Is US Dollar Headed for Doldrums?
10 June 2006 Business Times Singapore English (c) 2006 Singapore Press Holdings Limited
MARKETS have sounded the retreat. This week the Dow Jones Industrial Average felle below 11,000 for the first time in three months and other markets have fallen sharply in sympathy. As one of our panelists in this week's Investment Roundtable notes: 'With so much leverage in the markets, the potential for ugly corrections over the summer is high.'
The situation at present, he suggests, resembles in many ways that of the summer of 1987 before the last market crash. That proved to be a baptism of fire for Alan Greenspan, the immediate predecessor of Federal Reserve chairman Ben Bernanke. Could Mr Bernanke be in for a similar welcome now? Other problems that could come to the fore are those with derivatives and the unwinding of the yen carry trade.
Where to look for shelter from the coming storm? If there is one thing on which our panellists are in total agreement, it is that the US dollar offers no haven; quite the opposite. But they do favour some exposure to the Singapore dollar, and a diversified portfolio of investments that should enable readers to ride out the storm.
PARTICIPANTS in the roundtable:
Anthony Rowley, BT's Tokyo Correspondent.
Marc Faber, Investment adviser and publisher of the Gloom, Boom and Doom Report.
Christopher Wood, Managing Director and Equity Strategist, CLSA Asia-Pacific Markets.
William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.
Anthony: Welcome gentlemen, and thank you for taking time out from your busy schedules at this time of extreme turbulence in financial markets. Investors are running scared of inflation and the assumption is that most markets are going to continue experiencing turbulence as political tensions in the Middle East continue and the dollar remains volatile. Likewise, the outlook for interest rates and currencies is giving rise to angst, speculative positions in commodities are being unwound and derivative positions are getting squeezed by the contraction in global liquidity. Under this scenario, cash appears to be king. So, are financial markets in for a rough ride in coming months? Marc, let's hear from you first.
Since October 2002, all asset markets have been inflated, some more than others. Since the end of 2005, the technical position of the S&P 500 has been deteriorating and a significant correction is now likely to be under way. Emerging markets such as Russia, India, Brazil, Turkey, which had huge run-ups and became horribly overbought, are now very vulnerable. Industrial commodities such as copper are also vulnerable. In the last 100 years, there has never been a three-year time period during which, such as has been the case in the last three years, copper prices have risen by compound 70 per cent per annum. I am at this point less interested why markets are declining than by what the markets are signalling to the world by going down.
William: I supported a sell-in-May-and-go-away policy in a previous BT Roundtable. Until early May, almost all asset classes were priced for perfection floating in a sea of complacently, assuming the continuation of a 'Goldilocks scenario' of low interest rates, low inflation, high growth rates and stable exchange rates despite record global imbalances.
This was obviously unsustainable: the massive injections of liquidity were slowly being withdrawn. Meanwhile, the Middle East remains unstable, the dollar is overvalued, inflation is increasing and doubts are growing, as we predicted, about Bernanke's competence to handle his brief. The G-7 meeting by indicating a desire for a managed depreciation of the dollar helped upset the old equilibrium.
With so much leverage in the markets, the potential for ugly corrections over the summer is high. The situation resembles in many ways that of the summer of 1987 before the last market crash that, ironically, was Bernanke's predecessor Alan Greenspan's baptism of fire a few months after taking over the Fed. Other problems that could come to the fore are those with derivatives and the unwinding of the yen carry trade.
Christopher: This is a healthy bull market correction for Asian equity markets and commodities which could last over the summer. The correction will be worse if there is a real inflation scare on Wall Street to test Bernanke.
Anthony: How long has it been since we saw a conjunction like the present one, in currency and financial markets - and is there still any chance of a soft landing?
William: There are two similarities I can think of with today's position. Unfortunately, they give two different outcomes as possibilities.
The first is 1987, which I mentioned earlier which was a delayed response to liquidity tightening by the Fed and an adjustment of the dollar following the Louvre accord. The Dow lost 25 per cent in a couple of days. Greenspan flooded the system with liquidity and the market quickly recovered and went to new highs.
The other occurrence is 1973, when the Dow finished its recovery from the 1969-70 bear market, created a double top at 1,000 and then proceeded to lose 45 per cent of its value over the next two years. That was accompanied by a sharp decline in the dollar, the Yom Kippur war, a massive percentage increase in oil prices, stagflation, Watergate and a bull market in gold. The period included the installation of Arthur Burns, another academic like Bernanke, as the new head of the Federal Reserve Board.
