Weak Currencies, Stagnant Economies Weigh on U.S., U.K. Investors

News out of London via the Financial Times has amplified the recent calls for institutional break-ups of incredible size and scope.

Not just one but all financial institutions, once protected under the "too big to fail" sheltering efforts by governments and central banks, must now find viable core business plans to move forward. The mortgage heavy British lending giant Northern Rock, British Financier Lloyd's (LYG), and the Royal Bank of Scotland (RBS) face large divestment pressures from Tories bent on revenge and a ghostly Prime Minister Gordon Brown as England is facing debt levels near 100% of annual GDP. While the UK Government benefactor has planned a lessor degree of additional liquidity infusions into the nationalized banks and the U.S. FOMC is paring it's purchases of Fannie Mae (FNM) and Freddie Mac (FRE) assets by $25 billion dollars, the efforts are at best a day late and a dollar short.

Banks are now fearing the probable need for further equity offerings that will come to pass in the near future. British and American bankers both face a real danger as equity prices become less and less attractive given the simultaneous declines of the currency in which shares are held. Over the past 200 days the S&P 500, the per ounce price for gold and the WTI continuous spot price for crude oil have increased by 25%, 30% and 80%, respectively, while the US Dollar index fell by 10%. The three assets increased by varying degrees of intensity, responding congruently to market moving news throughout the period following the March 9th lows, while the dollar's value changed with a negative correlation. (Click chart to enlarge)

According to the chart, commodities have outperformed the US equity market since the March 9, 2009 low of 666 for the S&P 500. Then, why should foreign investors risk allocating funds to U.S. corporations bearing 20+ P/E valuations and an increasingly jobless consumer base? It is instead likely that they will avoid such risky assets as U.S. stocks, where the average price appreciation over the past 200 days is halved after accounting for the drop in the value of the dollar.

On top of these inflationary pressures, equities in the U.S. and Britain will most likely begin to depreciate as firms, not limited to the aforementioned banks, including U.S. Tarp recipients such as Bank of America (BAC) and Citi Group (C) find ways to raise additional capital needed by breaking off business arms and issuing more shares. It is the increasing share issuance, occurring as companies squirm for much needed capital, which will dilute shares in the coming months.

Finally, the dollar will likely continue it's inverse stickiness to equities as commodities maintain a direct correlation for a period of time following the imminent pullback in equity prices around the globe. The absence of stimulus and optimistic guidance for the next few quarters amidst rude reports of struggling economic activity will pull down all asset classes along with commodities. But, should equities fall through one or more levels of resistance and begin to change the tone from one of hope to one of fear, commodities will break free from the current trend and spike upwards as the dollar begins to fall due to a mix of inflation and the retreating consumer.

The U.S. Fed, Treasury and White House have made it brutally apparent that they will not take "no recovery" for an answer and will continue pumping money into the system by whatever means necessary. Yet there will come a time when the global appetite for U.S. debt will curb and the pressures of inflation will truly be felt. This time will be signaled by the market and will become apparent when equity markets fall on news of further stimulus spending. It appears that yields on long term treasury debt are already beginning to rise as the $300 billion Fed purchase program of such Long-Term U.S. paper has ceased, and may cause real interest rates on long term U.S. debt to increase. Unfortunately, such a decrease in demand for U.S. Debt would exacerbate the ill effects that a widening U.S. current account deficit will have on the dollar. A growing current account deficit had been largely responsible for the falling U.S. Dollar index from 2002 through 2006 that, despite it's narrow levels not seen since 1991 at 2.8% of GDP, will ultimately trend wider.

The weak dollar has most recently been fueled by the widespread dollar borrowing to fund "carry trade" investments, where the expectations for a near zero Fed Funds rate to remain low hurt the value of the dollar. The Fed went public on Wednesday, practically guaranteeing a 0% Fed Funds rate amidst Treasury admissions of probable long term debt yields rising. However, fundamental headwinds facing the U.S. currency described above will ultimately outweigh waining carry trade borrowing to drive the value lower.

Note: There need not be a specific date on which the U.S. physically begins quantitative tightening for the carry trade driver to wear out. The realization that riskier investments funded by the short dollar play are no longer feasible can equally drain the pool once enough game has come to drink. After a short rise in USD value and a drop in commodities, the Dollar will continue to decline. Equities have little room to appreciate.

Disclosure: No Positions

Comments

[Dave Wrixon:]

Good article.

Nov 07 06:55 AM

[Northern Da...:]

Speaking of the dollar, if you look at a chart (as I have since I can put them together with my charting service), of the S&P in terms of most foreign currencies, it becomes painfully apparent that since June, the American markets have traded basically flat. What this really means, in real life honest terms, is that they have risen solely on the devaluation of the USD, not on any realistic form of economic recovery, not on earnings reports (which mysteriously always "surprised" the so-called "street"), and in spite of all the bullcrap spin out of MSNBC, home of the Bozo Cramer gong show.

Nov 07 03:29 PM

[BRUCE E. W.:]

PRICE THEORY is being proven wrong exponentially and a total, utter failure: all it is doing is causing a chronic ANEMIA and it is bleeding this systemic failure into total disequilibrium. Speculative profit scavenging has become a dependency addiction in the financial sector. The next turn on equities will be collapse and the price will still go higher. So much for supply side Friedmanism; it's turnning into Dr. Frankenstein's version of creationism.

Nov 09 07:34 AM