The Current State of Currency


By Rob Edel, CFA

Predictions of a September crash were a bit off the mark as the S&P 500 rallied 8.8% to record its best September since 1939. The S&P/TSX was only able to muster a 3.8% return, but in U.S. dollar terms was up a respectable 7.6% as the Canadian dollar rallied almost 3%.

With such strong equity returns during a notoriously volatile month, one would be justified in thinking that the global economy must have exhibited strong positive signs in September. While it is true that the National Bureau of Economic Research finally decreed that the recession that started in December 2007 as over, and in fact has been over since June of last year, this wasn’t the reason for the run up in equity prices. It was actually poor economic numbers and concerns that a double dip recession and deflation are brewing that caused the market to rally.

Say what? The economy was so bad that it was good? Well not quite.

Traders believe that their ship has come in and the name printed across the bow is “QE II.” But it isn’t the luxury ocean liner that we are referring to — that was mothballed in 2008. No, what the QE II traders are excited about refers to a potential second round of quantitative easing by the Fed. In anticipation, traders have bid up the price of stocks, bonds, and especially gold.

Just a quick review, quantitative easing is where the central bank (in this case, the U.S. Federal Reserve) increases money supply by creating currency (in this case, U.S. dollars) out of thin air and then uses them to buy mortgages (as was the case in QE 1.0) or other government securities (as expected in QE 2.0) or anything else they want (which will probably be the case if there is a QE 3.0).

The Fed is not happy with the pace and progress of the economic recovery and has strongly hinted that more monetary stimulus might be needed. William Dudley from the Federal Reserve Bank of N.Y. estimates that $500-billion of quantitative easing is equivalent to a reduction in the federal funds rate of a half to three quarters of a percent. The hope is that mass purchases of longer-term bonds will drive medium-to-long-term interest rates lower. It would also result in excess liquidity at U.S. Banks that could be lent out to consumers.

Great, in theory. We would point out, however, that with consumers in a de-leveraging mode and rates already at low levels, the Fed may be pushing on the proverbial string. We don’t need more debt, we need to start paying off the debt we have. And if it doesn’t work? What then? QE3 and then QE4?

One of the concerns investors (us included) have in regards to quantitative easing and the increase in the monetary base is that it could lead to future inflation and debase the U.S. dollar. This is one of the reasons that investors are bidding gold, commodities and even equities higher. Real assets should help protect investors from a depreciating currency and the resulting inflation.

As Andy Smith of Bache Commodities was recently quoted, “Buying gold is a faith-based initiative, a faith that is reflecting a lack of faith in conventional currencies.” Gold traded above $1,300 a ounce for the first time ever on September 27 and has continued to move higher, closing above $1,370 on October 13. While gold is up over 20% year-to-date, silver is up nearly 40%. The U.S. dollar, on the other hand, is down versus most other currencies.

For their part, the U.S. government doesn’t mind a depreciating currency (though they claim otherwise).  A lower dollar makes U.S. exports more competitive and could help create much needed job growth.

There is a growing perception amongst Americans that they are getting the short end of the stick when it comes to international trade. A recent Wall Street Journal/NBC News poll found 53% of Americans feel free-trade agreements have hurt the U.S. versus only 32% in 1999. 83% of blue collar workers believe the outsourcing of manufacturing to foreign countries with lower wages is one of the reasons the U.S. recovery has stalled. A startling 95% of professionals, who should know better, agree.

Throw in the fact that it’s an election year and it’s no wonder China, with their undervalued currency and huge trade surplus, is a juicy target for every campaigning congressman. After Wall Street, China is Washington’s favorite whipping boy.

It’s not Washington’s fault the unemployment rate is 9.6%, it’s China’s, obviously.

Don’t get us wrong, China is a currency manipulator. Many feel the Yuan is undervalued by up to 40%. China has basically pegged their currency to the U.S. dollar and has only let it appreciate very slowly.

But it’s not the U.S. that is the big loser.  A revaluation of the Yuan will not move manufacturing back to American factories, but rather only shift it to another low cost emerging economy.  The real losers from China’s currency manipulation are all the countries that are competing with China that haven’t pegged their currency to the U.S. dollar.  As the U.S. follows their weak dollar policy, the Yuan depreciates with the dollar and thus appreciates against their emerging economy competitors.

Even worse, capital is fleeing the slow growing developed nations (like the U.S.) and seeking higher yields in the faster growing emerging economies (such as Brazil, Indonesia, Thailand and Malaysia), thus bidding up their currencies even more.  These countries need to keep interest rates high in order to keep inflation in check – something China also needs to do right now and something the U.S. may be forced to do in the future.

In an economic environment of slow growth, everyone is hoping to grow through increased exports and no one wants a strong currency. Markets are concerned that the world is on the verge of a currency and trade battle not seen since the great depression.

