VEON FINANCIAL SERVICES, INC.
A Registered Investment Advisor
Joan M. Veon, CFP - Editor
Volume 14, Issue 4
P. O. Box 77
Middletown, MD 21769
"TRANSITION: THE DEMISE OF THE DOLLAR?"
As the first year of the Third Millennium comes to a close, we must ask ourselves if what transpired in the markets is a glimpse of what is in store for us in the future. To be honest, we have seen "The Perfect Economic Storm." Is it over or is it just beginning? In order to answer that question, if it is possible, we must look at the year in total and see if the various storm systems are going to dissipate or if they are going to take on a fury of their own. Are we going "back to the 70's" or forward to "The Unexpected"?
According to the dictionary, transition means "passage from one state, place, stage, or subject to another" and "change." Change is defined as "to make or become different".
While it is possible that each of the market patterns could have more than one facet or "personality", a number of variables are at play which could lead to a number of different outcomes. Before we identify some of the known (versus unknown) variables, let us consider "A Return to the 70's ".
A Return to the 70's
In September, I wrote that the same variables which were instrumental in the economic recessions of the 70's are currently at play today. The primary variables are: (1) Currency crisis (2) Trade Deficit (3) Israel and (4) Oil. The secondary variables which are affected by the primary are: Interest rates, gold and Treasury Bills versus the stock market.
(1) Currency Crisis: Dollar versus the euro
In August 1971 Nixon finalized the break with the gold standard when he refused to convert the gold- backed certificates of any foreign country into gold. This in turn created a global currency crisis as all of the countries which relied on the gold-backed dollar to secure their currency had to rethink what stability was. As a result, over the years the dollar has dropped in value against the Deutsche mark (DM) (now replaced by the euro) and the yen from 3.66 DM and 3.57 yen to almost one on each of these currencies.
The new currency crisis of the Third Millennium is the euro which was birthed on January 1 1999 at a value of 1.17 to the dollar. Although the euro, dollar and yen were equal in value within a five percent difference in January 2000, the euro has dropped to under $0.88 on the dollar. The whole question now is how to strengthen the euro. THIS IS THE $64,000 QUESTION. FOR IN STRENGTHENING THE EURO, THE DOLLAR MUST WEAKEN WHICH THEN BIDS THE QUESTION, "WHAT WILL MAKE THE DOLLAR FALL?
(2) Trade Deficit
In the 1970's the U.S. went from running trade surpluses to trade deficits, i.e. we exported more than we imported. In the early 70's our trade deficit ran $15-20B a year with the stock markets coming under attack because of the trade deficits. During the 70's and 80s we closed our steel mills and transferred much of our manufacturing to Asia, specifically China and Japan. Most recently China surpassed Japan in having the highest trade imbalance with the United States.
Today our trade deficit is running at accruing in one month, $25-$30B, that which in the 1970s used to take a whole year! Our total trade deficit stands at $400B or more than 4.5% of Gross Domestic Product which is what we spend on defense.
In 1973 the United States supported Israel in the Yom Kippur War by supply them with military equipment. This pitted the US and Israel against the oil producing Arab countries. Today with oil prices rising, Israel has a great deal of unrest in Palestine. Although President Clinton has gone to great lengths to bring peace to the Middle East, he has not been able to do so. I was privileged to cover the Israel-Syria Peace Talks in Shephardstown, West Virginia which is fifteen minutes from my home.
Interestingly enough when I first visited Israel in 1974, every single Palestinian woman was pregnant with two or three little ones. When I asked my tour guide about it, he told me that "The Palestinians were looking to raise an army from within to overthrow Israel." He was not too concerned. However, today all these babies are in their late twenties to early thirties. I have to admit whole heartedly that Israel deserves some of what she is in for because the Israelis stole most of the rich olive groves and farms from the Palestinians who had toiled the land since the time of Christ. However, these blood brothers will have to work out their differences. This is one family feud which is worse than that of the McCoys and it appears that 2000-2001 is the time in which they will come to some conclusion!
In the 1970s, the Muslim oil producing countries plus Venezuela got together and created the Oil Producing Economic Countries, known as OPEC. In order to voice their outrage that the United States would side with Israel in the Yom Kippur War, they embargoed oil for the first time in history. Oil prices rose from $2.50 bbl. to $12.00 bbl. in 1973 and then later on when the Shah of Iran fell, to $35.00 bbl. causing inflation to rise to 11% and 16% respectively.
