Keeping eye on the $US

Global markets paused this week as investors took time to evaluate whether stock prices were getting ahead of the predicted (and hoped for) economic growth. The Nikkei was the only market to make bigger gains last week but it could not break through the magic 9,000 barrier. The DOW gained 54 points to close up at 9,117. The other US indexes didn’t move as weaker than expected US economic data disappointed investors. The University of Michigan consumer confidence index fell to 87.2. for May, down from 92.1. US exports also fell, hitting a 13-month low in May. Oil prices retreated on news of higher inventories, Brent closed last Friday at USD 26.43. Many Caribbean businesses are strongly linked to the United States Dollar, either through purchases of materials and products or through sales into the western hemisphere. As such, we feel it prudent to put forth some detailed research on the US Dollar and how major exchange rates are likely to move.

Our longer term forecasts predict the US Dollar will continue to weaken against the other hard currencies. Recently, honest comments by the United States’ new Secretary for the Treasury, John Snow, initiated a sell off which was then countered by strong dollar comments from President Bush. We do not believe the United States will do anything to stop the slide of the dollar. Nor is there much that the US Government could do, even if they wanted to. The USA does not keep any significant reserves of US Dollars to put on the market to defend the exchange rate, only about 35 billion, just enough to facilitate foreign trade matters and only 7% of what Japan has on hand as a comparison. Plus, all the USA’s debt is held in USD. Looking at foreign trade, the US is a net importer right now, thus more US Dollars are going out of the country than are coming in, increasing the US Dollar debt held by foreigners. In fact, the US current account is now at about 5% of GDP, and increasing by about US 1.0 billion per day. Thus it is reasonable to conclude that the dollar will float to a market determined level to balance off these debt and trade pressures. The only way it will get stronger is if the US economy settles into solid sustained economic growth rate higher than the other hard currency countries, a situation we do not feel too likely at this point. Also, remember that a lower dollar, lowers the standard of living of Americans, makes imported goods more expensive for US residents and increases the price competitiveness of US manufactured goods abroad.

In corporate news, Freddie Mac hit the news when it announced it had removed three of its most senior executives for allegedly failing to cooperate with the US Securities and Exchange Commission. The stock dropped 18%. Freddie Mac is to restate its results for the past financial year to more accurately account for its extensive use of derivatives. In the UK, Royal Bank of Scotland, purchased Churchill the insurer, for GBP 1.2B in cash from Credit Suisse. As for investment strategies, we believe that shifting assets into longer term bonds carries significant inherent risk of capital loss as interest rates will certainly rise with economic growth. We also note that many investors, especially the baby boomers, have been shifting significant assets into bonds (2.4 billion USD last week) as a result of the shell shock performance of equities over the past three years. This is a strategy that we would not consider prudent at this time. The recent bond rally was predicated on fears of deflation and a rate cut, thus the markets have already priced in a 25 to 50 basis point rate cut from the US Fed within weeks. Thinking longer term, a review of market performance immediately following bear markets where a 40% or more correction has occurred, shows the average equity return above inflation has been 8.6%, well above the typical yield of 6.5 to 7%. Although many investors don’t want to hear it, equities are the favoured asset class as we move forward with this economic recovery. We continue to support a strategy invested in large cap value based equities, keeping a watchful eye out for small to mid cap growth oriented companies in the financial, health care, consumer discretionary and tech sectors.
e-mail: darcy@investments-intl.com