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Until the latest pullback on Wednesday, the U.S. dollar index had
been on a rip-and-tear for most of this year. Earlier this week the
dollar hit a new multi-year high as concerns over Europe and China have
fueled foreign interest in U.S. assets. The greenback?s relentless
strength is also a cause for concern among investors who fear that a stronger
dollar will erode corporate profits this year. Since much of the bull
market of the last few years was based on the bull market in corporate
profits, this point is being taken seriously by Wall Street pros. It?s
also worth examining in this our latest installment.
Also of concern to investors is the weak oil sector. The WTI
crude oil price (basis May futures) fell to a nominal 5-year low of
$44.84/barrel earlier this week after testing the January bottom. A
decisive break below this level would likely catalyze another selling event
in crude oil as protective stops are taken out, but if the crude price can
stabilize above this pivotal low the market will get a needed reprieve.
Weakness in the oil market has also put significant pressure on oil
and gas stocks for much of this year to date. Most of the new 52-week
lows on the NYSE recently have been in the oil/gas sector. This in turn
put some short-term downward pressure on the overall stock market; remember
that a persistently high number of new 52-week lows (i.e. above 40) is often
a sign of internal weakness. That may soon change, however, now that the
Fed has once again given its assurance that it won?t be hiking interest rates
anytime soon.
The strengthening dollar is actually a double-edged sword. While
it hurts the profitability of corporations in the export market, it also
helps consumers by lower prices for goods on the domestic level. It also
encourages inflows of foreign capital, i.e. ?hot money,? which often has the
effect of lifting U.S. financial markets. U.S. equities have been prime
recipients of the weakness in foreign currency markets in the last year or
so, but certain municipal real estate markets in the U.S. have been huge
recipients of foreign investment. A substantial part of the demand in
U.S. commercial real estate in several major cities, for instance, is coming
fromChinese nationals.
Veteran market analyst Bert Dohmen points out thatflight capital can
result in major economic booms/bubbles, but since it represents far less than
the amount of total wealth of foreign investors, when the flight capital is
exhausted demand dries up. Concerning the flood of foreign hot money
into U.S. markets, Dohmen writes: ?Those foreigners who have most of
their assets in their own countries are growing poorer. They will
eventually start conserving capital and defer all new purchases.?
The dollar bull market is reminiscent of the strong dollar
environment of the late 1990s. Back in 1998-99, relentless strength in
the dollar index ? and a corresponding crash in several foreign currencies ?
led to a flood tide of capital into U.S. financial markets. U.S. stocks
and bonds were highly sought after and the Internet stock bubble of those
days was at least partly fueled by foreign flight capital. The late ?90s
dollar bull market also led to a veritable bull market for U.S. consumers as
retail prices plunged to levels not seen in many years. Gasoline pump
prices fell to just under $1/gallon as crude oil dropped to $10/barrel.
At that time the strong dollar was also part of President Clinton?s
fiscal policy as then Treasury Secretary Robert Rubin, a former Goldman Sachs
partner, masterminded the currency policy in the wake of the East Asian
financial crisis. The strong dollar, however, eventually led to its own
set of financial problems as the economies of several countries imploded in
1998 and nearly kicked off a global commodities price collapse. It also
ignited a mini bear market in the U.S. stock market in the summer of ?98,
which lasted all of 10 weeks.
So, we can see from history that while a strong dollar can definitely
fuel a strong domestic economy and an equities bull market for a while, it
eventually evokes its own reversal. As Dohmen points out, since the
dollar?s strength comes at the expense of foreign currency weakness. And
persistent weakness in foreign countries means that ?hot money? capital flows
from those countries into the U.S. will eventually cease. When the
flight capital coming into U.S. markets ceases so does the upside momentum in
financial prices.
I believe we?re still probably at least a year or two away from the
proverbial “danger zone”when persistent dollar strength creates major
problems for the U.S. If anything, we?re probably closer to the ?sweet
spot? of the currency cycle where a strengthening dollar provides economic
leverage for consumers as well as investors. But as with any persistent
trend, the pendulum will swing too far in one direction and will eventually
swing back in the other direction. Let?s keep that in mind as we look
for opportunities in the coming months.
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