Dr. Jeckyll’s Ace: The Rupturing US dollar?

``In capitalist financial markets, discipline and prudence require that investors fear – yes, fear – that they can lose; and lose big time. Nonetheless, there can be no denying that a Fed Put does exist; indeed, that was the primary reason the Fed was created in 1913, to provide an "elastic currency" so as to truncate cycles of panic that predated its creation.”-Paul McCulley PIMCO

However, our understanding is that under the Minsky’s Ponzi finance scheme, credit requires even more credit to ensure rising prices to sustain operations. Hence, the foremost question in our minds…will the global central bank administered potions regenerate enough “velocity” of credit to sustain its momentum and place Dr. Jeckyll as the dominant market personality? Or will its paucity lend to the Stevenson classic denouement?

Meanwhile Dr. John Hussman of the Hussman Funds argues that all the jubilation over the recent expectations of a successful Fed intervention has been downright misleading since he says (highlight mine)``there is no credible mechanism by which Fed actions control the economy.”

Dr. Hussman argues that the investing world bolstered by media needlessly fixates on the sensational and the trivial without propitiously examining the extent of the overall impact of the ongoing transitional process.

We quote Dr. Hussman, ``It's important to emphasize that the impact of these changes is mainly psychological, and outside of a pool of a few billion dollars, won't have any effective bearing on the “liquidity” of the banking system, nor on the solvency of $3.4 trillion in real estate loans, and $6.3 trillion in total bank lending.” See figure 2.

Figure 2: Hussman Funds: The Fed: Magical Fairies and Pixie Dust

From an earlier article Dr. Hussman’s pungent observation anew, ``The total amount of U.S. bank reserves affected by FOMC operations is less than $45 billion, and only the “excess” portion of that – typically about one billion dollars – is what determines the overnight Federal Funds Rate. Meanwhile, the total amount of borrowings through the “discount window” – though higher than in recent years – still amounts to only about $3 billion.”

In essence, central bank operations including the rate cuts influence only a minor segment of the entire banking based US financial system. His argument separates the forest from the trees, where Central bank operations will likely do little to resolve the current insolvency problems, except that it has and could further influence the market through psychological means temporarily.

But there appears to be a shadow banking system, which we have earlier discussed, in our September 10 to 14 edition [see US Commercial Paper Markets: A Run on The Shadow Banking System?], where as we quoted Paul McCulley of PIMCO, “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures…which may or may not be backstopped by liquidity lines from real banks.” The shadow banking system is tantamount to Mr. Das’ new liquidity factory.

The issue here is one of leverage, where margin based positions have amplified the impacts on the earning quality of assets especially for those thriving on scanty 1-2% returns. Marginal interest rate or price action movements magnify gains or losses for these structures. Ergo, lower rates could be expected to help cushion on the impact of loan losses and higher borrowing spreads.

Nonetheless, could a psychological booster be enough to uphold the Dr. Jeckyll good natured being without backsliding to Mr. Hyde?

The US equity markets, which we believe as the inspirational leaders of the global equity markets, including our Phisix, has substantially recovered following a short episode of a near Mr. Hyde metamorphosis.

For the third consecutive week, US major equity benchmarks has regained most of its losses and in fact is just a breath away from restoring its old glory. Nevertheless, today’s euphoria has been borne out of the continued expectations of the “FED-Bernanke Put” therapy.

Let us scrutinize why US markets have steadily remained upbeat in spite of the cognizance of growing “wall of worries”.

An article from Vikas Bajaj of New York Times, says that the US markets has positioned away from endogenous developments and instead focused on earnings from external factors. To excerpt Mr. Bajaj (emphasis mine),

``The market appears to be buoyed by a belief that the problems in the housing and credit markets will not be severe enough to pull the broader economy into a recession and that growth in Europe and Asia will help offset those ill effects. The optimism is most vividly manifest in the performance of foreign stock markets, particularly those in the fast developing nations like China and India. One widely followed index that tracks emerging markets is up about 24 percent since Aug. 16, when it hit a low point. Markets in developed countries excluding the United States are up about 12 percent in the same time.

``Even in the United States, the market’s return has been led by industries like materials, energy, technology and industrials that investors believe are best positioned to take advantage of the growth in foreign markets. By contrast, the financial and consumer discretionary sectors have lagged because they are seen as having the most to lose from a declining housing market and slowing consumer spending domestically.”

