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The dollar has been in a three-year bull market. It has moved massively
against the yen and the exchange rates of many of the world's emerging
economies. Lastly, the Asian economies it has rallied against have now
entered serious recessions.
The US
trade deficit is deteriorating rapidly. Given the lags in trade, much of this
year's weakness in these foreign currencies and economies has yet to impact
our trade deficit. Much more trade deterioration lies ahead.
The US stock market
has recently shown signs of weakness because of adverse earnings reports stemming
from dollar strength and economic weakness in Asia.
The recent US/Japan intervention to lower the dollar against the yen and
avert another downward spiral of the currencies and economies of South East Asia caused worried investors to breathe a
sigh of relief and led to a reflex rally in US stocks. Investors may now favor a weaker dollar.
The Rubin Treasury has pushed for a strong dollar in order to
encourage short term capital inflows into US stock and bond markets. It has
feared a weak dollar on the grounds that a weak dollar could reverse this
capital flow, with negative implications for US stock and bond markets.
We believe that economic weakness in Asia is setting the stage for a
new currency and economic crisis in Latin America.
Because the US trades more
with Latin America than Europe does, such a
crisis could weaken the dollar against the European currencies. A declining
dollar relative to Europe and Japan
is the very dollar weakness that the Rubin Treasury fears.
A strong dollar may now be bad for US profits and thereby for the US
stock market. A weak dollar may generate short term capital outflows, which
may also be bad for the Us stock market.
The following report sketches out a scenario. It is not a forecast.
The US
stock market is a bubble which will eventually burst. Collapse of the US stock market will cause a US recession.
However, it is the nature of bubbles that they go on longer and get larger
than any same person can imagine. We set out in what follows a dynamic path
that could burst the US
stock market bubble and lead to global deflation. However, all the political
constituencies in the world want economic growth and reflation.
It is our guess that, if this dynamic begins to unfold, policy everywhere
will move enough toward stimulus to result in reflation,
not deflation, and thereby postpone the inevitable denouement for a later
date.
Past US Policy---Competitiveness Called For A
Reasonable Exchange Rate
From the early 1970's onward, American industrialists have been concerned
about competitive inroads from lower wage countries on a rapid path toward
modernization. In the 1980's the focus was on Japan and its successful takeover
of a long succession of consumer durable goods markets (
autos, TV's, etc. ) and some high tech markets ( semiconductors ) that
were developed initially by US firms. By the 1990's concerns were rife that
imports of an ever widening range of goods from lower wage countries,
particularly in the Far East, would "hollow out" America's industrial
base.
Past Secretaries of the Treasury in the United
States conducted economic policy with an eye toward
preventing a loss of US
competitiveness. Faced with calls for protectionism from firms and workers
whose industries and jobs were at risk, these former Treasury regimes were
biased toward a low dollar exchange rate which would enhance the position of
US industries in world trade without running the risk of trade wars posed by
protectionist solutions. Most of these Treasury Secretaries remembered an
earlier era when the US
ran current account surpluses and was the world's largest creditor nation.
From this perspective, US current account deficits were a source of weakness
they wished to rectify. It was only a few years ago at 100 yen to the dollar
that Mickey Cantor and Lloyd Bentsen were fighting to improve US
competitiveness in global tradeables markets with,
among other weapons, a threat of dollar devaluation.
The Rubin Treasury---A Strong Dollar Supports US
Financial Markets
In recent years, the Rubin Treasury has differed from its predecessors
in that it has followed a very strong dollar policy. Secretary Rubin has
differed in his focus: trade competitiveness is seldom cited as an issue;
instead, he emphasizes the support a strong dollar gives to domestic financial
markets. We see this clearly in an interview Mr. Rubin granted to the New
York Times, September 29th, 1996.
Mexico was still
boiling when Rubin faced his second potential political disaster, the fall of
the dollar to below 80 yen. For Rubin, this was more familiar territory: he
had supervised the currency traders at Goldman, and he knew both the fiscal
and political risks. "These kinds of occurrences are not without
consequences," Rubin said. A declining dollar tends to drive investors
out of American stocks, bonds and Treasury debt, putting pressure on the
federal government to raise interest rates. "It would take a while to
show up, but I'm certain it would have happened," he said.
What can one say about Mr. Rubin's approach to exchange rate policy?
First, it presumes that destabilizing speculation rules the foreign exchange
roost. If the dollar was deeply undervalued at 79 yen to the dollar, US trade
would improve relative to Japan.
Trade improvement implies an inflow of foreign exchange, which is supportive
to the exchange rate. US assets become cheaper relative to assets in Japan. The
cost of production of goods in the US
falls relative to Japan,
raising returns to investment in the US
at the expense of Japan.