Today after dropping to 30 year lows, oil has now climbed to new highs, rising 30% in the last year. This is one of the variables which has caused many companies to declare lower earnings. Unfortunately the United States never implemented a National Oil Policy and we are still today as vulnerable to an oil embargo as we were thirty years ago!
Depending on what happens above, will determine how gold, interest rates and Treasuries and the stock market respond. We are going to consider some different scenarios.
(1) The Dollar versus the Euro
In the September economic newsletter, I outlined all of the key financial changes which were falling in line with "A Return to the 70's". These included the major and secondary variables. Since then, all of the subsequent reports by The Wall Street Journal, The Financial Times, BusinessWeek, and CNBC Financial News, all support the changes which are occurring and which could lead us into a repeat of the 70's. What I have noticed is that there is a big disparity in how the economic situation of the U.S. is portrayed in American financial newspapers versus the European newspaper, The Financial Times.
Most of the headlines have to do with the dollar (versus the euro). When we consider the dollar, perhaps we could equate it to the blood in the body. If the blood is flowing to all parts of the body, we can say that a person is in good health, if there is a blood clot anywhere in the body, or the heart is clogged, blood cannot keep the body healthy and functioning. Similarly if our economy is spending too muchnational, trade or current account deficit, or if our economy is slowing down, then the dollar will be sick Let's take a look at what the financial newspapers are concentrating on:
U.S. Financial Newspapers
WSJ - 11/29: "Dollar Falls Against Key Currencies"; "Nasdaq Falls Again as Industrials Fall"; Barrons 11/29: "What the US makes, the world takes "
FT: - 10:27: "Shadow Falls on Corporate America"
11/29: "The US slows"
11/25-26: "Jitters on the increase over US hard landing
U.S. Financial Newspapers
WSJ - 12/1: "Euro closes above 87 cents as dollar hurt by Economic data, stocks plunge"
FT: - 12/1: "Slowdown Ends Dollar's Bull Run - Data on US Growth and gloomy outlook for tech companies may Herald revival for euro" and editorial: "Keeping faith In the dollar"
From the above you can see there is an emphasis on the dollar and the euro. The December 1 Financial Times article entitled, "Slowdown Ends Dollar's Bull Run" is extremely key. In it Andrew Hill claims that the 3 cent rise of the dollar for the week ending December 1 is enough of an increase to show that the euro has now turned around. He writes, "market- watchers have often heralded the revival of the euro but there is a growing feeling that this is
the real thing." What an insult! Three cents and the dollar is out! To think we bailed the whole lot of them out after WWII and here they are saying a three cent change signals the death of the dollar! In an editorial that same day called, "Keeping faith in the dollar," they write,
Could the mighty dollar be vulnerable? For years, the unwavering strength of the US economy has kept investors' money pouring in and has ensured a strong currency. But now that the country is experiencing a sharp slowdown, fundamental questions are being asked about whether the dollar can maintain its exalted position. A series of negative economic figures this week has knocked the currency down. Third quarter growth to 2.4%the slowest in four yearswas followed with news of the first drop in personal incomes in two years. US companies are also facing the start of a credit squeeze as financial markets weaken and banks become more careful in their lending. These factors could also stem the flow of direct investment, particularly from Europe which has been an important prop for the dollar. THE OUTLOOK FOR THE DOLLAR WILL ULTIMATELY, REFLECT THE MARKET'S JUDGMENT ON WHETHER THE US CAN CONTINUE TO DISPLAY THE DYNAMISM OF THE PAST DECADE (emphasis added).
The attention which the euro is receiving is of great interest to me for if the dollar is about to lose its status as the "world reserve currency", then what this heralds is a MAJOR SHIFT FROM US ASSETS TO EUROPEAN ASSETS AND INVESTMENTS as well as the DEMISE OF THE ECONOMIC STRENGTH OF THE DOLLAR! Two other major indicators also need to be considered: the international magazine, "Global Finance" and the powerful global economic conference, the World Economic Forum.