I think there is a significant likelihood that the US dollar has to decline 30 per cent on a trade-weighted basis over the next two or three years. If global geopolitical events intervene, then the probability that this will be a hard landing is quite high. We have a huge hidden problem with derivatives, which could explode at any time. With problems in the Middle East and the likelihood that the Republicans will lose Congress in November means a replay of the Watergate years is a definite possibility.
If these events come to pass, then the 2003-06 recovery in the US markets will be seen as a rally in a bear market that began in 2000, and the bear market in the US is about to resume. Given the geopolitical background, I believe this is a higher probability outcome than the first postulate in the medium term.
Marc: We had in the S&P the third longest rise on record without a 10 per cent correction. A correction/bear market was long overdue. Obviously when asset markets will decline, the US Fed will try to cushion the damage by 'printing money'. This may not help the economy but would at least prevent equities from tumbling. Stagflation will then likely occur.
Christopher: There can still be a soft landing in the US. Much will depend on whether the Fed retains the confidence of foreign creditors.
Anthony: Specifically, how you see the outlook for equities in a) mature markets and (b) emerging markets.
Marc: As I said, I regard for the next three to six months emerging markets, which have significantly out-performed the US in the last three years, to be more vulnerable than the US. Some emerging markets such as Malaysia, Thailand and Taiwan would seem - thanks to their high dividend yield - to be less vulnerable than others. I may add that some emerging market currencies - Turkish lira, Brazilian real, Mexican peso - would also seem to be vulnerable.
Christopher: I think Wall Street is still in a secular bear market, Japan and Germany are my favourite developed equity markets. For Asia and emerging markets, my view remains firmly that they remain in long-term bull markets.
William: In developed countries, markets have recovered from the bear market of 2000-3 and valuations are generally on the high side of fair in the US, but without the manic valuations of 2000. Japan and Germany are recovering with Japan the more convincing case. There is a case for exposure there since the currency is also likely to be supportive. Since I expect volatility and I do not like the US dollar's prospects, I would severely underweight the US equity market and wait for better prices.
I would remain over-weight Asian emerging markets but would do some reallocation around the region to recognise geopolitical risks. Regardless of everything, it will remain the fastest growing region in the world and people in developed economies around the world worried about their pensions must participate in this development. They remain underweight the region.
Sure, Asian emerging markets got a little ahead of themselves before the recent sell-off but I look on India as a decade play and below 10,000 on the Sensex should be owned. Taiwan and Korea are longer term growth and recovery plays. Taiwan is following the Japan recovery story and Korea is in the early stages of a recovering market after breaking out of a 17-year trading range. Malaysia is safe, boring and represents good value. Singapore and Hong Kong are stable and have some very good companies.
Latin America is another story, in which I claim little expertise. It appears to be going through one of its cyclical swings to the left. It will end badly for the economies and in the interim will not be good for their equity markets.
Anthony: What about the outlook for bond markets?
Marc: Long term I am extremely negative about US government bonds. In fact, each Singaporean should just buy one US 30-year treasury bond, frame it, and put it on the wall of his living room, in order to show his grandchildren how the US dollar and US dollar bonds became worthless over time. Still, for the next three months, I think US government bonds could rebound because the economy is likely to badly disappoint as a result of a sharply weakening housing market. So, whereas equities outperformed bonds since 2003, for the next three months bonds are likely to outperform equities. But this is a short-term call. Long term, with one money-printer - an academic - at the Fed and another money printer - from Wall Street - at the Treasury, what can you expect?
William: Bond markets represent better value than they did at the beginning of the year. But while inflation is still increasing, they are still a gamble. If long US rates increase by a percentage point, to closer to 6 per cent, then they would be still more interesting. Until then, investors should hold short-duration issues.
Anthony: Let's turn to commodities, which have been the darlings of the market until recently but now look like the Cinderellas.
Marc: Industrial commodities are likely to sell off as the economy begins to disappoint. Don't forget that within secular bull markets, 30 per cent to 40 per cent corrections are not unusual. I also think gold will decline near term, but since it is more of a monetary asset than dependent on industrial production growth, I suppose that gold will outperform other industrial commodities. I still like the grains, which may outperform for a while. I would accumulate gold on any decline because with the money printers in the US administration, its bright future is assured. Long term, commodities - following a massive correction - are, however, likely to outperform the Dow Jones for many years.
Christopher: If commodities continue to correct, there is a real chance that the US bond market will not break the long-term trend line on the 10-year Treasury, which it tested at 5.2 per cent earlier this month. But a renewed surge in commodities will make bonds very vulnerable.
