Two interesting articles in today’s WSJ discuss how a fragile economic recovery can be derailed by its own success. I find myself in partial agreement (or disagreement) with both.
The first article, “Increases in Commodity Prices Send Mixed Signal on Hopes for Recovery,” is the less scary of the two. The second, “Dollar’s Strength Against Euro Could Trim U.S. Corporate Profits,” raises serious questions regarding the nascent economic recovery.
The commodity issue is a bit misleading. In the 1st Q ’03 for example, the S&P500 had a nice gain in earnings; When we drilled down sector by sector, we learned that a very big part of the overall gains was due to the surge in energy prices. That spike, courtesy of the Iraq War, led to energy having a one time windfall profit. With Energy sector earnings up by an astounding 180% – back that out of the index, and Q1 would have been a disappointing reporting season.
The market had no problem absorbing that news. After a long profit drought, they took it anyway they could.
We recognize that a one time earnings spike was due to unusual circumstances. Even still, its not unreasonable to expect energy demand to pick up when an economy recovers; With the present geopolitical situations — Venezuala, Nigeria and Iraq — Crude at $30 barrel seems downright reasonable. Indeed, we should consider ourselves lucky that Crude hasn’t spiked closer to $40. Perhaps relatively low Oil prices are a benefit of an anemic recovery.
The Journal also looked at Copper and Lumber price rises; They note the price rise was due to constrained supply rather than an increase in demand. I find it difficult to separate the two — Prices couldn’t be maintained at such high levels if there wasn’t some sort of increased demand. Still, I see their argument;Its just another datapoint worth watching — but I would add that the prices of Aluminum, Pulp, Gold, Silver, and Stainless Steel Scrap are just as important.
Note the CRB Index below; Its not exactly on fire. It also suggests an anemic recovery, with the manufacturing sector not yet starting to really gain much traction.
Source: Hays Market Focus
Indeed, the CRB Index has been going up steadily since October 2001, peaking just before the War started in February 2003. For the past 6 months or so, commodities have been mostly going sideways. You can see the CRB Index chart here: http://stockcharts.com/gallery?$CRB; And the Goldman Sachs Industrial Metals Index here: http://stockcharts.com/gallery?$GYX, has a similar chart.
Gold, however, is a special case. The Journal wrote:
Gold, which is traditionally a sign of nervousness by investors, is up 4.4% this year, or $15.40, to $363 a troy ounce on the Comex division of the New York Mercantile Exchange. It sagged $10.50, or 2.9% in June and July but has taken off again this month. Tuesday, it rose $3.10 partly because of disappointing consumer-confidence data.
After several eons of being in a Bear market, Gold has moved up smartly over the past year. The most plausible explanation is the re-inflation of the economy, thanks to massive Fed stimulus; Even the steep yield curve suggests a reinflating economy. I don’t find that a negative all by itself.
So much for commodities; Now lets look at the Dollar:
A sustained dollar rise certainly raises questions about the health of the rest of the World’s economy; When the buck was weak, the industrial sector had a nice currency based rise in Q2 earnings; Now we are looking at the potential flipside of the issue. The WSJ quoted Derek Halpenny, a currency economist at Bank of Tokyo-Mitsubishi in London: “A significantly stronger dollar would raise concerns over the incipient recovery in the U.S. manufacturing sector.” About a third of the net gains in S&P 500 companies was due to currency factors, with revenues up 7.4% versus estimates of 5.5%, according to First Call’s Chuck Hill. (BTW, I keep a list of everyone in finance with an onomatopoeic name, and a currency analyst named “Halpenny” certainly qualifies . . . )
While I agree with that assessment, its worth noting that a stronger U.S. currency means that foreign investors are placing their bets in U.S. dollar assets – and that helps to keep the markets rising. When the dollar was weakening prior to the war, we saw a lot of repatriation of overseas assets.
Gary Shilling, writing in Forbes a few months ago, had the right idea anticipating a dollar rise:
Odds are, though, that the dollar’s weakness is only temporary. The U.S. is too strong economically for the dollar to stay down much longer. Besides, whatever problems we face will not be cured by foreign exchange rates . . .
Short run, the dollar should strengthen because global economic weakness abounds, and the U.S. is the best of a bad lot, particularly since most other countries rely on it as a destination for their excess goods and services. And the buck should benefit from the U.S.’ superior efficiency over Continental Europe, where socialist regulations, language barriers and labor immobility prevail, and over woebegone Japan.
In the long run America’s commanding lead in new tech suggests that the dollar will reign for at least a decade or two. Historically the country with the fastest productivity growth is the center of the action and a magnet for foreign investment. That was true of Britain with its Industrial Revolution in the 1800s. It is true of us now.
–Strong Dollar Ahead, A. Gary Shilling, 07.21.03
Lastly, I don’t often find myself agreeing with the frenetic Mike Norman, but he made an astute observation today:
“The wealth of nations literally rests upon their ability to sell into the U.S. market, and they guard that jealously. Consider, for example, China’s reluctance to let its currency float, despite massive international pressure to do so. Or how about Japan’s $70 billion campaign to keep the yen down and the dollar up? Countries like Japan, Germany and China find it in their national interests that U.S. purchasing power remains strong. Their national prosperity is tied to that, so it should be no surprise that when the dollar gets too low, policy engages to bring the buck back up again. That’s the cycle we’re in now.” – Dollar Rebound May Bring Market Top Closer
Mike’s right; Because of the importance of the dollar, there is a Homeostasis to its rise and fall, which is (mostly) self correcting under normal circumstances.
Commodities, interest rates, and the dollar should all gradually rise in a healthy, recovering economy. We want a g r a d u a l increase in these areas, however; Otherwise, we risk a derailment. Big spikes are conterproductive, and possibly dangerous. But the basic premise of some observers — the rest of the world’s economy stinks, and ours is the least smelly only by comparison — is fairly accurate.
Whether we can jumpstart the rest of the world before 2004 ends is an entirely different story.
Dollar’s Strength Against Euro Could Trim U.S. Corporate Profits
Increases in Commodity Prices Send Mixed Signal on Hopes for Recovery
Strong Dollar Ahead
Dollar Rebound May Bring Market Top Closer
Goldman Sachs Industrial Metals Index
If memory serves, commodity prices are also rising because of robust demand from China’s burgeoning industrial sector. Andy Xie said as much in a recent missive at the Morgan Stanley economics forum, but unfortunately I’m unable to find the link.
Also, I agree that the media is exaggerating the danger posed by the appreciation of the greenback. Exports only account for 10% of the US economy. Meanwhile, foreigners own something like one-third of US treasurys and 15% of US stocks. A declining currency could foment dislocations in our capital markets — and that would surely outweigh the export sector’s gain in competitiveness.