In the December 2000 issue, the front cover of this magazine featured a strongman flexing his muscles in which the muscle is a dollar. They show someone pricking the muscle with a needle while the headlines read, "The Steroid Dollar: When Will it Pop?". They write,
The dollar can defy economic fundamentals for a while but there are signs the party may be ending soon. By almost any conventional measure of economic fundamentals, the dollar is overvalued. The raging trade deficit and negative current account numbers racked up by the US economy would have sent most currencies into a tailspin long ago but the greenback keeps setting new records for strength. The decade-long growth spurt is based on a convergence of special events and technological achievements that have created a unique cycle of productivity gains and expansion with low inflation. As other countries embrace the same information technology revolution that has turbo-charged the US economy, the dollar's relative dominance will erode.
In the magazine's editorial, they write: "The dollar is still a demon of strength, thrashing other currencies left and right with an air of invincibility that the real numbers don't justify. Common wisdom tells us that the dollar has soared over the past decade because the US has been the pre-eminent innovator of the information technology field. But other countries are catching up and thus the[ir] unique competitive advantage is slowing down."
The World Economic Forum
I have been most fortunate to cover the 1998 and 2000 Forums and to be invited to cover the upcoming 2001 Forum in Davos Switzerland. One of the theme's of that conference is "The Dawn of a European Era?". Held yearly for the past 30 years, I find it quite interesting that CEO's from the top 1000 multinational and transnational corporations, along with world leaders, academia, and key leaders from the United Nations hierarchy will debate this topic.
In their pre-conference documents they write, "The strong economic prospects enjoyed by most European countries are creating a new sense of optimism and confidence about the continent's future. What actions are still needed to rid Europe of labor and market rigidities so that the continent can emulate the productivity gains enjoyed by the US economy? Discussion in Davos will provide an opportunity to assess the future course of the euro." What
could bring the dollar down?
It appears that the most primary factors would be our trade deficit and our huge financial debt. As mentioned, the trade deficit will top $400B this year. In all the article I have seenboth domestic and foreign, the trade deficit is cited as the primary factor to pull the dollar down.
What could exacerbate the fall of the dollar? (1) Falling stock prices as a result of reduced earnings due to the euro and higher energy prices, thus leading to an overall economic slowdown in the U.S. or (2) foreigners taking their money out of Treasury bills, notes and bonds either because they need the moneyif Japan's economy takes a turn for the worst and they need to liquidate their savings which is invested here or because they feel America no longer is a bastion of strength.
As of December 5, "[t]he euro forged to a ten week high against the dollar amid concern over the health of the US economy. Underpinning the euro's rise has been growing fears that the US is heading for a swift and bumpy landing. Avinash Persaud, global head of research at State Street Bank said he had started to recommend clients build long euro positions." Persaud said, "It is not just that the USA economy is slowing, but that for the first time in a while European assets have been outperforming in dollar terms." David Bloom, currency strategist at HSBC said, "The euro is the only one of the major currencies which is not afflicted by a structural imbalance. The dollar has its current account balance and the yen its fiscal imbalance. If things go wrong with the global economy, the euro zone should be best able to handle it" (Financial Times-FT, 12/5/00,1). The good news is that the dollar remained strong throughout the five-week presidential uncertainty.
Lastly, the November 18-19,2000 Financial Times reported that according to "Federal Reserve Lawrence Lindsey, Bush (now President elect) might favor a weaker dollar."
(2) Deficits and More Deficits
Most people don't really understand the deficits which America has, not only to its citizens but to investors from around the world. Just as we might charge items on a charge cardmost of the time because we don't have the money at the timeso too, America has charged. It was President Roosevelt who took the advice of a socialist British economist, John Maynard Keynes, to deficit spend in order to get us out of the Depression, 67 years later, we find that every level of government is broke. Al Gore instituted a program at the request of Bill Clinton to "reinvent and reinvigorate our entire national government." In order to do so, they opened up ways for corporations to bail every level of government out by a new arrangement called "public-private partnerships."
The $5.8T which the American people owe for money they have borrowed from the Federal Reserve has been accruing interest. The question which should be asked is, "Why can't the American people forgive themselves the interest on the federal debt?" The answer is, "Because they do not owe it to themselves, they owe it to a private corporation called "The Federal Reserve."
