plus the many others, have prevented economies from sinking into a Global Depression and this has helped the swift recovery of global equity markets.
We have a recovery. Equity markets are higher. Global risk appetite is back and with a vengeance. All this is true.
Yet I cannot stop myself from thinking that without the daily stimulus of a weakening US dollar this year’s recovery would have shown a much bumpier ride. As a matter of fact, I think that if it weren’t for the continuous attacks on the global reserve currency, risky assets (such as shares and commodities) would have had their long speculated correction by now, and probably by more than two percent here and another half of a percent there.
Yet the fact remains we are and remain in a weakening US dollar environment, and hence the stimulus for investors to take a much riskier approach than usual remains in place.
This is one of the reasons why I remain positive on the outlook for equities in the year ahead.
We could, of course, organise a public debate about whether a weakening USD is the cause or the result in the present environment, but frankly I don’t think it matters. A weaker USD makes US products and services more attractive in foreign markets. This spurs on more optimism in the ultimate fate of corporate profits, and thus share prices rise. Elsewhere, investors cannot help but to continue taking a lead from the US (even if, arguably, this shouldn’t necessarily be good news for companies in the UK, Europe and Japan).
Elsewhere, prices of crude oil, copper, sugar and grains continue to benefit from this extra stimulus as well. This in turn reflects well on the share prices of companies with leverage to these markets, as well as on the currencies behind commodity exporting countries.
It looks like a free ride for all, and so far it is.
To top things off, all of the above feeds into positive looking trends on technical charts, which further feeds into ongoing investor optimism. I am sure you all get the picture by now: financial markets are in a positive, self-supporting circle – and frankly I don’t see an immediate end to this.
Unless the US dollar reverses trend.
Is this is a real and present danger? It most certainly is.
In fact, I know of a few hedge fund managers who are currently short everything that continues moving up (see above). And they have taken these market positions because they believe that what we are witnessing will prove an unsustainable trend.
One such manager recently declared on live financial television: “Gold is the new crude oil” (in reference to the bubble last year that led crude oil futures to surge to US$147 per barrel and then collapse).
Within this framework I can report that the number of experts talking about gold having set its sights on reaching US$1100, then US$1200 and then possibly US$1300/oz has increased exponentially over the past weeks.
Meanwhile, the US dollar continues to carry an almost relentless pressure to weaken further. Even if we dismiss all conspiracies about the world showing it is fed up with the Americans and their ever expanding mountain of problems, the fact that global interest rate differentials are once again moving away from the US dollar should be enough to suggest that we have yet to see the end of this trend.
That is the real message the Reserve Bank of Australia has given the world this week.
According to global consensus, the US is in nowhere near a position to start raising interest rates itself. Some optimists are talking about the second half of 2010, others don’t see it happening before the calendar writes 2011. Whatever the timeline, the past has taught me that financial markets tend to take guidance from trends more so than from actualities.
This means that from the moment US Fed Funds move up, the US dollar might start doing the same thing. Lucky for all of us right now, this seems but a distant prospect right now.
So it’s still plain sailing from here on?
Unfortunately, not. The US dollar can still move counter-trend because of other factors. Witness, for instance, the weakness in the British Pound these past weeks. Investors are worried the UK economy is sliding further away from health.
Probably the biggest danger is that the US economy will start showing weaker than expected data and corporate profits in the months ahead. As things have developed since late 2007, this is bound to push the USD higher, and all else down. Because of the double-whammy impact of a negative demand signal plus a quick reversal of that extra-stimulus, the impact on risk assets can be quite pronounced.
Put this against a background of risk assets increasingly climbing the wall of worry (as prices have surged a lot already) and every investor should feel inclined to be a bit more cautious than usual. As widely acclaimed investment expert Marc Faber stated this week: history shows investors always tend to jump on board and become most excited when a trend has become entrenched and firmly established. However, that is exactly the point when they should not join the rally in an aggressive manner – as proven over and over again.
Do seven consecutive months of significant price rises make for an established trend? What do you think?
The way I see it, the most optimal scenario would be one whereby economies across the globe continue to expand over the year ahead, but without breaking any speeding records. This remains a reasonable assumption. That way inflation will remain subdued and central bankers in the US will remain uncomfortable enough to keep interest rates untouched and quantitative easing in place for longer.
Watch out for signals of changes in either of the two – there is a chance it won’t be taken as a good thing by investors and the US dollar is likely to benefit if investors do pull the trigger.
A stronger than generally assumed economic recovery, as forecast by some, is not a good scenario either. It will bring forward the Fed’s timeline for quitting quantitative easing and for lifting official interest rates. Higher US interest rates plus a stronger US dollar -even though it could be argued both would be a symbol of a healthy economy- will create significant headwinds for risk assets.
So… where does all this leave us?
If I have to make a choice between the three growth scenarios as mentioned above, I retain a preference for the most advantageous one: a modest, rather tepid economic recovery in most developed economies. This is why I remain positive about the underlying trends for equity markets and commodities on a twelve-month view.
The smart ones among you would have already figured out that most of the upside coming from a persistently weak USD will be negated by an ever stronger Aussie dollar. Correct. Yet I still believe the net effect will be positive for the Australian share market.
The going is getting tougher, that much is certain. Watch out for those sudden reversals. They tend to come from left field and trigger more talk about the end of the rally.
With these thoughts I leave you all,
Till next week!
Your editor,
Rudi Filapek-Vandyck
(as always firmly supported by the Ab Fab Team at FNArena)
P.S. I – Technical market commentators at Griffiths McBurney point out gold has just completed a reverse head-and-shoulders pattern (one that took 18 months to complete). This should be a very positive signal, one that is further reinforced by the fact that most chartists are convinced the USD has further to fall.
Chartists at WJB Capital Group believe gold is on its way to US$1300/oz, crude oil is on its way to US$90/bbl and silver has US$21/oz in its sights.
P.S. II – Here are a few charts to further illustrate all of the above (with thanks to BTIG market strategist Mike O’Rourke)
(If you cannot see the charts you are probably reading this story via a third party channel and the victim of technical limitations. My apologies.)
P.S. III – This week’s editorial was written in Perth coffee shop La Via (St George’s Terrace). They serve an excellent herbal tea and the weather here is so much better than in Sydney and Melbourne.
P.S. IV – All paying members at FNArena are being reminded they can set an email alert for my editorials. Go to Portfolio and Alerts in the Cockpit and tick the box in front of Rudi On Thursday. You will receive an email alert every time a new editorial has been published on the website.
