USD – ONLY GIRL AT AN ALL BOY DANCE

I have been suggesting that the U.S. economy would likely be unable to meet current estimates of sustained and robust economic growth of 3% or more due to the global slowdown. Despite ongoing Central Bank interventions, the deflationary pressures in the Eurozone and Japan are likely to flow back to the U.S. sooner rather than later.

Just over a week ago, Japan fell into a recession as economic growth and inflation failed to gain traction despite the Bank of Japan’s massive internal stimulus program. This, of course, is really no surprise as Japan has been fighting disinflationary pressures in their country for the last 30 years as shown in the chart below. Japan’s internal struggle with an aging population, lack of savings and accelerating debt/GDP ratios continue to plauge economic prosperity.

While Japan has its specific issues, the Eurozone has now effectively entered into the same “liquidity trap” as the member countries continue to dismiss making the necessary structural reforms to cure their burdensome debt ratios. As shown, the decline rate in economic growth since 2007 shows the real problem, despite fits and starts of activity the Eurozone countries simply cannot generate an economic liftoff.

Furthermore, as I stated previously:

“…the recent surge in the US Dollar will likely suppress demand for exports, particularly with Japan, the Eurozone and China either in or near recessions. When you factor in that exports to our major trading partners comprise roughly 40% of domestic corporate profits, the impact to profitability could be greater than currently anticipated.”

This is an important point as the dollar is not surging due to rapidly increasing economic strength, but rather due to a “flight to safety.” Currently, the U.S. is the “only girl at an all-boy dance” and historically these “flight to safety” rotations have tended to be fairly short lived.

While none of this analysis suggests that a domestic recession is imminent, it does suggest that the hopes that the U.S. can “decouple” from the rest of the world’s deflationary drags are likely misplaced. As shown in the chart below, the U.S. economy has historically been unable to achieve accelerating rates of economic growth when both the EuroArea and Japanese economies have been weak.

The current detachment of the U.S. economy (red dashed circle) will most likely be unable to withstand the drag of economic weakness from two of its major trading partners. With Q3 estimates already being ratcheted down, any impact from geopolitical unrest, weather or a misstep in monetary policy could have a substantial impact to already strained financial markets.

Of course, this does not mean that the ECB, Japan, or the Federal Reserve won’t continue to implement further expansions of monetary policy despite limited evidence any efficacy. As Reuters reported this morning:

“European Central Bank Executive Board member Yves Mersch warned on Monday about the negative side effects were the central bank to start buying up government debt, urging political leaders instead to reform their economies to boost growth.

 

‘Easing of monetary policy cannot work effectively when the European economy is structurally not in good shape,’ Mersch said in a speech at an annual banking conference in Frankfurt.

 

He also questioned the impact that such purchases, known as quantitative easing (QE), had in Japan, referring to its unexpected slip into recession in the third quarter.

 

A central bank that began buying government debt risked being dominated by fiscal pressures, Mersch said, while rising debt levels may make it hard for the bank to control inflation.

 

‘That in the course of this our balance sheet expands is neither an end in itself nor a fetish,’ but rather a consequence, Mersch said.”

All of this reminds me of Albert Einstein’s definition of “insanity.” With deflationary pressures surging in the Eurozone, China and Japan, it is unlikely that the U.S. economic “renaissance” has finally arrived. However, given that the U.S. already well advanced into the current economic expansion as the rest of the globe fades, there are relatively few options available.

The implications to investors are important. The current growth in domestic profits is one of the last remaining footholds of market “bulls.” With valuations now expensive, interest rates near zero and yield spreads flattening, the risks to the markets have risen substantially. While this doesn’t seem to be the case as markets push up against all-time highs; it is worth remembering that we saw much the same in early 2000 and 2007. This time is likely no different, only the timing and catalyst will be.

However, if you disagree and believe that we have entered into the next great bull market, it is worth leaving you with this quote from fellow “bull” Anatole Kaletsky:

“Even if economic conditions continue improving, equity prices are bound to fall sharply at some point, inflicting painful losses on investors. This is what happened in 1987, roughly five years into the last structural bull market. Boom-bust cycles are inevitable because improving economic conditions encourage speculative excesses, which are then blown away as greed gives way to fear.

 

But the bust cannot come before the boom — and global economic conditions suggest that a full-scale stock-market boom may be just starting.“

My job is simple – I analyze the risk of having money invested. As Anatole correctly suggests, at some point “hubris” will give way to “fear.” It is at these macro-turning points that it is crucially important to remember the “math of loss” and the long-term impacts on your financial well-being. We know very little about what the future holds and betting on the “fortune-telling” abilities of Wall Street has rarely been a profitable strategy.