Investing at the Limits of Monetary Policy

October 9th, 2014
in contributors

Macro Strategy review for October 2014

by Jim Welsh with David Martin and Jim O'Donnell, Forward Markets

Economics has often been called "the dismal science" for good reason. President Harry Truman became so frustrated with the equivocations of his economists that he said, "Give me a one- handed economist! All my economists say, '...on the one hand... on the other.'"1 As the world was mired in the Great Depression in 1936, John Maynard Keynes wrote The General Theory of Employment, Interest and Money, which offered a theory for dealing with recessions.

Follow up:

When private demand slackened due to a recession, Keynes advocated for intervention by the government and central bank to rejuvenate demand in the economy. This entailed the central bank lowering interest rates and the government launching infrastructure projects to inject government spending into the economy, which would then increase demand and create jobs. The deficit created by government spending during a recession would be funded by the issuance of government bonds. Once the economy returned to a path of steady growth, government surpluses would be used to pay off the bonds issued during the recession. The logic and common sense of Keynes' theory made it easy to embrace. Any time a recession developed after World War II, Keynes' game plan of lower rates and deficit spending was always implemented. By then the Federal Reserve (Fed) and Congress had embraced it so completely that President Truman's wish for a one-hand economist was finally realized since there was only one widely accepted economic option and no "on the other hand."

For the most part this economic prescription worked well. In seven of the 15 years after World War II the government actually ran a surplus, and in the 27 years between 1946 and 1972 economic growth averaged 4.15%. There was one problem, however: in the 300 months from 1957 to 1982 there were 64 months of recession. During these recessions, the unemployment rate spiked before the therapeutic effect of lower interest rates and fiscal stimulus turned the economy around. A recession caused the unemployment rate to zoom from 2.6% to 5.8% in 1954 and from 4.0% to 7.4% in 1958.

Between 1968 and 1976 it soared from 3.4% to 8.9%. This pattern was unacceptable to the political system since elections could be lost if they occurred during a recession. To address this problem, Congress passed the Full Employment and Balanced Growth Act, which was signed into law by President Jimmy Carter on October 27, 1978. In addition to the Fed's primary mandate of stable prices, the act would order that the Fed also conduct policy to ensure a low unemployment rate was maintained.

Labor costs make up approximately 65% of the cost of goods sold. Historically, full employment meant there was very little slack in the labor market, which often led to higher wages as companies bid up wages to keep or attract workers. Rising labor costs result in higher prices as companies are forced to raise the prices of their goods and services to cover higher labor costs. Wage inflation is far more intractable than inflation caused by higher food prices due to a drought or a temporary shortage. For the Fed to pursue a policy that would achieve full employment, it risked undermining its mandate for price stability. The contradictory nature of the two mandates wasn't as important as passing legislation at a time of high unemployment with the words "full employment" in the title. For Congress, the notion of policies that are contradictory is almost perfection, since half the voters will be satisfied and the other half ripe for campaign contributions to fix the new problem.

Normally, people or organizations wouldn't be given any additional responsibilities unless they had handled their original tasks well. Prior to 1979, the Federal Reserve had one policy mandate, which was to conduct monetary policy so prices remained stable. In 1965, the Consumer Price Index (CPI) rose a scant 1%. By 1975 it exceeded 12%, on its way to 14% in 1980. There were mitigating circumstances: the Organization of Petroleum Export Countries (OPEC) cut back on oil production and oil prices soared from $3.00 to $12.00 a barrel in 1974. Even with this concession, no one considered Fed chairmen Arthur Burns or G. William Miller as maestros of monetary policy. By any standard, the Federal Reserve did not do a good job of accomplishing their stable price mandate. This poor performance, however, did not dissuade Congress from giving the Fed the potentially contradictory second mandate of full employment.

