Download July Economic Outlook

July Economic Outlook
Since we’re half way through 2015, it’s a good time to review the first half of 2015. We will also look at
where we are in this economic and interest rate cycle.
Summary

The U.S. economy continues to grow with low inflation and interest rates, and with an improving
outlook for the consumer and spending.

Most economists see a low probability of a recession for this year.

Risks remain, but most risks are external.

The strong dollar has been a drag on the economy.
GDP
This economic cycle started in mid-2009, so we are in the sixth year of this economic cycle. Most
economic cycles last about 4 to 5 years.
Source: WSJ Economic Forecasting Survey
The WSJ economic forecasting survey is from more than 60 global economists, from different industries
and academia.
Economic growth is low. The forecast for economic growth continues to be below 3%. I explained last
month why our economy has slow growth and why slow U.S. economic growth will probably continue.
Click here to read why U.S. economic growth is slow, the “new normal”. The “new normal” section starts
on page 5.
Source: WSJ Economic Forecasting Survey
The probability of a recession for this year is very low, 10.33%, according to the economists’ survey from
the WSJ.
Unfortunately, the risks to our economy are growing and most are external:
Let’s review some of these risks
Again, most of the risks are external. The stronger dollar is hurting our exports (I explain the impact of
the dollar’s impact in the Dollar section below).
The risk of a Greek exit from the Eurozone has increased. This is creating great uncertainty in terms of
what it means for Europe and the rest of the global economy. Theoretically, the financial impact should
be small because Greek loans are held by governmental entities and not private. Also, the loans are small
compared to the size of the Eurozone. There is a fear of contagion that other Eurozone nations may follow
Greece and the economic depression in Greece could impact the rest of Europe.
Geopolitical/Security Issues – The Ukraine/Russian crisis continues. The oil rich Middle East and
especially ISIS Syria and Iraq are serious geopolitical concerns, and a resolution is nowhere in sight. If
Iranian nuclear negotiations turn bad, military confrontations between Iran, U.S. and Israel are on the
table.
The U.S. strong dollar is impacting U.S. international trade and profits. The section below is from my
May Market Outlook. The dollar outlook is worth repeating.
Dollar
One of the concerns that our Federal Reserves and the International Monetary Fund have is the strong
ascent of the U.S. dollar index (a basket of the major currencies in the world), as it is up about 25% since
last summer.
The concerns revolve around the amount of dollar denominated debt that has been issued since 2009,
about $9 trillion. With a dollar that is worth about 25% more, those loans and interest rates have increased
about 25%. A 10%, $1 million dollar loan has increased to about $1.25 million and the interest rate has
essentially increased to about 12.5%. If we have a global recession, the increased burden of these loans
could slow down the economy more, and there could be a significant rise in defaults.
The dollar has not increased 25% against all currencies.
It’s important to note that the dollar has appreciated against certain currencies more than others, the
markets are discounting the differences in growth, interest rates, inflation… for each currency.
According to the map, the dollar has not appreciated against the Chinese yuan. The dollar has increased
about 31% against the euro. Again, any dollar denominated loans made in Europe or overseas will
probably have a difficult time servicing the debt, especially if there is a global economic slowdown, or
recession.
The dollar’s rise and its impact on dollar denominated loans is another reason why the Fed will have to be
very careful in raising rates.
In the Fed’s last news conference, the Fed stated they were aware of the global risks of rising rates and
the dollar, and the Fed would take caution due to the disruptions the strong dollar could have on the
global economy including dollar denominated loans.
How Do We Value the Dollar?
The questions is, is the U.S. dollar undervalued, overvalued, or fairly valued? Can the dollar go higher
from current levels?
There are many ways to value an asset, whether its real estate gold, stocks, bonds, oil…
Valuing the dollar against other currencies is nebulous and difficult.
There are many variables that determine the value of a currency: inflation; interest rates; economic
growth; the assets, resources that back the currency; the size of the countries’ economy; GDP; rule of law;
debt; political system; accounting systems and reporting; transparency; the diversity of its industries; the
educational attainment of its citizens…
One of the simplest and oldest ways to value a currency is PPP (purchasing power parity). The theory
of PPP is the price of a good in one country should equal the price of the same good in another
country.
For example, if a foreign currency is overvalued, the PP of the domestic currency is lower in the
foreign economy. As the flow of the lower currency moves, domestic prices rise and foreign prices