The Trade Deficit
How the world monetary system is set up is that our trade deficits or surpluses are according to how much we import and export. America currently imports far more than we export. This is because we are no longer a manufacturing society but a service society. We consume, we do not produce. This automatically puts us at a disadvantage. In addition because of the strength of the dollar, it puts our exports at a disadvantage since our dollar is strong which makes our exports very expensive and our imports cheap.
The nation's reliance on foreign capital to finance the economy is growing significantly. The US is now absorbing roughly 70% of the world's available capital. If foreign capital stopped flowing into the US and started flowing to Japan or Europe, the economy would be in huge trouble. According to Brian Wesburg, chief economist at Griffin Kubik Stephens & Thomson, the dollar's strength is a byproduct of tight US monetary policy. Because the Fed is restraining the amount of liquidity in the economy. The greenback has no where to go but up. [However,] there is a school of thought that says the dollar isn't getting too strong" (Barron's, 12/27/00).
With regard to our deficit, according to Barron's, "The US is now absorbing roughly 70% of the world's available capital. If foreign capital stopped flowing into the US and starting flowing to Japan or Europe, the economy would be in huge trouble" (Barron's 11/27/00). There are others who are worried about an outflow from the US to Europe and one of them is British economist and writer Martin Wolf who speculated recently, "in 1999 a current account deficit of $339B was more than financed by $228B in net foreign private sector purchases of US non-governmental securities and $130B in net inflows of foreign direct investments. If this inflow turned into an outflow, the US would have to finance both that outflow and the current account deficit. This could be only done with huge inflows, the US would have to finance both that outflow and the current account deficit. This could only be done with huge inflows of short-term speculative capital or purchases of dollars by foreign governments and central banks" (FT, 12/6/00, 14). Basically all of these people are saying the same thing.
(3) War in the Middle East Prompting a Replay of the 1970s
All of the same variables are at play today. The Palestinians are allied with the surrounding Arab countries which could be quite formidable if they were to have an all out war. I am afraid to speculate but it is a strong possibility that "we ain't seen nothin' yet!" This would precipitate very high oil prices, major problems with corporate earnings, high inflation, and perhaps a rise in interest rates.
(4) Possible Outcomes
There are a number of possible outcomes from all of the above:
1. The Japanese are the second largest investor in our Treasury bills, next to the Saudis while the Chinese are the third largest investor. Should the Japanese not be able to stabilize their economy, they may need to liquidate some of their T-bills. Obviously this would cause some difficulties prompting the Fed to raise interest rates, the stock market to drop and foreign governments to bail us out.
2. If we continue with a "bumpy landing", a loss of confidence might occur, prompting investors to
go to Europe.
3. If foreigners decide our trade and/or federal deficit is too high, we might see an exodus of
investors flea to Europe, which would cause a drop in the dollar and an increase in the euro.
4. If there is a war in the Middle East and energy prices escalate, we just might find ourselves in
the same position as in the 1970s when our cost of living rose substantially causing inflation to reach double-digits.
5. If other countries catch up with our technological edge, there will be a shift from the U.S.
THE LAST WORD
The last word belongs to the Federal Reserve who controls the monetary system of the United States of America. Since they are a private corporation and they are concerned about their bottom line, we must play close attention to what they say and do.
First of all, we should understand what they did for the Clinton Administration. In the November 12 Washington Post magazine, the front cover featured a picture of Greenspan and Clinton with the heading, "The AllianceHow Greenspan and Clinton helped build the boom." The writer, Bob Woodward, tells how when Clinton became president he made a deal with Alan Greenspan who told him if he reduced the federal deficits, he would lower and keep interest rates low. In Clinton's first State of the Union address on February 17 1993, he announced a $140B deficit reduction package. Within a week, long term interest rates began to fall to a 16 year low, with the yield on the 30 year Treasury bond dropping below 7%. There were several democratic Senators who urged Clinton to drop his five year deficit target. Woodward writes, "Greenspan told the House Banking Committee, 'If you appear to be backing off, I think the markets would react appropriately negatively.' Clinton's hands were effectively tied. He stuck with this deficit-reduction and which then passed both the House and Senate." Needless to say, the rest is history. When Clinton was elected, the Dow was at 3168. It has effectively tripled. The headlines in the Wall Street Journal on January 2, 1992 read, "Recession. War. Upheaval. And Yet the Bull Markets Run".
