falling dollar, US twin deficit, bond market collapse

What’s ahead for stocks? Watch bonds!

03.12.2004

by James Ferguson

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What is going to happen when the weakness of the dollar hits the Treasury market in the US? The stockmarket is likely to tank, says James Ferguson.

So far, the falling dollar has been a good thing for the US, as it makes exports cheaper and cuts the country’s trade deficit. But will the situation stay so stable? If the falling dollar threatens the Treasury market, things will take a turn for the worse. Why? Because rising interest rates are usually a disaster for debt-fuelled economies. It could result in a massive slowdown in US economic growth, which, in turn, could trigger an increase in precautionary savings and then, perhaps, a full-blown recession. Equally worrying, higher rates in and of themselves would justify a lower equity market valuation in p/e terms, and that would exacerbate any earnings contraction taking place.

The twin deficits

Economists have long been warning that America’s twin deficits - the trade deficit is 5% of GDP and budget deficit $450bn - would cause the dollar to collapse.The trouble is, for a long time, it didn’t fall, and the lack of immediate bloodshed caused many people to believe the situation wasn’t really a problem, or at least not an acute one. But not any more. Since George Bush was sworn in back in January 2001, the dollar has slumped by 30% against the euro, and this fall is probably far from over. The enormous US trade deficit still sucks in a mind-boggling 80% of the world’s savings, yet America only has a 1% national savings rate. So who is funding this debt-fuelled spending binge? The answer is Asian investors. The Bank of Japan has been particularly happy to recycle the dollars it earns from goods to the US back into US Treasury bonds. Why? If the dollar stays up, and hence US interest rates stay low, Japan’s major export market carries on humming. Keeping the yen relatively weak also helps at home because it minimises the impact of imported dollar-denominated deflation from the rest of Asia. This policy has ended up pegging the yen pretty close to the dollar in recent years. The Chinese yuan is also pegged to the dollar, on a formal basis. Thus the dollar has not only stayed unrealistically strong against Asian currencies, but long-term US rates have been kept too low. And the American consumer’s understandable reaction, year in, year out, has been to borrow yet more artificially cheap money to buy even more artificially cheap Asian imports.

Our currency, your problem

Had this three-way dance-macabre not transpired, the dollar would now be coming off a much lower peak, US interest rates would have much less upside, and it would take less of a wrench to bring the US trade account back into balance. For Euroland, it’s time to relearn an old lesson. As Nixon’s Treasury Secretary, John Connolly, once famously remarked: “The dollar is our currency, but it’s your problem.” And Europe is feeling the pain. No wonder ECB president Jean-Claude Trichet has declared that the rapid descent of the dollar is “not welcome” and has called on the US to boost its savings rate as an antidote to the budget and trade deficits. But the only two ways to boost your savings rate are to hike interest rates and/or have a recession, which increases precautionary savings. Neither approach is going to appeal to the US. Besides, the trouble is the US is happy with a weak dollar as it helps to cut the trade deficit. A typically unsympathetic US Treasury secretary, travelling in Europe in November, put the onus back on Europeans, saying they need to carry out structural economic reforms and address their own “growth deficit”.

Brutal for Europe, nice for the US

So, while the immediate and direct impact of a weaker dollar on eurozone stocks can be quite brutal, the effect on the US stockmarket is, if anything, mildly positive, as the recent strength of the S&P implies. However, that will only last as long as dollar weakness remains quarantined from US debt markets. If the recent currency falls trigger, or worse, reflect, a loss in confidence by foreign, and particularly Asian, Treasury market investors, the contagion could spread to bonds, making yields surge (they rise when bond prices fall). In fact, this might already be happening. Malcolm Moore in The Telegraph notes that “the steep rise in Treasury yields in the last two sessions” occurred, rather ominously, “without any material news”. If that continues, the consequences for equities could be immediate and catastrophic.

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US price earnings ratio is high

The right-hand chart below shows the earnings-per-share (EPS) forecasts for the S&P 500, rebased to the index. Based on this alone, you can see that the stockmarket bubble started as early as 1996, before finally peaking in 2000. Since the crash wasn’t deep enough to bring the market back in line with EPS, the subsequent 50% rally in 2003-2004 was a real surprise for many. Now, because the price earnings ratio (PER) is still quite high, at 21x, many analysts believe the market is now too expensive, compared to historic norms. From that point of view, the bubble never fully burst.

Adjust for rates and all’s well

However, things are not quite that simple. While earnings are obviously important, share prices also reflect the investment yields you get elsewhere, which, in turn, reflect the state of the economy, currency and inflation. So, it is not just earnings, but also bond yields that explain equity prices. Indeed, nearly half the gains in the S&P since 1987 - and a lot more than half since the mid-1990s - can be put down to the beneficial effects of falling interest rates. According to John Mauldin at frontlinethoughts.com, since the third-quarter of 1994, US earnings have risen by a total of 72%, half of which was inflation, whereas the market has gone up by more than 172%. So, to see what will happen next, we have to look at both bonds and earnings. On the earnings front, the news is not good. In the run-up to the US election, George Bush threw a huge amount of stimulus behind the economy. He introduced 50-year low-interest rates, big tax cuts and huge amounts of government spending, with the result that the economy boomed. But as firms felt uncomfortable about the debt-fuelled recovery, they didn’t really start hiring to the degree that they were expected to. This has kept costs low and hence profits high. But, without new jobs, it is unlikely that there will be much economic follow-through. “In the early 90s, after-tax profits were less than 5% of revenues,” notes Mauldin, but now “the S&P 500 has profits of 9.2% of revenues - in short, it doesn’t get much better than this.” Analysts forecast that earnings will grow by a further 18% over the next year, but this seems unlikely in the absence of further policy stimulation and given that the ten-year earnings growth rate has averaged just 5.7%.

Apart from earnings, the only thing that will support the US market will be low bond yields and that depends on the dollar. If it keeps falling, yields will rise and stocks fall. One possible solution to this doom-laden domino-effect is a dollar rescue mission. “Intervention on a massive scale could occur at any time,” say economists at ING, but even they admit that intervention is likely to provide only “a temporary reprieve”.

Double-whammy endgame

The risk now for US equities is that they end up facing a dollar-induced double-whammy. By sapping foreigners’ appetite for Treasuries, the weak dollar could trigger the bond-market collapse, driving interest rates up. This would choke off the cheap credit that has driven both the private and public-sector spending sprees, thus putting the brakes on GDP growth and causing an inevitable deterioration in corporate earnings. In turn, this would push the US PER even higher than its current 22x rate. But, even worse, as rates push above the 5% range, they will no longer be able to support a PER of anywhere near 20x. If Treasury yields drift towards, say, 6%, the sustainable PER will fall to 17x. Yields that have risen 7% imply a market PER of just 14 times. In conclusion, investors should keep a very close eye on the dollar and an even closer one on bonds.