William: Gold and other precious metals have had a healthy shakeout but their bull markets remain intact. They remain a critical anchor to portfolios in the volatile times ahead.
The fundamental story on other commodities remains in place, whether energy, minerals or agricultural commodities. Prices are catching up with demand after years of underinvestment. However, there is also no denying that hot money has entered these markets and blown some of them to levels unsustainable in the short run. Hence, the increased volatility, which we can expect to be maintained going forward.
Anthony: What about the outlook for currencies?
Christopher: Modern central bankers, most particularly at the Fed, have only targeted asset prices on the downside in recent years. This asymmetry will ultimately lead to the destruction of the US dollar paper standard. For this reason I dislike the US dollar fundamentally. My favourite paper currency is the Singapore dollar.
William: My anxiety about the US dollar is known and is compounded by the fact that we may be at a turning point in history about the use of the US dollar as the sole reserve currency of the world. The portents are all there: central bank nervousness leading to a quiet diversification of reserves into other currencies and asset classes. But more than that, talk by the Russians and other oil powers of pricing oil in non-dollar currencies. Both the Russian rouble and the euro have been mentioned. The Russian oil bourse is set to begin rouble-based oil trading in June. The Teheran bourse is also mooted. Events like this cannot be shrugged off - they are highly significant. I have quoted Paul Volcker and others who say that the US dollar needs to decline substantially to reduce its current account deficit to a sustainable level.
To reduce the deficit to a level of 3.5 per cent of GDP (which is still on the high side of sustainable) would require a devaluation of the order of 30 per cent against a basket of currencies. That can only be accomplished through an appreciation of the major Asian currencies as well as the developed country currencies. I believe investors need to get out of the US dollar and into the euro, AUD, yen, Sing dollar and Malaysian ringgit. A euro of 1.40 and a yen of 100 by the end of the year are quite possible.
Marc: Six months ago, I made a case for a weaker US dollar. The US dollar is from a longer perspective a doomed currency - that should be clear to anyone with any brain, except of course to Asian central bankers who continue to accumulate US dollars. Still, near term, as with my point about US bonds, the US dollar could hold or even rally somewhat. This is, however, a very low confidence bet. With gold prices expected to decline further, the US dollar would obviously also rally against gold for a little while.My favourite paper currency is the Singapore dollar.
I may add that the position of the US dollar depends entirely on the US Fed. If the Fed prints money, asset price declines are cushioned but the dollar goes down. If Fed tightens further, asset prices decline - dollar strengthens. Since I am blessed not to work in the US administration, I cannot give a precise answer.
Anthony: So, is a super-defensive investment posture called for at this time?.
Christopher: No. A hedged portfolio is advised. My recommended global portfolio for a US dollar-based investor would be: 5 per cent in German physical property, commercial and residential; 20 per cent in Japanese equities, weighted according to my Japan thematic portfolio; 15 per cent in Asia ex-Japan equities, weighted according to my Asia ex-Japan thematic portfolio; 5 per cent in Asian physical property, including Japan; commercial and residential; 15 per cent in unhedged gold mining stocks; 10 per cent in gold bullion; 20 per cent Singapore dollar cash; 10 per cent Japanese yen cash.
Marc: I'm not sure there is such a thing as a defensive position, when the bubble is the entire overblown asset market and financial system. Super defensive would imply that there is a way to short the US administration. That aside, I still like Asian real estate and farmland, and, as mentioned above, I feel comfortable to accumulate gold - ideally between US$550 and US$600. Food, pharmaceutical, tobacco and beverage stocks would seem to be defensive.
William: Portfolios should always be tailored to the investor's risk profile. Since we are transitioning from a bull market to something more volatile and uncertain, it is certainly time to do a stock-taking, and for many that will mean risk reduction. But the portfolio must be structured to withstand many conflicting storms and currents: stagflation, devaluation, war and geopolitical turmoil as well as the sunny uplands of economic growth. It doesn't mean hiding in cash. That is a part of a diversified portfolio, but you also have to pick the right currency.
Anthony: Thank you again, gentlemen for imparting your wisdom to us. I'm sure we can all profit from your advice.
Emerging markets such as Russia, India, Brazil, Turkey, which had huge run-ups and became horribly overbought, are now very vulnerable.
Asia is likely to remain long-term bull markets.
While inflation is still increasing, bonds markets are a gamble though they represent better value than they did at the beginning of the year. Long term, commodities - following a massive correction - are likely to outperform the Dow Jones for many years.