Ironically, the tide of history was about to change after Paul Volker became Fed chairman in August 1979. Volker increased the federal funds rate to 18% in 1981 to break the back of inflation, which resulted months between 1983 and 2007 there were only 16 months that the economy was in recession. By comparison, there were 64 months of recession in the 300 months from 1957 to 1982, as stated previously. The recessions during this 25-year period were more frequent and deeper than the shallow recessions in 1991 and 2001, which each lasted eight months. Between 1983 and 2007, the CPI spent most of its time range bound between 2% and 4%, much more under control than it had been in the 1970s. After peaking at 10.8% in November 1982, the unemployment rate consistently trended lower until it was back under 4% in 2000-returning to levels of the 1950s (see the U.S. Unemployment Rate chart on page 1). On the surface it appeared that manipulating monetary and fiscal policy had achieved the economic holy grail of full employment, relatively low inflation and decent economic growth. If the business cycle hadn't been completely eliminated, it had at least been tamed.

The apparent success of monetary and fiscal intervention did result in a number of unintended consequences. The economic stability encouraged more risk-taking and a greater use of leverage. For instance, hedge fund manager Long-Term Capital Management L.P. (LTCM) had two Nobel Prize winners for Economic Sciences on its board and was levered 100 to 1. After the LTCM hedge fund imploded in the summer of 1998, the Fed stepped in to stabilize the financial system and provide a floor under the stock market.

This intervention and memories of the Fed's intervention after the 1987 stock market crash provided investors confidence that the Fed would always intervene, which became known as the "Greenspan put." This assurance fueled the dot-com bubble and a 378% increase in the Nasdaq's composite from its low in October 1998 to its high in March 2000. While speculation ran rampant and valuations reached the sky, the Fed saw no bubble and took no action.

In 2004, investment banks petitioned the Securities and Exchange Commission (SEC) to increase their balance sheet leverage from 12 to 30 times their capital. Since the volatility of the business cycle had been low for a long time, the SEC granted the request and the investment banks proceeded to leverage their balance sheets on the "safest" investment of all. Home values had not declined since the depression, so what could go wrong? After 2002, lending standards disappeared, liar loans became the norm and median home values rose 50% above their historical norm of 3.5 times median income. Despite a plethora of warning signs, including TV ads in 2004 and 2005 promoting mortgage loans of 125% of a home's value, the Fed saw no housing bubble and exercised zero supervision over home lending.

The second and more important unintended consequence was an enormous increase in debt between 1982 and 2007. In 1982, household debt was 44% of gross domestic product (GDP), but by 2007 it had climbed to 98% of GDP. Homeowners levered up on the personal ATM. Based on analysis by Federal Reserve Board members Alan Greenspan and James Kennedy, mortgage equity withdrawal was responsible for more than 75% of the growth in GDP from 2003 to 2006. In other words, rising home values and housing market speculation made the extraction of home equity possible and was far more important than the increase in personal income in powering economic growth during the housing boom. This made the economy far more vulnerable to a decline in home values and the commensurate cessation of home equity extraction.

Household debt escalation was only part of the widespread debt increases in response to low interest rates and ample liquidity provided by the Fed. Total credit market debt, which includes private and public debt, was 165% of GDP in 1982 and reached 370%, or $3.70 for each $1.00, of GDP in 2007. Although the Fed increased the federal funds rate from 1% in June 2004 to 5.25% in 2006, it never really tightened credit availability. Spreads between Treasury bonds and corporate bonds continued to narrow until mid- 2007, even with the rate increase. This provided clear evidence that risk-taking and liquidity remained available despite the increase in the cost of short-term money rates.

From 1982 until 2007, monetary and fiscal policy was manipulated to ward off recession and keep unemployment rates down while debt grew as if on steroids. Even though the debt funded an increase in demand, economic growth actually slowed. Between 1946 and 1972, GDP growth averaged 4.16%, 28% faster than the 3.23% average from 1982 through 2007. The enormous increase in debt borrowed demand from the future, but really didn't help the economy grow faster. In effect, each additional dollar of debt between 1982 and 2007 increasingly generated less than a dollar of GDP growth. Since debt as a percentage of GDP rose from 165% in 1982 to 370% in 2007, the value of each additional $1.00 of debt only generated $0.44 of GDP in 2007.