Currently there is all kinds of speculation as to how President-elect George Bush will work with Alan Greenspan and the Federal Reserve since his father did not. I think from what Bob Woodward wrote above, that it is clear, Alan Greenspan is writes the tune while the president marches to the tune.
As a result of a speech Alan Greenspan gave on December 5, the Dow rose 339 points or 3.2%, its third largest one day gain ever and the Nasdaq rose 274 points or 10% which was its largest one day gain since its inception in 1971. What did Mr. Greenspan sayexactly? The press reported it as "The Fed has said basically they're very cognizant of the impact all the [credit] tightening has had...and now the risks are on the other side." However, Greenspan said,
" Technological innovation has revolution- ized the conduct of business over the past decade, resulting in rising rates of productivity growth.
 Higher prospective rates of return from the application of newer technologies has led to a surge in business capital spendingwhich in turn has contributed to a significant pickup in household spending on houses, durable goods, and consumption more generally. It has contributed to the rise in the turnover of existing homes, engendering a marked increase in realized capital gains.
 Recently, wariness about risk again has increased as default rates on less than investment-grade bonds have moved higher, debt downgrades have become more common place and many high-flying dot-coms have collapsed.
 In periods of transition from unsustainable to more modest rates of growth, an economy is obviously at increased risk of untoward events. The sharp rise in energy prices, if sustained, is worrisome. Rising energy could engineer risks to both inflation and economy activity. If accommodated by monetary policy, the jump in energy prices could spill over into general inflation and inflationary expectations as was so evident in the 1970s.
In light of the above, you will notice that Mr. Greenspan concentrated solely on energy, not even addressing the euro/dollar relationship.
Lastly, I covered the June Bank for International Settlements meeting in Basle Switzerland. The BIS is the global body which determines what kind of growth the world is going to have and where. At this meeting, Managing Director Andrew Crockett said, "It's Europe's time to grow." In response to a question which was a follow-up to a question I asked, Crockett said,
In the short-term, US current account deficit has been covered by even larger capital inflows putting upward pressure on the currency and those larger capital inflows have been driven by the perception of profit opportunities in the United States either through physical investment or through investment in financial assets. Over the longer term, we know that no country goes on indefinitely with a large current account deficit, although it can happen. The US economy is performing very well but at some state there are potential factors that would cause it to change: (1) Increase profit opportunities in European countries (2) the change of investor expectations with regard to asset prices, and (3) the slowing of the US economy to a more moderate pace.
I have underlined all of the same points which I have written about in this newsletter. For your information, it was not until I was finishing this newsletter that I looked at this quote.
As we go to press, 12/19/00, CNBC has just today made the connection between a weaker dollar and stronger euro!
Is technology dead? No, it was forced into hibernation. Obviously the rules of the game have changed and we are in a transition time which just may see a shift from the dollar to the euro. It is my responsibility to help you make money and to protect your investments. It is up to you to determine if you agree or disagree with the conclusions I have reached. If we are in a period of transition, I can tell you the next place to boom is Europe. Should there be war in the Middle East, energy is the key place to invest. Therefore investment recommendations remain the same as September: energy, Europe, euros, basic metals, and an increase in cash.
What have we re-learned in 2000? One day at a time and count your many blessings!
Post Script - 12/19/00:
As we go to press, the market is waiting for news as to what the Federal Reserve is going to say and do. Various analysts have provided their comments with regard to the economy. Morgan Stanley has projected a "hard landing" while others say that the Fed will change its position from "inflation watch" to "recession" and highlight energy costs as one of the reasons for their change.
Newsletter subscriptions are available for a yearly cost of $36.00 for 2001 subscriptions. This entitles the subscriber to a minimum of three and a maximum of four newsletters. All information is fresh, gleaned from current domestic and international newspapers, magazines, and conferences by Joan Veon, CFP. All rights reserved. Copyright December 2000. Send $36.00 to VFSI, P. O. Box 77, Middletown, MD 21769-0077.
VEON FINANCIAL SERVICES, INC.
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"TRANSITION: THE DEATH OF THE DOLLAR?"
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