The Hindu Business Line : Unconvincing dollar rally

Though the dollar rallied when spot crude oil prices pulled back by more than 10 per cent during the week ended August 27, it does not mean the currency has strengthened. The market reaction is dangerously myopic and long-term investors should use the opportunity to diversify, says V. Anantha Nageswaran.

AFTER the breathless ascent, spot crude oil prices pulled back by more than 10 per cent during the week ended August 27. However, it is still well above $40 per barrel. Until such time economic data conclusively prove that the global economy has slowed down under the impact of high oil prices, optimists would point to the still expanding global economy as proof that oil does not matter. Most economic causalities and outcomes are clearer in hindsight. This one would prove to be no exception.

US dollar rallies; so do American bonds

In the wake of the retreating oil prices, the US dollar rallied. The rationale is that the retreat would allow US economic expansion to continue and hence the Federal Reserve tightening process could continue unhindered. That would eventually reduce the rate gap with other currencies. Thus, the dollar has strengthened. One chink in this argument is that, if it were to be the case, yield on American Treasuries must have gone up. They did not. So, what gives?

How to explain both?

One explanation that seeks to tie both the behaviour of the currencies market and the bond market is that retreating oil prices would not only underpin growth but also lower inflation and hence, it returns America to its goldilocks days of high growth, low inflation in which investors are happy with American assets.

That supports the strength in the American equity market, bond market and the dollar. However, it is precisely this yearning for a return to the halcyon days of the 1990s that bothers the sceptics including this writer.

Investor complacency is the explanation

When markets quickly return asset prices in line with conditions that have to be perfect, it reflects complacency and hence a mispricing, underpricing or non-pricing of risk.

This tendency that was seen in the stock market bubble days of the late 1990s has not disappeared yet although the bubble itself has, arguably, vanished.

Growth slowdown is not a `soft patch'

Economic growth in the US slowed in the second half quite significantly. The preliminary estimate of growth for the second quarter at 3.0 per cent (these are annualised figures) was revised down to 2.8 per cent on Friday. This was despite the fact that inventory accumulation accelerated in the second quarter compared to the first quarter.

Bulk of such accumulation must be involuntary as employment creation, consumer spending and durable goods orders were all lower than expected.

Dave Rosenberg of Merrill Lynch has helpfully summarised the extent of economic slowdown:

"What do these numbers tell you 7.4 per cent, 4.2 per cent, 4.5 per cent, 2.8 per cent? That is the quarterly annualised pattern of GDP in the past four quarters. Or how about 324k, 208k, 78k, 32k? That is non-farm payrolls over the past four months. Or what about -7.4 per cent, +9.1 per cent, -5.6 per cent, -6.4 per cent? That is the per cent change in new home sales in the past four months. And what is this -1.7 per cent, -0.6 per cent, -0.3 per cent and +0.1 per cent? It is the change in ex-transportation durable goods orders in the past four months. Or how about 5.3 per cent, 3.3 per cent, 3.8 per cent and 1.2 per cent — these are the growth rates for "discretionary consumer spending" (for example, medical care, food and energy) over the past four quarters." (Dave's Top Ten List, Economic Commentary, August 27)

Will the Federal Reserve continue to tighten?

Given this telltale signs of slowdown, it might be a bit difficult to believe that the Federal Reserve would embark on sustained interest rate tightening. Should it do so, that would signal a shift in its thinking from blowing bubbles to deflating bubbles. That would, in the long-term, be a definite positive for American assets. However, two important reservations are in order.

One is that the Federal Reserve has not given any hint that it has moved away from sustaining bubbles to deflating them. After all, the Fed Chairman has consistently averred that he sees a role for the central bank only to support economies recovering from busted booms.

He has not defined a role for the central bank in ending leveraged consumption booms and in boosting national savings. Second, should the unthinkable happen and if the Federal Reserve were to embark upon a sustained campaign to hike interest rates, it would first result in a significant correction in stock and housing prices, in a severe contraction in the economy. Consequently, the US dollar would weaken. Of course, that would be a long-term buy opportunity. But, then, we are jumping too far ahead, now.

Comfortable funding of current deficit

Given these scenarios, it is not a surprise that Financial Times of London termed the dollar recovery of the week unconvincing. Steven Roach of Morgan Stanley reminds us that the comfortable funding of the American current account deficit by Asian governments should not lull us into thinking that it could be sustained forever. No economy has sustained high growth relying on external savings.

While external shocks could easily derail this cosy arrangement, Steve Roach points to endogenous developments such as ageing societies in other countries requiring more of domestic savings to be routed to internal funding needs and the US, with its own changing demographic shift, demanding even more of global savings, as potential triggers that could end the easy funding of American current deficit and send the dollar lower.

Pension funding gap close to a trillion dollars

As though to underscore his pessimism, his usually salubrious colleague, Richard Berner, paints a dire picture of the inadequately funded defined benefit pension plans. According to him, the funding gap (between the present value of pension obligations and pension assets) was about $170 billion in end-2003 for Standard & Poor 500 companies.

However, low interest rates and flat equity markets have likely pushed it to a high of $240 billion by end-2004.

He adds that "the Pension Benefit Guaranty Corporation, the agency overseeing the pension safety net, estimated the gap for all corporate plans at $350 billion at the end of fiscal 2003; doubtless, it is larger today.

Pension assets for private plans are around one-third of total invested assets in pension funds, with the balance being in state and local plans which are thought to have even deeper funding problems (although the data is even more opaque for these funds).

The bottom line is that the current hole is probably more than $1 trillion despite last year's huge rally and the highest contribution level of funds in many years." (Source: http://www.morganstanley.com/GEFdata/digests/latest-digest.html dated August 27. This URL will not work once a new digest is added on August 30. Readers will have to click on "Archives" to access this digest).

Investors should diversify and wait

Given such enormous holes in the government budget, in corporate pension plans, in household savings, it is hardly logical that the American dollar should rally as it has, in the last week, simply because oil prices came down by five dollars.

The market reaction is dangerously myopic. Long-term investors should use the opportunity to diversify, as has been my refrain all along.

It has been a frustrating year for all types of investors — whether it is mutual fund managers or hedge fund managers.

Ordinary investors hoping for a repeat of 2003 due to the logic of Presidential elections in the US have been disappointed too.

However, that is no reason to take on undue portfolio risks at this stage. Investors should hold a diversified portfolio of bonds in various currencies, allocate some portion for Emerging market bonds, some for Gold, some in dividend yielding stocks and hold around 30 per cent in cash and that too in various currencies. There should be no doubt that the US dollar is an accident waiting to happen.

(The author is a Singapore-based economist. The views are personal. Feedback may be sent to nageswar@singnet.com.sg)

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