The Bank of Japan recently attempted to stem the rise in the Yen by selling $20-billion worth of Yen on the open foreign exchange markets, the biggest one day intervention ever. They followed this up on October 5 by lowering their benchmark rate from 0.1% to a range of 0% to 0.1% and front-running the U.S. in announcing their own ¥5-trillion (which equals about $60-billion, but ¥5-trillion sounds so much bigger) quantitative easing program.

Brazil, whose currency is up over 30% versus the U.S. dollar over the past year, has raised taxes on foreign fixed income investments in an attempt to slow the flow of foreign capital into the country while Thailand has loosened controls on the export of capital. Brazilian central bank president Henrique de Campos Meirelles estimates nearly $2-billion a day is flowing from developed markets to emerging markets in Asia.

A trade war is in no one’s best interest. It didn’t work in the great depression and it won’t work now.

THE U.S. ECONOMY

As noted above, the National Bureau of Economic Research proclaimed that an economic recovery began last June, bringing to an end the 18 month great recession that began December 2007 and resulted in a 4.1% decline in GDP. Now that we finally know when the recession ended, we are able to compare the recovery to recoveries from previous recessions. While the “Great Recession” was certainly the longest and one of the deepest recessions in the post-WWII era, the recovery has mirrored that of recent recessions and was nowhere near as severe as the Great Depression.

The problem is that severe recessions like the Great Recession usually result in strong recoveries. Recent recessions like 1991 and 2001 were much shorter and less severe. The past recession is different than past recessions because it was long, severe, and the recovery has been weak.

Warren Buffett thinks the NBER acted too soon. Mr. Buffett believes you can’t call an end to the recession until real per capita GDP returns to pre-recession levels.

To his point, while Q2 GDP growth was revised up slightly to 1.7% from 1.6%, GDP has still recovered only 2.9% of the 4.1% lost during the recession. While Buffet believes the U.S. will eventually emerge from recession, he believes it’s going to take a while. The Organization for Economic Cooperation would tend to agree, saying recently that the U.S. unemployment rate would stay at elevated levels until at least 2013.

Manufacturing remains one of the few bright spots in for the economy but even it is starting to fade. With inventory re-stocking nearly complete, the recovery in manufacturing will need help from the job market to maintain momentum, and as the OECD points out, that is not looking very promising.

Jobless claims moved in the right direction during the month of October but the non-farm payroll number continued to disappoint.

While 64,000 private sector jobs were created, they were more than offset by the loss of 159,000 government jobs, 77,000 of which were temporary census jobs. This is bad, and looking to get even worse. While most of the state and local government jobs lost were the result of cash strapped school districts bringing back less teachers and thus likely a one time event, the Center on Budget and Policy Priorities is forecasting state and local government budget deficits for 2011 and 2012 to hit $260 million and lead to roughly 900,000 job losses.

Also bad is the fact that the marginally attached and involuntary part time unemployment rate (commonly referred to as the “real” unemployment rate) jumped up to 17.1% and hours worked and wage inflation were flat. Even worse, the Bureau of Labor Statistics’ preliminary benchmark revision is expected to revise March 2010’s level of employment down by 366,000, which effectively means employment gains for the year have been 30,000 per month lower than previously estimated. Plenty of ammunition for the QE2 crowd

While the job market is tough, it’s a lot tougher if you only have a high school diploma. The official unemployment rate of 9.6% for the population as a whole soars to 10.3% for workers with just a high school education. The unemployment rate is 4.6% for those with at least a bachelor’s degree. What’s more, college grads are only taking an average of 18.4 weeks to find work versus 27.5 weeks for high school grads. This is not to imply that college grads have not been impacted by the recession. Their 4.6% unemployment rate is the highest it’s ever been since data began being collected in 1979. Even when the unemployment rate hit 10.8% in the 1980’s, only 3.9% of college grads were out of work.

One of the few good things about the large number of unemployed workers is that fewer people are going out after work and driving home when over the legal alcohol limit. Alcohol-related traffic deaths in 2009 dropped 7.4% to 10,839. Add to that the fact that more drivers are using seat belts and cars are generally safer, and traffic deaths in the U.S. fell to their lowest level since 1950. Let’s hope the increasing popularity of smart phones doesn’t reverse this trend. Don’t text and drive!

Inflation remains well below the Federal Reserve’s informal target range of 1.5% – 2.0%, which continues to concern those worried that deflation will take control of the U.S. economy.  It is one of biggest reasons that QE2 is getting serious consideration.  New York Federal Reserve President William Dudley suggests that the Fed should target a higher inflation target in the future in order to compensate for inflation coming in under target this year.  This is similar to the IMF’s chief economist Olivier Blanchard’s suggestion that the inflation target should be doubled to 4%.  The fear is that if consumer expectations of inflation continue to move lower, deflationary expectations could hurt the economic recovery, even in an environment of slightly rising prices.