At the end of the first quarter this year, debt as a percentage of GDP receded from 370% to 347%, primarily because household debt has declined as a result of homeowners defaulting on mortgages. The decline in household debt has been mostly offset as government deficit spending soared during the recession. Total public debt as a percentage of GDP soared from 63% in 2007 to 112% as of June 30, 2014, and has skyrocketed from less than $6 trillion to $17.63 trillion.

Of course, the Fed can't take all the credit (pun intended) for the massive debt buildup since Congress has been an active coconspirator for decades. Keynes' economic theory depended on fiscal policy being a counterweight to swings in private demand. When private demand slumped and a recession developed, fiscal deficits were a useful tool to pump up demand through government spending. The resulting deficits were financed through the issuance of government bonds and then paid off as economic growth generated government surpluses. The strength of Keynes's theory is its simplicity. What Keynes did not appreciate, however, was that its success over time depended on the discipline of Congress not to spend surpluses and instead use them to pay down accumulated government debt. After the end of World War II, government debt as percentage of GDP was 121.7%, but by 1972 was less than 40%. Between 1946 and 1960, the government posted a budget deficit in seven out of 15 years. However, from 1961 through 1972 the only year of surplus was 1969. The main contributor to the decline in debt as a percentage of GDP came from economic growth, which averaged 4.16% between 1946 and 1972. It really is simple math: if GDP grows faster than the growth of debt, debt as a percentage of GDP falls; when debt grows faster than GDP, the ratio rises, as it did between 1982 and 2007.

In 2007, federal debt as a percentage of GDP was 64.5%-almost double 1982's ratio of 32.5%. This increase occurred because the federal government ran a budget deficit in every year except four: 1998, 1999, 2000 and 2001. Capital gains tax revenues from the dot-com bubble were one of the primary reasons for the surplus years. Thus when the stock market declined in 2001 and 2002, those surpluses vanished. When it comes to government deficits, we are agnostic. A deficit is a deficit: whether it is the result of government spending or tax cuts, either way, future generations are on the hook to pay for them. This is one case where the means (liberal or conservative ideology) does not justify the net result.

Both parties would, of course, argue this point. Ironically, each party is the opposite side of the same coin, which is currently valued at more than $17 trillion of debt.

A prominent Nobel Prize winning economist has argued that the reason the current recovery is so lackluster is because the government stimulus plan was too small. In other words, if the government had increased outstanding debt since 2009 by $8 trillion or $10 trillion instead of $6 trillion, the country would be better off. This argument totally ignores the fact that since 1982 each additional one dollar of debt has increasingly produced less than one dollar of GDP growth. Hopefully this economist has lots of children, grandchildren and great grandchildren so they can pay for his ideological largesse. A 3% annual budget deficit is commonly

accepted as good by the majority of mainstream economists. This is like saying going broke is not a good thing, but if we're going to go broke, it is better to do it slowly. But, according to the U.S. Office of Management and Budget, the average annual deficit from 1946 through 2013 was 2.09%, which has led to $17.6 trillion in federal debt.

A May 2012 ABC 20/20 news report entitled "Losing it: The Big Fat Trap" reported that Americans spend $20 billion a year on weight loss programs and diets with disappointing results. Losing weight is fairly straightforward-eat smaller portions, eat less fattening food and be more active. Getting our fiscal house in order is also straightforward-no more deficits and use surpluses to pay off prior debt. With each political party pitching their formula of spending or tax cuts to voters who, on balance, spend more time focused on sports, reality TV and social media, the odds of fiscal discipline breaking out anytime soon are slim. As we discussed in the June MSR section "Economic Enervation," Congress could also reduce the number of its regulations, which have likely contributed to slower economic growth since 1982. Since both political parties use regulations as a primary fundraising tool, we don't expect a "let's roll back regulation" movement to sweep the nation. Nor do we anticipate that Congress and the Federal Reserve will abandon their multidecade unsuccessful attempt to tame the business cycle.

