The following is an excerpt from the 28 January Latest Letter at www.dinl.net.
Year of the Dog
Our global gaze today is on the US rate outlook and the Eurozone currency. There has been a lot of banter about the US slowing down and eurozone picking up. This may be true or not. We would say it is definitely too early to tell but the chess pieces are slowly falling into place. Firstly, we have witnessed in the past that if the US catches a cold then Europe follows on with a flu or worse. Trade between these two economic areas dwarfs trade, say, with China. The US and the EU are linked at the hip in terms of trade volume and that is often why EU exporters are hurt on both US slowdowns and US currency weakness fronts. Nevertheless, we are somewhat baffled at some of the economic reporting going on about the upcoming FOMC meeting on Tuesday, 31 January. The general consensus is that the Fed rate will rise one final time to 4.5%, and that, despite the signs that the economy is weakening. Various reports have pointed out that a halting of the FFR (Fed Funds Rate) at 4.5% would be likely bullish for the market as it might give continued spending impetus to consumers and signal that "it won't get worse from here" in terms of rising debt servicing. Yet the graphic below shows a different story. As the FFR (by proxy 3m Tbill) approached 6.25% in January 2001 the DOW had been going sideways for 18 months and then started to fall drastically. It kept falling until mid 2003 when the FFR was just above 0 ! The Fed was giving money away for near free. Just when the FFR started to incline again from below 1% to its current 4.25% the DOW has been grinding slowly higher and mostly sideways for 2005. Hence we feel the likelihood that a FFR stopping at 4.25% or 4.5% could be a psychological trigger to the markets that "it's over", the recovery is ending else why would the Fed Committee be halting? The other interesting thing in this overall picture is that the US housing market looks set to go lower and thus pinch consumer shopping as their house cum ATM-machine is valued lower than before, also known as negative equity for home owners who bought at the high end and expected the market to go even higher. According to MacroMavens, US home equity loans peaked in 2005 and have since dropped over 40%, even going below the 1996 base threshold. What does this mean? It means the funny-house-money may be drying up. With the US GDP driven mainly by consumption, whence shall cometh the liquidity ? Not savings - that is now below zero in the US. With, as Stephen Roach calls it, a wageless recovery a few years ago, I take issue with the term "recovery". It was a consumptive recovery of sorts based on debt liquidity rather than a productive recovery whereby sustainable earnings / wages are thrown off from core productive investments. It looks as though the hens are now coming back to the roost - with a vengeance. It was a wageless recovery because no major productive investment took place and because there was no real "inflation" on the wage front - wages remained stagnant.
Again, if the 1999 to 2001 scenario below can be taken as a precursor to the current situation, and we believe it can since a dot.com bubble may in fact be no different than a housing.com bubble, the markets may simply already be foreseeing a lower market to adjust to what consumers and investors already seem to realize - the fundamental elements are not conducive nor in place, we believe, for a sustainably higher or, as I say, "licentious" market. We know Wall Street is calling for a "new bull" but believe this is illusory based on the current data. Notice it took two years of liquidity (dropping the FFR from 2001 to 2003) before the DOW market started to reverse move (rapidly) higher in Q1 2003.
The other possible negative of this market scenario, and one we feel has a potential to be realized, is that of the next cyclical leg lower in the US Dollar. As we know, capital moves quicker than people or governments may prefer. Nevertheless, the USD-Index story is more complicated than elsewhere. In a world of USD-denominated commodities, everybody needs USDs on hand in order to purchase and get access to those resources or goods, be it corn, aluminum or oil. With the potential for an oil crisis, it would be wise for Central Banks to have enough USDs on hand or enough of something else on hand which can be traded for USDs. Therefore a certain buffer of de-facto support for the USD may translate to a somewhat benign currency handling - after all, currencies can be devalued but the follow on currency cross rate may "kill" trading partners, nor do they want that either. But alas, it is our belief that this may be a big reason for the gold and silver movements over the last 12 months - fear, not inflation - being the main driver. As a matter of fact, gold has been rising against most all currencies and will likely continue to do so. Inflation has in fact been quite tame if one takes the official figures and even so, with food and energy taking a large chunk of consumption away from the consumer, that tends to be "deflationary" in nature, i.e. not in monetary terms but in consumption terms. Yet the stealth rise in gold and silver may be a realisation that something is not quite "right" with the "USD based system". By the way, also note that the commodity rises from 1999 began in earnest during the 2001 to 2003 timeframe and has been trending higher ever since. We may witness the 2nd leg upward in precious metals once the FFR starts to roll over - enterprises and consumers may again be looking for stability and yield. This in fact has been one of the 2005 stories - Fund purchases have increased in both the base and precious metals sectors. Is it simply yield chasing or does this have further connotations? We believe that institutional money is flowing into the resource sector for good reasons - scarcity, fear leading to safehaven and the global geopolitical outlook. Yes, the resource sector is comparatively small verses others but that, along with psychological and geopolitical parameters, is also what creates yield - supply and demand.