fall as the domestic demand falls, or the foreign currency falls until the two currencies reach parity.
Unfortunately, the global economy is much more complex than this currency valuation theory.
Another way to determine if a currency is undervalued or overvalued is to determine the total value
of a currency that currently exits and compare that to the value of the GDP of the country.
There is a total of about 23.18 trillion dollars in the global economy (about $12.68 trillion are in
foreign reserves, and about $10.50 trillion are in M1, M2 and M3 here in the U.S.). Our economy is
about $17 trillion, so there are more dollars than the size of our economy. Because the U.S. dollar is
the largest world reserve currency. There should be more dollars in the world compared to the size of
our GDP.
Even though the dollar is the main global reserve currency, the euro has increased its share as a
global reserve currency when it began in 1999.
If we back out our exports from the foreign reserves, then the dollar should be close to being fairly
valued, but it’s hard to determine what the dollar value should be using this method.
One could make the argument that if we factor in total government debt and future obligations
(Social Security and Medicare) then the dollar is overvalued.
We can also take a look at the dollar historically to have a clue especially by looking at the highs of
the dollar, and determine if the dollar could reach those historical levels.
Here is a long-term chart for the dollar:
Before we analyze what caused the dollar to rise and fall during this time period, I would like to
point out two trends of the chart above:
1. Stocks tend to move quarterly because of earnings reports. Commodities and currencies don’t
have quarterly reports, so they can be stuck in trading ranges for long periods of time. We
can see that in the 1990s, and from 2008 to 2014.
2. The latest rally is almost parabolic, normally a sign of speculation. These type of moves are
normally not sustainable. See current chart for dollar below.
Can the dollar reach the highs that it made in the mid-1980s, and the late 1990s?
Before the fall of communism, the U.S. dominated the global economy. This is no longer the case,
the U.S. now shares the global economy with China, India, Latin America…. I doubt the dollar could
be as strong as it was in the mid-1980s because the global economic pie is shared by more
economies. Also in the 1980s, baby boomers were having families helping boost the economy in the
1980s. Millennials are large in numbers, but they are not starting families and buying homes like
baby boomers did.
The dollar bottomed in 1992 at about 80 and rallied about 50% due to the U.S. technology and
internet revolution by 2000. The U.S. does not have a major economic trend like the technology,
internet boom to boost growth and wealth in the U.S.
The dollar was probably overvalued by the late 2000s. The dollar crashed about 41% after 911 and
the Great Recession that started in 2007.
The dollar has rallied over 40% off its low of 70 made in 2008 and tested in 2011, close to the rise
during the technology revolution.
The causes of the dollar rally include: QE ending, the Fed may start raising rates, the economic
growth in the U.S. is stronger that most of our trading partners, except China. We are attracting
foreign capital because of higher rates, better growth, and the safety and liquidity of the dollar.
The reasons for the current rise are not as strong as the reasons in the 1980s and 1990s, but the dollar
is up about the same. If the dollar did rise 50% that would put the dollar at about 105 (50% of 70
would be 35, a 50% move would be about to about 105).
A rise of the dollar index to 105 would be about a 5% above this year’s peak. Again, a 50% move
would not be justified on a fundamental basis, but if the rally matched the move in the 90s, 105
would be the target.
The Dollar and the Futures Market
In the short-run the futures market is determining the direction of the dollar. Below is a table from
Barron’s that shows the activity of the Eurodollar futures market:
The Eurodollar has the most contracts of the three assets listed above. There are also significant contracts
and activity in other currencies: pound, yen, Canadian dollar, Swiss franc….
The main function of the futures market is to shift the risk from producers to risk takers. The other
function of the futures market is price discovery.
If you look at the above table, most of the contracts belong to commercial hedgers, as they try to reduce
their price, currency risk.
The rest of the futures market is dominated by speculators and traders (not investors, click here for an
explanation of the differences between investors, speculators and gamblers.) because of the significant
leverage in these futures markets.
The U.S. dollar index is $1,000 times the index value. If the U.S. dollar index is 100, then the futures
contract is worth about $100,000. The margin requirement is only $1,950, so the there is tremendous
leverage, and this attracts speculators.
Large speculators, deemed as the smart money, have more long contracts. Also long contracts increased,
and the shorts decreased.
Small traders have more shot contracts than longs.
