The Dollar, Deflation and a Birthday!Submitted by Moller Financial Services on March 12th, 2015
Brief and to the Point
Darn, John’s article about time puts me on the spot to respect your time commitment in reading this article. I will attempt to be brief, but I will also use headings liberally to break out the different sections so you can jump to whatever interests you the most. Yet, I must admit that many things going on around the world and in the financial markets interest me. So here goes …
The U.S. Dollar Has Been on a Tear!
Last month I wrote about the diverging economic policies being employed around the globe. As the U.S. seems to be moving to “normalize” by raising interest rates, virtually every major economy – China, Japan, and Europe – are moving in the opposite direction by lowering interest rates and/or employing quantitative easing. With more Japanese Yen, more Chinese Yuan, and more European Euros now circulating, their values relative to the U.S. dollar have declined. The strong dollar has many repercussions – some known and some undoubtedly still to be revealed.
Is There a Trade War Brewing? Did It Already Start?
The strong dollar makes imported goods and services cheaper as it takes fewer dollars to purchase the same amount of goods. While great for U.S. consumers, it puts downward pressure on prices as U.S. produced goods become relatively more expensive. The pricing conflict might be an opening salvo in a tit-for-tat trade war. For example, just six months ago it took nearly $1.40 to buy €1.00 (that’s Euros). As I write this, it has shrunk to $1.05. So, using an admittedly simplistic example, six months ago Adidas shoes may have cost $140 but now have fallen to $105. American-made shoes automatically become pricey. U.S. manufacturers suddenly are under severe pricing pressure – if they maintain prices they likely will lose sales and if they cut prices they will have smaller margins. Either choice would likely result in lower company profits. As this currency-dictated, pricing dynamic is playing out, I wonder how long it will be before our economy is negatively impacted. If it hurts us economically, will the politicians get involved by erecting trade barriers? Time will tell, and of course, the hope would be that we are strong enough to pull the rest of the world out of their doldrums.
(Imported) Deflation Possible Headwind for Economic Growth
So far, though inflation has dipped to less than 1% (consumer price index), we have yet to see falling prices and have avoided the deflationary impulses impacting the rest of the world. However, taking the Adidas example above to a logical conclusion, falling import prices will put downward pressure on all prices in the U.S. Furthermore, if the Federal Reserve begins to raise interest rates as anticipated, the higher borrowing costs for businesses and consumers could be a further drag on company profits hampering economic growth and triggering more pricing pressure to get goods to move. Our inflation rate is already quite low; will it dip into negative territory? Would deflation create major problems? Again, I have no crystal ball so will just have to wait and see.
Strong Dollar Possible Tailwind for Domestic Investments?
While the strong dollar may hurt U.S. companies’ competitiveness vis-à-vis their counterparts around the world, it has definitely helped dollar-denominated investments. For example, today an investor who wants to buy bonds can choose a 10-year German Bund yielding just 0.3% or a 10-year U.S. Treasury yielding 2.15%. While neither choice seems too attractive to me, in this case it seems like a no-brainer; not only does the treasury investor benefit from nearly 2% better yield but also from receiving the income in appreciating dollars.
Stocks are a bit different story and less clear-cut in my view. While the strengthening dollar helps dollar-denominated securities such as U.S. stocks, cheaper borrowing costs and cheaper currencies may have a greater positive impact on companies outside the U.S. Furthermore, many stocks outside the U.S. are trading at much cheaper levels relative to earnings (lower P/E ratios).
Bull Market in U.S. Stocks Has Six-Year Birthday
March 9 marked the birthday for this long-running market advance that began from the depths of the market collapse six years ago. That was a really dark and scary time with investors selling in a panic, the world economy seemingly teetering on the brink of systemic collapse, and the Dow Jones Industrials trading a shade over 6,500! What a recovery! The Dow turned on a dime and has more or less steadily gained to close a week ago at 18,300. This near tripling of prices in six years (and more than a tripling in value when factoring in dividends) has been richly rewarding for the brave investors who stayed on board amidst those dark days.
Have we come full circle? Are we near the end of this bull market? I have no idea and do not pick up on the euphoria that often accompanies market tops as the flip side of the panic at market lows. Yet, it does seem that investors might be losing sight of the potential market risks. While many markets are trading at some of the highest levels in history, my concern is that many investors complacently (and naively) believe the Fed will continue to provide support ensuring a smooth ride with little downside risk. Other investors may realize the risk, but are nonetheless fully invested in stocks because of the dearth of investment alternatives in our zero/negative interest rate world.
I do believe we are overdue for some volatility. A 10% correction or a 20%-plus bear market would not surprise me. While not predicting anything, I also believe it is imperative for investors to have in place a strategy that assures they can stay the course whenever one of these periodic down drafts do hit. They eventually will.
Robo-Advisors – a Signal?
The latest “innovation” in financial services and financial advising is to offer computerized portfolio management at very low costs, euphemistically known as “robo-advisors”. Conceptually, these sound appealing as the best strategies can be applied en masse at very low costs thus allowing investors to keep more of the gains. Okay, I admit I’m a bit biased; however, it is our strong belief that it is not “smarts” that keys investing success but primarily discipline and patience. I just can’t see how those can be imparted by an impersonal robo-advisor during those inevitable periods when things get very, very difficult. We all are impacted by our emotions when it comes to investing. Having a personal relationship with an advisor is invaluable at those very times when we most want to abandon our long-term strategies. In my experience, the times when we most want to change strategies are almost inevitably the worst times to do so.
I don’t want to sound too cynical. Undoubtedly, these “advisors” will be here to stay, particularly for the lower-asset investors who don’t find it economically feasible to work with a live person. Yet, I will be interested to see if there is wide adoption during the entirety of a market cycle including both the bull markets and the bear markets.
Just a Thought – Is Greece the Next Lehman Brothers?
Arguably, allowing Lehman Brothers to go belly up in the fall of 2008 triggered the tsunami of selling as the counter-parties (those holding Lehman debt – IOUs) collapsed in sort of a chain reaction. Many have pointed to Greece, fearing they may end up failing in a similar replay. Greece is clearly bankrupt and is currently experiencing significant political and economic difficulty in negotiating with its creditors – principally the rest of the Eurozone led by Germany. While, to this untrained eye, an eventual Eurozone exit seems almost inevitable, I doubt that it will lead to systemic collapse. People have just had too much time to prepare. If and when a Eurozone exit does occur, it might be more like the fall of Bear Stearns earlier in 2008 which created volatility but not collapse. Similarly, if Greece does end up exiting, the key will be to keep an eye on the other countries which might be in precarious shape. As long as Spain, Italy, etc. hold up and remain in the Eurozone, I expect things to be okay. Hopefully, the powers-that-be will prevent a more dire breakup.
Ending on a Positive Note
While this column has certainly focused on issues of concern, please know that I continue to be a “bull” on investing in the stock market for the long-haul. My hope is that by being aware of some of the potential short-term risks, we can be prepared emotionally (and with an appropriate investment strategy) to weather the inevitable storms. Peter Lynch famously pronounced the simple key to successful investing in stocks as, “not getting scared out of them”.
I still believe very strongly that, if I live out my life expectancy, I will live to see a Dow Jones Industrial Average over 50,000 and quite likely even over 100,000. Personally, I’m not really concerned if it falls a few (or even several) thousand points first. I plan to make sure I’m on board for the eventual new highs, and encourage you to have a plan/strategy in place that keeps you on board for this inevitable long-term advance as well.