So far, Fed boss Ben Bernanke doesn’t seem to agree and called the notion “drastic.”

History would seem to back Bernanke up. Bespoke Investment Group points out that over the past 70 years, U.S. stocks have performed better during times of deflation than inflation. Since 1940, there have been four periods of deflation and the market has increased an average 19.7%. Conversely, there have been five periods of inflation that have produced an average decline of 2.5%. Of course, the great depression was excluded from this data and would have reduced deflation’s advantage somewhat.

The reason for the discrepancy in performance is that deflation generally occurs in times of recovery while inflation is typically occurs near the end of an economic cycle. It’s rare to have deflation during an economic recovery, if this is indeed a recovery.

Deflation isn’t a concern everywhere, of course.  Commodities are moving higher with oil and copper up 16% and corn, wheat, soybeans, butter and sugar also moving higher.  Cotton recently traded above $1 a pound for only the second time since the Civil War and is up 35% this year and 20% since early August.  For those interested in hedging their future t-shirt demand, there is even a cotton exchange traded fund available to investors.

While retail food prices in 2010 have been increasing at their slowest pace since 1992 as producers have generally resisted the need to raise prices given the current economic climate, this is likely to end next year. Wells Fargo economist, Michael Swanson is estimating increases of at least 3% to 4% next year. Capital Economic estimates a 5% increase would cost American households an extra $360 per year with lower income homes feeling the bulk of the pain.

The Fed should be careful what they wish for. Inflation is not a good thing if it isn’t accompanied by job growth and wage inflation.

Also pushing higher is the price of top 2009 Bordeaux wines.  Part of the reason is that good weather in France in last year means the 2009 vintage is expected to be particularly tasty.  The other factor is soaring demand from China.  China passed the U.S. last year to become the largest export market outside of Europe for Bordeaux wines, with export volumes 39 times that of 2000 and 97% higher than only last year.  Hey, you have to spend your money somewhere.

 

Consumer confidence moved slightly lower in September, especially the Conference Board’s index.  This bodes poorly for future retail sales.

August saw positive retail sales for the third month in a row with clothing sales rising 1.2%, the first increase since March.  Even better, September same store sales came in better than expected against tough comparisons from last September with children and teen clothing particularly strong.  The back to school shopping season looks to have been successful, but discount driven, thus leading to expectations that holiday shopping will follow much the same pattern.  The annual Hay Group survey reports that 20% of retailers expect to hire more seasonal workers than last year with 26% anticipating more discounts and promotions.

Not only are consumers spending more on clothes, but they are also eating out more often. A recent WSJ survey found restaurants were one of the top five areas where consumers said they plan to resume spending. Vacations, entertainment, home improvement and shoes were the others.

Interestingly, the ultra affluent, defined by American Express as those charging over $7,000 to their credit cards a month, plan to maintain their frugal ways by increasing their consumption of fast food. They are more indulgent when it comes to travel, however, increasing their spending on business class plane tickets 114% in Q2 versus last year while also increasing spending on cruises, car rentals, and luxury hotels.

 While consumer spending has recovered off the lows seen during the depths of the recession, don’t expect a return to pre-recessionary levels any time soon. U.S. household net worth declined 2.8% to $53.5-trillion in Q2 as weak equity returns took their toll.

Household debt fell $77-billion to $13.5-trillion and household debt to disposable income fell to 119% versus a peak of 130% in September 2009. Most of the decline in household debt, however, was due to consumers defaulting on their debt rather than paying it down. Over the past two years, mortgage and consumer debt has fallen $610-billion while the Federal Deposit Insurance Corp estimates that lenders have written off $588-billion.

Not all consumers are coming out of the recession equally, however. Phoenix Marketing reports that the number of American households with investable assets over $1-million increased 8% over last year while those with over $5-million increased 16% and those over $10-million increased 17%.

Alternatively, the poverty rate, which is defined as income of $21,756 for a family of four, increased to 14.3%, its highest rate since 1994. More young adults are living with their parents and more families are doubling up with multifamily households increasing 11.6% between 2008 and 2010. Median household incomes have fallen 4.2% since 2007.

The housing market stabilized somewhat in August with existing home sales managing to increase over the disaster that was July and pending sales pointing to further increases in the coming months. Still, the market remains fragile and many feel further price declines are in the cards as foreclosed homes eventually find their way onto the market.

