June Postmortem: World Markets, The Dollar, The Banks

Includes: ACWI, IYF, KBE, UDN
by: Cliff Wachtel

It's the Economy, Stupid (Still)

In our prior bi-weekly review of world markets, we recalled the above famous summary of Bill Clinton's presidential campaign theme that helped him seize the White House from George Bush Senior in 1992. Then too, the U.S. economy was suffering a decline that started with…surprise!!... irresponsible bank lending and a resulting Savings & Loan (S&L) banking crisis that threatened the health of even the largest U.S. banks.

FYI, the S&L crisis was not the first time in even recent memory that irresponsible bank lending in pursuit of short term gain gave the US economy a kick in the groin. Remember the "Latin American Debt Crisis" of the early 1980s?

We didn't learn from history, so here we are again, repeating it.

The Big Question (Still): Do Fundamentals Support the March Rally?

In Mid-June, global markets had already begun pulling back from their March rally highs, and mostly spent the rest of the month dropping then recovering to roughly the same level they held in mid June, and thus have recently stayed in mostly tight trading channels. In sum, the same indecision about the rally and recovery remains.

Thus at the end of June, the same big question hangs over world markets:

Will regional and/or world economies improve in the coming year enough to justify the 20%-30% rise in riskier assets like stocks, the roughly 30% overall rise in the riskier currencies (AUD, NZD) against the perceived safest currencies (JPY, USD), and roughly 100% rise in crude oil?

The Short Answer: No

The evidence we have so far does not appear to support these rallies, since we just don't have signs that employment, GDP, earnings or anything else is likely to improve 20% or more in the coming year. But traders have not given up, and markets still are awaiting clarity. Until then, markets may continue to bounce around within trading ranges.

So, Are We On the Brink of Disaster?

Not necessarily.

On the One Hand, the Banks are Still on Life Support

Bank fundamentals stink and are likely to get much worse along with rising unemployment and the resulting further deterioration of every kind of debt portfolio they own, and that's just the stuff we know about.

On the Other Hand, No One Dares Pull the Plug

Washington and Wall Street (oh, what the heck, Brussels, London, Beijing, Tokyo, etc) will band together if needed to keep the US and world economies going, and that means sustaining the banks. Per IMF estimates, they'll need another $500 Billion to cover the bad loans. So far they have about $200 Billion. Guess who'll be ultimately covering that, fellow US taxpayers? Think the IMF figured in the off balance sheet stuff, the credit cards, etc?

In sum, lots of pain ahead for We the People, but no need to run out and buy shotguns quite yet.

The USD: Down But Far From Out

Another key issue overhanging world markets is the status of the US dollar. America's creditors, essentially the entire world, and especially the major exporters like the BRIC group (Brazil, Russia, India, China), have regularly expressed both desire to diversify out of the dollar and continued support for it as the world's reserve currency. Beyond mere words, they have continued to buy Treasury bonds with gusto. This divergence between words and action already has traders beginning to interpret such talk as, well, just talk, and adding a whole new interpretation to what the 'B' in BRIC stands for.

No One Will Let the Dollar Die. Nor Will the Exporters Stop Buying the US Dollar or Treasury Bonds

Ok, BRICS, honesty time.

What else can the exporters / America's Creditors do?

Threaten Washington to Prevent an "Obamanably" Devalued Dollar

On the ne hand, America's creditors and importers justifiably feel they must at least try to threaten Washington with consequences so that Obama will make some attempt to minimize new debt, money printing, and other dollar obamanations. Of course, the US debt will be paid. The question is, will the dollars paid still be worth much. Most exporting countries hold very large portions of their foreign currency in USD. For example the Chinese are estimated to hold well over 60% of their reserves in dollars.

That becomes one very putrid, large corpse if the dollar rolls over.

Cover Your ASSets (and Exports)-Support the Dollar

On the other hand, most of America's creditors/importers depend on the US consumer for an irreplaceably large proportion of their exports. Who else will replace that volume of purchases?

Domestic consumption won't do it, not in the near term. Export countries are successful usually because their workers don't get paid much, and often actually save whatever money they can. That makes them lousy consumers. Thus, to keep their factories going and workers employed, they will continue to buy Treasury bonds and thus fund the US consumer.

Short Term Exporters' Employment Concerns Support US Treasury Purchases

In the short term, that keeps up their employment levels, which are often already hurting.

In the longer term, all that accumulating US debt could devalue or need to be "renegotiated." So long term interests would perhaps be better served by buying less US debt, even if it means reduced exports, employment, political stability, etc.

Long term good versus short term gain (while they're still in office). Hmmm. What do YOU think a politician (any nationality) is likely to choose?

Forget the US Banks. The Dollar and the US Economy comprise the ultimate "too big to fail."

Admittedly, in a worst case scenario, America's creditors could wind up much like the US financial industry. Having lent money to those not creditworthy to fuel near term revenues, they may wind up with a lot of bad debt. Who will bail THEM out? One way or another, their taxpayers will, of course.

Hey, considerate it a partial pay back on the Marshall plan, foreign aid, whatever.

Thus while the USD may continue to weaken in the near term, its status as reserve currency seems quite safe for now. Ditto the market for US Treasuries. Indeed, a new bout of fear, aka "risk-aversion" could send it higher along with the other safe haven currency, the Yen.


Barring a big surprise event in the coming weeks, the likely near term resolution could come from the emerging theme in second quarter earnings, especially from the big financial institutions. From these the current crisis began, from these the March rally ignited, and from healthy banks and credit markets will come a critical pillar of economic recovery. Many face considerable challenges, like unemployment levels already beyond bank stress test worse case scenarios that will only exacerbate their capitalization problems.

However, because confidence in the financial system must be maintained, governments and banks worldwide will literally band together to do whatever is needed, and that's one powerful team to try to sell short.

If the markets perceive overall earnings positively, we could see some additional rallying or at least stabilization at current prices

If earnings disappoint, a retest of March lows becomes more likely.

A mixed earnings season would suggest more range-bound trading. On optimistic days, riskier assets like stocks, commodities, and their associated riskier currencies would move up against the safer but lower yielding assets like the USD, Yen, and Treasuries. On pessimistic days, the opposite result.

Disclosure: The author may have positions in above mentioned assets, or that might benefit if the above is correct. Indeed, he dearly hopes so.