Figure 3: Standard & Poors: Sectoral Performance Breakdown as of Sept 28th

Mr. Bajaj’s observation appears to be accurate enough, as sectors with prominent exposures to world markets or are highly levered to global developments continue to deliver the gist of the gains (see figure 3), particularly Energy, materials, industrials, information technology, and telecoms. About half of the earnings from the large transnational companies are derived from outside of the United States.

In contrast, financials, consumer discretionary, health care, consumer staples and utilities are sectors mostly devoted to internal dynamics hence the recent underperformance brought about by the continuing housing recession and the downshifting pace of economic growth.

Figure 4: Hang Seng Sectoral Performances: Almost the Same Construct As S & P 500

In absence of available data from Japan or from Singapore, due to our unfamiliarity with their websites, the sectoral performance of Hong Kong’s Hang Seng index peculiarly shows of almost the same performance as with the US led by Materials, Energy, Telecoms and Industrial goods. Put differently, macro themes appear to have diffused in diverse markets.

With a tinge of similarity the Philippine Stock Exchange’s aggregate year to date gains of the local indices in pecking order: Mining and Oil + 62.82%, Property +27.82, Phisix +19.79%, ALL index +19.69%, Holding Firms +17.43%, Services +16.73%, Industrials +16.05% and Financials +10.41%.

Now we believe that global growth is only ONE dimension of the entire picture. The other spectrum omitted by the NYT article is the most important operative—the LIFETIME LOW of the US Dollar Index!

With the US dollar trade weighted index losing its purchasing power as reflected by its continued decline against the currencies of its major trading partners (aside from the rest of the world), hard assets as commodities have been steadily gaining in value.

Hence, the expectations of a resurgent inflationary climate as well as investments themes aimed at inflation directed dynamics. Why do you think, materials and energy have been the global best winners of late?

Since commodities are major export products of emerging countries hence, rising commodity values undergirds their export strengths and consequently an important contributor to their economic output.

So it is quite logical that a declining US dollar has fueled a recovery in emerging markets equities (dependent on rising commodities) which likewise powered US large multinationals earnings outlook, hence the strength in the US markets.

On Friday, the widely followed and respected independent Canadian research outfit the BCA Research noted of the snowballing “Anti-U.S. Housing Trades” themes in the…

Figure 5: BCA RESEARCH: Anti US Housing Trades

``Global portfolio investment flows continue to move towards equities, commodities and currencies that are farthest from the U.S. housing market, i.e. away from the epicenter of economic weakness. The relentless slide in the stock prices of U.S. subprime lending companies is ominous for homebuilding stocks. In fact, subprime lenders' stocks hit new lows Wednesday, despite the rally in the S&P 500 index during the past week! Conversely, emerging market equities have completely recovered, hitting a new high. Meanwhile, the dollar continues its steady downtrend, reflecting waning interest in U.S. paper as a consequence of relatively unattractive economic and investment prospects. In sum, the environment is the opposite of the 1990s, when the dollar and U.S. equities were king.”

What goes around comes around. What we used to believe as US inspired equity leadership appears to have now gradated into a US dollar DIRECTED global recovery which seems to have underpinned the US markets of late.

So, could Dr. Jeckyll have found a new ingredient to postpone his day of reckoning?

Maybe. It all depends on HOW the financial markets will respond to a US recession or a credit shock should there be one.

Be reminded that economics is NOT solely the pillar of financial markets or in particular, equity markets. As in the case of Zimbabwe which has suffered successive years of hyperinflationary depression, monetary administration in support of corrupt and perverted fiscal policies has been responsible for destroying its national currency value which subsequently has channeled excesses money creation into stock market speculation, which we dealt in our September 3 to 7 edition [see A Global Depression or Platonicity?]. Even today, the Zimbabwe’s Stock Exchange continues to fly!

In short, Dr Jeckyll’s recipe for sustenance has been and continues to be from:

1. Mainstream expectations that Global Central Banks led by Chairman Bernanke will continue to lean on accommodative policies which focuses on economic growth and forestall a sclerosis in global credit flows while erring to the side on inflation.

2. Mainstream expectations have likewise been grounded on continued global economic strength to offset the slack in the US economy, which should avoid a recession, and/or lastly

3. The UNSEEN driver in the form of a cratering US dollar which could have stoked an inflationary mindset in the global investment community leading to inflation directed investment themes.