Such considerations should draw in long term capital and thereby foreign
exchange. Therefore, under such conditions, the dollar would fall only if the
flow of short term speculative capital which chases price momentum rather
than long run returns outweighs the exchange inflow from the trade account
and the long term capital account.
Economists have long argued whether speculation in any market is
stabilizing or destabilizing. In fact, in any market both exist, with
predominance shifting periodically from one to the other. There are always
Milton Friedman's speculators who stabilize markets by betting against a
market that departs from its long run equilibrium. And there are other
speculators who, by riding trends, drive markets away from such equilibria. Rubin's statements emphasize the role of
destabilizing speculation. For him, it is important to have a strong dollar
to encourage trend following speculative inflows of short term capital.
Encouraging strength in a dollar that is too low is constructive in that
it reverses the flow of speculative short term capital in a fashion that
restores long run equilibrium to the exchange rate. This is what coordinated
intervention is all about when it is on the "right side of the
fundamentals". This may have been appropriate on the dollar's rise from
its 1995 low at 79 yen. However, once the dollar rises appreciably, such
encouragement of trend following speculative short term capital becomes
questionable. It eventually can become destabilizing, causing a speculative overshoot
in the direction of extreme overvaluation. The dollar has risen from 79 yen
to 140 yen. The threat of deepening chaos in Asia and other emerging
economies and threats from China
have finally forced Mr. Rubin to intervene against the dollar. Yet Mr. Rubin
still contends a strong dollar is in the interests of the US and is warranted by the
fundamentals.
It appears that Mr. Rubin believes that a strong dollar is always
desirable to the extent that it encourages short run speculative trend
following capital inflows which buoy domestic stock and bond markets and keep
domestic interest rates low. The other side of this coin is that a weak
dollar from any level is dangerous in that it will reverse such capital flows
which can, to use Rubin's words, "drive investors out of American
stocks, bonds and Treasury debt". A loss of competitiveness, a rising
current account deficit, and a growing net debtor position, all associated
with a very strong dollar, appear to always be
outweighed by any potential risks from destabilizing capital flows out of US
stocks and bonds. This would appear to be an example of the type of "US
short termism" that one would expect from a
trader from Wall Street. It is noteworthy that this is the appraisal of Mr.
Rubin's Treasury given by the press organ of the Chinese central bank just
prior to the US/Japanese intervention on behalf of the yen.
Washington could cut
interest rates and intervene in FOREX markets to stop the yen's decline but
feared that "a sharp fall in the dollar would very likely cause an
outflow of foreign capital, causing a plunge in US stock and bond
markets," it said. US Treasury Secretary Robert Rubin had often touted
the benefits to the US
economy of a strong dollar, it added. ( Reuters, June 16, 1998 )
Eventually, Relative Prices Matter
What, might we ask, does such "short termism"
on the part of a trader from Wall Street lead to when he becomes Secretary of
the Treasury. When the exchange rate is overshooting
to the downside, as it may have in 1995, it admirably reverses destabilizing
short term capital flows, thereby restoring long run equilibrium. But if
pushed too long and too far, it fosters a new set of disequilibria. It
results in a loss of trade competitiveness. It propels asset markets ever
higher with unstable fuel from inflows of short term global speculative
capital. In the case of the US
it is now hurtling the world's largest net debtor nation toward a record
current account deficit as a share of GDP. And it is helping send a stock
market with an unprecedented overvaluation ever higher.
At some point, encouraging trend following short term speculative
capital to support an exchange rate and stock prices at extreme points of
overvaluation comes a cropper. Why? Because relative prices do matter in the
long run. Trade competitiveness erodes. As the current account deteriorates
ever greater offsetting capital flows are needed to support the exchange
rate. At the same time, returns to investments in tradeables
fall. Why would anyone build a plant in such an economy when factor
endowments and relative prices make it more profitable to build it elsewhere?
And, encouraged and abetted by speculative flows of international capital,
domestic share prices rise to valuations which are far too high relative to long
run prospective returns.
We are seeing ample signs of this in the US economy and markets. Every day
US corporations now report earnings disappointments. Owing to a strong
dollar, they suffer profit margin pressures. Owing to a strong dollar, they
suffer eroding domestic and foreign sales. In the present instance the
outflow of short term capital from the emerging world into the US has
created financial and economic crises in these economies which further weaken
global markets for US industries. Overall, the strength in the dollar
exchange rate is now so great that US corporate profit performance is
deteriorating and is falling short of expectations. As a result, the US stock
market has been floundering, with weakness focused on corporations exposed to
the adverse direct and indirect consequences of the dollar's strength. Now,
finally, a key relative price, the US dollar exchange rate, may have moved so
far from its long run equilibrium that the relative price effect on US
profits may pose a greater risk to the US stock market than the possible
withdrawal of the flows of short term international speculative capital to
which it may have grown addicted.