There is a natural ebb and flow for everything on this planet, from ocean tides to seasons of the year. Recessions are a natural part of the business cycle, just as night follows day. In a practical sense, periodic recessions cleanse the economy and financial system of excesses, such as unneeded inventories or overleveraged companies. In this way, a balance is maintained between the supply and demand for raw materials, labor and credit, which ensures the underpinnings of the economy remain sound. The business cycle has been in existence as long as there has been something to sell and suppressed or eliminated with the ministrations of monetary and fiscal policy should have been deemed preposterous. Instead, hubris trumped common sense. In the pursuit of minimizing increases in unemployment and reelection, politicians embraced fiscal stimulus to ward off recessions but scorned the discipline to pay for the stimulus. The Fed has aided and allowed debt to grow faster than GDP, and in the process printed their way into a blind alley. With $3.47 of debt for every $1.00 of GDP, how much can the Fed raise rates without interest expense becoming a significant headwind for the economy and federal budget? At the September 2014 Federal Open Market Committee (FOMC) meeting, the median forecast for the 2017 federal funds rate was 3.75%.

We suspect the Fed will be as correct on the federal funds rate forecast as their projections for 3%+ GDP growth in each of the past four years. The Fed has trained investors to be so dependent on an accommodative monetary policy that markets are fixated on when the Fed will remove the phrase "considerable period" from the FOMC statement. There will come an "uh-oh" moment when the global financial markets realize that central bank monetary policy is tapped out and perception can no longer trump economic reality. In the meantime, global markets can find comfort in the fact that the European Central Bank (ECB) will probably launch their version of quantitative easing by early 2015, the Bank of Japan will continue to debase its currency and the Fed won't increase rates for a considerable period.

The Return of the Almighty Dollar and Deflation

Since 2010, a vocal chorus has proclaimed that hyperinflation and a crash in the dollar was right around the corner once the Fed became a serial advocate of quantitative easing in the wake of the financial crisis. Since 2008, the Fed has expanded its balance sheet from $900 billion to more than $4.2 trillion in 2014. Although neither a crash in the dollar or hyperinflation has reared its ugly head, it hasn't diminished warnings from proponents like Peter Shrill (fictitious name), who in a recent CNBC interview reassured viewers that the plagues of hyperinflation and the dollar's demise are still on their way. He's just been a bit early. As we have discussed previously, there are a number of reasons why hyperinflation and a collapse in the dollar has not happened and likely won't for some time. A stronger dollar is usually bearish for commodities and increases the deflationary threat from excessive debt. We will discuss dollar strength and commodity weakness in more detail in the emerging markets section of this commentary.

The classic definition of inflation is too much money chasing too few goods. Although the Fed has greatly expanded its balance sheet since 2008, most of the money has not made its way into the economy. Free reserves held at the Federal Reserve by U.S. banks totaled $2.71 trillion as of September 19, 2014. One of the reasons the current recovery has been mediocre is because there is too little demand, not just in the United States, but globally.

Capacity utilization rates around the world are low, which has kept business investment weak and inflation rates low. The U.S. Federal Reserve, ECB and Bank of Japan have been far more concerned about deflation and have strenuously tried to revive inflation with the greatest amount of monetary accommodation ever attempted. Most of the money created by central banks though is not coursing through domestic economies but sitting dormant. Although bank lending has modestly picked up in the U.S., it is still contracting in Europe, with banks more focused on strengthening their balance sheets than lending into a weak economy.

The velocity of money measures how fast each dollar of M2 money supply is turning over. When consumers and businesses are confident, the turnover of M2 rises as consumers spend more and business investment increases. The increase in velocity results in faster GDP growth and fosters a virtuous cycle of better job creation, business investment, wage growth and more bank lending. When they are cautious, consumers spend less, businesses hold back on new investments, banks reduce lending and GDP growth slows. As you can see, the velocity of money is at its lowest rate in more than 50 years and has continued to slow precipitously irrespective of the increase in the Fed's balance sheet. This is another reason why GDP growth has remained stalled around 2.5% during the last three years despite the efforts of the Fed. Those forecasting hyperinflation and a dollar crash are likely going to need even more patience.