To conclude, the above remains our fundamental backdrop which lays the groundwork for our investment outlook. Nothing is set in stone (yet) but we feel this is the scenario which will continue to drive our portfolio forward.
Now turning to the EU, we wanted to look at the fundamental psychological situation as a follow on to the failed Constitution and the riots in France and the crisis which the Eurozone seems to find itself in. Our fundamental view on the core EU States remains guarded at best and downright pessimistic at worst. Without going into the gory details of the failure of the EU Constitution to be ratified by France or Holland during last year, the main failure of the EU - at the most elementary level - has been to actually do something constructive in terms of reforms on a coordinated level. A patchwork of reforms here and there, a lethargic populace weaned on 50 years of socialistic thinking and a political elite intent more upon re-election than hard-knocking reforms has led to a discontented unity and a growing divide. Add to that the 10-member enlargement and the need for 100% voting structures with regard to many EU issues and the groundwork is laid for Least-Common-Denominator rule, otherwise known as "grinding halt". Within this framework some nations are trying to forge ahead with structural reforms on a national level, e.g. Germany. This is, as we have stated in previous Letters, a condition whereby nationalistic tendencies start to prevail and the people turn their noses up to Brussels, as in, "What have they ever done for me?" attitude. This disenchantment combined with poor economic growth and falling wages starts to take its toll on any support for an EU Suprastate supported from the State constituencies. With this overall background, that of a soft political union, and seemingly growing weaker, combined with nationalistic tendencies and a disenfranchised and job-fearful populace, it is our current viewpoint that in the medium term this may have an effect on the Euro currency, albeit the unraveling is not even close to starting - it simply remains a threat. This will by no means affect our portfolio choices for the moment but it does play into our overall long-term-threat picture. IF USD-reserve holders like China or petro$$-nations should diversify a portion of their USD holdings, which we believe will happen or is happening to a larger degree towards non US holdings, the Euro could, despite the political weakness certainly gain a substantial portion of that diversification. Equally, on a more "bang for yer buck" basis, they may also diversify into the monetary metals since gold has largely been rising against all currencies.
The next issue is of course the ongoing energy outlook in the EU. For the most part, Western Europe is a largely dependent upon Russia for its energy needs. Most nearly all gas is supplied from Russia. A recent joint venture to produce an export pipeline across the Baltic Sea to Germany has received much press coverage along with Ex-Chancellor Schröder taking a place on its Board of Governors. Being buddy-buddy with Premier Putin certainly oiled the cogs of that placement. Hence most likely all energy deals with Russia would be in Euros. This would go a long way to not only enforce the Euro strength but also to at least provide choice in a USD-controlled resource world. Yes, currency options do exist for energy deals but the dominant question for investors must be of timing. Will it happen this year or next? We have read a number of articles calling for the end or dismantling of Petro-Dollar regimes and the like. Certainly there are political and geopolitical factors at present in a USD choked world and regimes are of course tuned in to the US vulnerability on the energy front. If you have not read my Café piece I would urge you to read it.
(Globalisation - Opinion & Book Review) http://www.dinl.net/cafeDINL.php5?id=125
To conclude this part, we feel that Euro certainly has upward potential to the 38% and even 50% fibo lines in the graphic below. The shorter term puzzle pieces remaining include Euro growth perspectives and the ECB rate increases as well as the upcoming FOMC meetings on 31 Jan and 28 Mar. Also, although both the German consumer and business confidence indexes have now reached recent highs, these indexes have gyrated psychopathically in the past. Trying to get a constant and clear reading of true sentiment from these has been like playing roulette. The most important factor we feel remains the energy Achilles Heel. Europe is simply much more expensive in real terms than North America and imports near all its energy needs in US Dollars of course. We understand the Petro-Dollar argument yet believe more geopolitical pieces must fall into place before we can or will see a "blowing up" of the USD lock hold. Right now we cannot see a stampeding out of the USD just yet.
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