RealtyTrac estimates 95,364 homes were repossessed in August, an increase of 3% from July and 25% from August 2009, the ninth month in a row that the year-over-year pace has increased.  The keys to more than 2.3 million homes have been turned over to lenders since the recession started in 2007 and RealtyTrac estimates more than 1 million more will be handed over this year.

Despite the increase, the percentage of existing home sales classified as distressed fell to 30% in July from a high of 45% in January 2009 as relaxed marked-to-market rules and mortgage modification programs helped ease the urgency for Banks to liquidate their foreclosed inventory. As these programs wind down and tax credit driven demand eases, distressed sales could again dominate the existing home sale market. Ivy Zelman from research firm Zelman & Associates estimates that distressed sales could account for 50% of sales if normal demand doesn’t pick up – and there is no reason to think it will.

 While home prices have fallen and a recent Fannie Mae survey reported 70% believe prices are near a bottom and it’s a good time to buy, 33% say they are more likely to rent than buy versus 30% in January.  Even worse, only 67% believe housing is a safe investment versus 70% in January and 83% in 2003.

Part of the problem is that despite the correction in the housing sector, housing costs are still too high.  As of 2009, housing costs for 41.7 million households, or 36.7% of total U.S. households, exceeded 30% of their pre-tax income, which is typically defined as the affordability threshold.  This is an increase of 1.5 million versus 2007 despite the decrease in prices and mortgage rates.  Renters fared even worse than homeowners with only 31% of homeowners over the 30% threshold versus 47.7% of renters.  Rents have remained high as defaulting homeowners have increased the demand for rental properties.

 

While the trade deficit moved in the right direction in July, politics are likely to rule the headlines over the next few months. With the November 2nd congressional elections looming, expect more anti-free trade and anti-China rhetoric.

THE CANADIAN ECONOMY

Canadian GDP declined for the first time since August 2009, continuing the slowing economic trend seen over the past few months. Manufacturing, construction, and retail led the decline with mining and finance posting small increases. Leading indicators and the Ivey purchasing managers index indicate that all is not lost and the Canadian economy should swing back to growth in the following months.

After last month’s reprieve, the job market reverted back to contraction in September as Canadian payrolls came in worse than expected.  All the losses were in part time jobs with 37,100 new full time jobs being more than offset with the loss of 43,700 part time jobs.  Versus last year, however, the Canadian economy has still added 349,000 new jobs (net), and hours worked and hourly wages were both solid.  The unemployment rate moved down to 8% from 8.1%, but only because the labour force shrank by 24,400 workers.  Clearly, nothing to celebrate.

Headline CPI moved negative again in August while Core inflation remains positive but well contained.  Year-over-year numbers are inflated by approximately 0.7% due to HST.   Using numbers over the past six months, core inflation in Canada has plummeted and is lower than in the U.S.

Increases in the Bank of Canada rate are probably on hold for the immediate future.

 

 

Consumer confidence has fallen in Canada and retail sales has followed suit. The Conference Board consumer confidence index dropped for the fourth month in a row to its lowest levels since July 2009. The Conference Board estimates that a 10-point drop in the confidence index suggests a future drop of 0.6% in consumer sales after five quarters. The index has lost 20 points since the beginning of the year.

A poll conducted by the Canadian Payroll Association found 59% of Canadians are living pay cheque to pay cheque and are becoming more and more concerned with their debt load. 80% responded that their first or second priority if they won a $1-million lottery would be to pay off their debt, an 11% increase from last year. 47% of Canadians are saving less than 5% of their net pay while 40% say their not even trying to save.

Home sales and prices generally moved lower in August. As with July, HST was more than likely a contributing factor. Mortgage rates, however, continue to move lower. Despite the ultra low rates, the Canadian Association of Mortgage Professionals believes about 375,000 Canadians are being forced to curtail their spending in other areas in order to stay in their homes. If mortgages rates were to increase to 5.25%, an additional 475,000 would need to tighten their belts.

The Organization for Economic Co-operation and Development recently warned that high debt levels make Canadians vulnerable to “any future adverse shocks.”  They believe Canadians could be “financially vulnerable” by 2012 if the current borrowing pace is maintained and interest rates rise as forecast.  Canadians are not likely to walk away from their homes like Americans did, but rather are more likely to cut spending in other areas.  The OECD is recommending an increase in the down payment needed in order to get federally insured mortgages.

CIBC believes the Canadian housing market is over valued by 12%, largely due to high prices in B.C. and Alberta.  CIBC believes B.C. is almost 17% over valued while Alberta is 12.5% over valued.  Ontario is not that far behind being 11.6% over valued.

 

The trade deficit widened in July as strong imports from the U.S. lead to a smaller U.S. trade surplus.

After a series of strong quarters, it appears cracks are beginning to show in the envied Canadian economy. While nothing is looming, consumer spending and interest rates are areas to keep an eye on.