A Rubin-In-A-Box?
What might Mr. Rubin do if mounting earnings disappointments threaten
the US
stock market with its unprecedented valuations? Like other Treasury
secretaries before him, he could move toward coordinated intervention against
the dollar and try to "manage expectations" by "talking down
the dollar". The recent intervention on behalf of the yen was no doubt
encouraged by investors' adverse reactions to earnings disappointments
arising out of a too strong dollar and to pressures from US corporate
interests that were adversely affected; in effect, prospects of a lower
dollar were seen as a positive for the US stock market. But, alas, if
dollar weakness goes too far, it might encourage the cumulative speculative
capital flows of the last several years to turn tail and run. By his own words, such dollar weakness could "drive
investors out of American stocks, bonds and treasury debt."
Perhaps the penchant to purchase stocks by US households is so great
that even earnings disappointments will not undermine the US stock
market.
(Note: We take this option very seriously. The US stock
market is now driven by "bubble dynamics". Long run prospective
returns no longer govern the formation of investor expectations of future
returns to stocks. Rather , investor expectations
formation has become almost completely backward looking or
"adaptive": it is the past rate of stock price appreciation that
determines expected future returns. We have witnessed a one time move in
stock valuations from historical lows in 1980-1982 amid adverse economic
conditions to record valuations amid unusually benign economic conditions.
This one-time rise in valuation has created a rate of appreciation in stock
prices that vastly exceeds trend. Investors with adaptive expectations of
stock price performance assume past 1982-1998 returns will go on forever.
Surveys show that 80% of US households expect 14% or higher returns to stocks
forever. In fact, at today's lofty stock valuations, trend returns must
approximate the growth in nominal GDP ( 4.5% ) plus
the dividend yield for an overall trend return of only 6%. Today's stock
valuations reflect unrealistic expected returns which in the end will not be
validated. Eventually, when disappointed, expected returns will erode, which will reduce warranted valuations and the demands for
stocks. Then the positive feedback loop of bubble dynamics will go
into reverse, drawing stock prices to and below their long run equilibrium.
But, near term, past positive stock price performance may still drive
investor demands for US
stocks, resulting in a firm stock market despite earnings disappointments.)
Perhaps we are wrong that the US stock market is 50% to 100%
more overvalued than it has been at prior historical peaks and that it
exhibits classic bubble dynamics and therefore is especially vulnerable.
Then, Mr. Rubin faces no risks; neither disappointing earnings nor a
withdrawal of short term capital will threaten today's lofty stock market.
But if it is vulnerable, then Mr. Rubin may be caught in a dilemma. He will
have encouraged an addiction to short term global speculative capital that
has gone on for too long and that has gone too far. In the end, relative
prices will matter. Too rich an exchange rate will erode profits. Too rich a
stock market valuation will create unusual market vulnerability. Too high an
exchange rate will create current account deficits that may more than offset
short term capital inflows, which will in turn risk a sustained retracement of the dollar and a massive withdrawal of
short term speculative international capital. There may be no way out. A
sustained high exchange rate may lower earnings relative to unrealistic
expectations and imperil stocks. A move to lower the exchange rate may pull
the support of large cumulative speculative global capital flows. Mr. Rubin's
sustained courting of short run global speculative capital at the expense of
almost all else may place him in a box: a sustained high exchange rate may
hurt too much and for too long, eroding the current account, profits, and
ultimately stock prices, and a declining exchange rate may cause withdrawal
of critical mobile global capital flows, which in turn may also undermine
stock prices.
By : Frank Veneroso
The Gold
Newsletter
www.goldnewsletter.com
Editorials and essays by Frank Veneroso
are available on The Gold Newsletter
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From
1991 to 1994 Frank Veneroso was the partner responsible
for global investment policy formulation at hedge fund Omega Advisors. From
1995 to 2000 and prior to 1991, through his own firm, Mr. Veneroso
was an investment strategy advisor to global money managers and an economic
adviser to institutions and governments around the world in the areas of
money and banking, financial instability and crisis, privatization, and
development and globalization of securities markets. His clients have
included the World Bank, the International Finance Corporation, and The
Organization of American States. He has advised the Governments of Bahrain, Brazil,
Chile, Ecuador, Korea,
Mexico, Peru, Portugal,
Thailand, Venezuela and
the United Arab Emerates. Frank is a graduate from
Harvard and has authored many articles on the subjects of international
finance.
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