Here is a current chart for the dollar:
The dollar’s rally accelerated last December, then the dollar consolidated its move in February.
The dollar accelerated again after the consolidation. The move was parabolic and was not
sustainable.
There is resistance at 100. If the dollar can break above resistance 100, then the dollar could rally to
105, matching the rise in the 1990s.
It’s possible that speculators drive the dollar above 105, but the dollar would be overvalued if this
happens.
The dollar has established a trading range with support around 94, and resistance around 100.
Currently prices are around the middle of the trading range.
The Dollar’s Impact on the U.S. Economy, the Consumer, Corporate Profits, Gold and Oil
A strong dollar is a good thing for consumers as it makes foreign goods and services cheaper. A
vacation to Europe would be about 30% cheaper than in 2013.
Domestic producers and service providers will have to keep prices lower to compete against cheaper
foreign goods and services. This should keep a lid on U.S. inflation, and therefore interest rates.
A strong dollar is bad for U.S. international companies, because foreign buyers will need more of
their home currency to buy stronger dollar priced U.S. goods and services. The stronger dollar and
higher priced U.S. goods and services are expected to lead to weaker sales.
Also hurting U.S international companies is the currency conversion loss that happens when a
weaker foreign currency sale needs to be converted into a stronger dollar. Currency losses are
expected to lead to lower earnings for U.S. international companies.
In the short run a strong dollar could hurt a gold and oil recovery.
I have made the case in past Outlooks and Updates that the dollar oil relationship is overstated.
Briefly, even though the dollar is stronger than the euro by about 30%, oil prices are down about
50%, so oil is still cheaper and the dollar should not impact demand. Most countries’ currencies
aren’t down as much as the euro so their demand should not be impacted by a strong dollar because
the drop in oil prices is greater than the appreciation of the dollar. Also, our 2015 global outlook for
oil based on the EIA and IEA’s outlook see global oil demand rising in 2015.
If the dollar moves above 105, gold could make new lows. Remember the all in cost for gold is about
$1,100. Below that price producers will probably cut output and supply and demand can eventually
achieve equilibrium and price stability.
Inflation, the Fed and Interest Rates
Below is the trend and forecast for inflation:
Source: WSJ Economic Forecasting Survey
Inflation has been very tame during this economic cycle, especially lately as the bottom row of the graph
above shows. Inflation is expected to stay low this year, and may get to the Fed’s target of 2% in 2016.
Below is the latest dot plot from the Fed:
Source: FRB website
Each dot reflects the forecast of each Fed member and where they expect the fed funds rate to be.
In past economic and interest rate cycles, when the Fed raised rates it was because the economy was
showing signs of inflation, and the Fed raised rates to slow down an overheating economy that was
causing inflation or inflation expectations.
In this cycle, the Fed kept rates lower than normal during the Great Recession and the economic recovery.
The Fed needs to raise rates to get back to normal levels. Normally rates reflect inflation and inflation
expectations. Currently rates do not reflect inflation and interest rates.
Currently the fed funds rate is at .25% and they’re expected to rise to about .5% by the end of 2015 and
rise to about 1.5% in 2016. Most members see rates rising to normal levels by 2017.
Long-term bonds are starting to anticipate the Fed’s raising of rates. Below is a current chart for the 10Year Treasury:
Source: WSJ
The 10-Year Treasury yield was 1.65% in February and rose to about 2.5% last month, about a 50% rise
in yield.
Yields have fallen due to rising risks from Greece and China and the flight to quality to U.S. Treasuries
that are backed by the full faith and credit of the U.S. Government.
The Consumer, Housing and Autos
Consumer sentiment continues to improve due to a better job, real estate and stock markets.
Below is chart showing the trend in consumer sentiment and expectations:
The consumer is 70% of our economy. An upbeat consumer is good for retail sales, autos, and real estate.
Here is a chart that shows the trend for retail sales:
Retail sales took a hit during the Great Recession, but they have been increasing each year. Again, the
consumer, retail sales are very important to our economy.
Home sales are doing better this year:
Notice that last year home sales leveled off, but this year sales are doing better. Some analysts believe
home sales are doing better because many home buyers believe that mortgage rates will be moving
higher, so they want to take advantage of low mortgage rates.
During this economic cycle, when home sales are strong we see weakness in auto sales and vice versa.
Here is trend for auto sales:
We can see auto sales have declined the last few months.
The current economic conditions are good for the markets. My July Market Outlook should be out late
next week.