On February 18, 2001, Treasury Secretary Paul O'Neill said, "We are not pursuing, as often said, a policy of a strong dollar. In my opinion, a strong dollar is the result of a strong economy."2 With his comments, O'Neill appeared to distance himself and the Bush administration from Robert Rubin's insistence when he was treasury secretary in the Clinton administration that a strong dollar was in the best interest of the United States. The dollar index topped out five months later in July 2001 at 121.29 and then declined in earnest in 2002. When the Bush administration failed to offer even token support, currency traders shorted the dollar with impunity. The dollar lost 42% of its value between July 2001 and March 2008, when it bottomed at 70.69. As the financial crisis erupted in the fall of 2008, international investors poured money into the dollar as a safe haven, and by March 2009 it had risen 27%. As the stock market recovered and financial market volatility calmed down, the dollar entered a broad trading range during 2009, 2010 and 2011, fluctuating between 73.00 and 89.00.

As discussed in the April 2014 Macro Strategy Review (MSR), we thought the dollar was on the cusp of a solid rally after trading in a very narrow range in 2012 and 2013: "The euro represents 57.6% of the dollar index, so a decline of 7.5% to 9.2% in the euro versus the dollar would add 4.3-5.3% to the dollar index. With the dollar index trading near 80.00, the decline in the euro would add 3.4-4.2 points to the dollar index, and easily enable the dollar to trade above near-term resistance at 81.30. Once above 81.30, the next level of resistance is 84.30 to 84.50, the highs in May and July last year." In the May MSR, just days before the peak in the euro, we wrote, "Shorting the euro has the potential to result in a profitable trade over the next year." On September 19, the dollar index traded as high as 84.78 and the euro fell to €128.30. In the September MSR our downside target for the euro was €128.25-128.75. The dollar and euro have reached our targets, and the dollar is overbought while the euro is quite oversold. This suggests that the potential for a two or three month rebound in the euro is probable, which should usher in a modest decline and consolidation of the recent gains in the dollar. This respite from dollar strength could allow commodities like oil and gold, which have been trending down and are also oversold, to experience oversold technical rallies. Although a bounce in the euro and pullback in the dollar is overdue, the long- term technical trends seem clear.

Between July 2001 and March 2008, the dollar index fell 50.6 points from 121.29 to 70.69. Using a common Fibonacci ratio to measure the rebound from a large decline, a 38.2% retracement of this decline would be 19.33 points, which targets a rally to 90.02. This target is just above the highs of 89.25 in November 2008, 89.71 in March 2009 and 88.80 in June 2010, so we expect the index to hit within the price range of 88.80 to 90.00 in coming months.

Should the dollar index reach this range as we expect, the odds of it breaking out above the range are good. The dollar has already tested this zone three times, so a breakout after a fourth attempt is very probable. A 50% retracement of the dollar's 50.6 point plunge from 2002 to 2008 would create a target of 95.99 while a 61.8% rebound (another common Fibonacci rebound from a large decline) would suggest a possible high of 101.97. We think the higher target more likely as after breaking through serious resistance at 89.00-90.00, a rally to just 95.99 seems too small, whereas a pop to 100.00-101.97 would be a more appropriate follow through. Finally, if we are correct about the eurozone's extended economic malaise, the euro will decline significantly from current levels.

As we discussed in detail in the September MSR, what happens in France and Italy matters as their combined GDP is 132% of Germany's. The structural labor market challenges within France and Italy are likely to take years to unwind, even if the politicians discover the courage to act soon. Any additional easing by the ECB will likely generate a more muted economic response in these two countries since the distinct labor market problems besetting them are beyond the reach of monetary policy. Limits to the scope of monetary policy are being reached in the eurozone, United States and Japan. The decline in the euro from €139.93 is a first step, but much more will need to be done to make exports from France, Italy and other southern European countries competitive in an intensely competitive global environment. The lag time between a decline in a country's exchange rate and a meaningful pickup in exports can range from nine to 18 months, so the recent decline in the euro won't begin to be felt until mid-2015 at the earliest. This suggests the euro will need to decline more in coming months so the eurozone receives a larger lift by the end of 2015. Our belief has been that the ECB will wait to move forward with its version of quantitative easing until after the results of the asset quality review (AQR) are announced on October 17. With interest rates already near 200-year lows in a number of countries, there won't be much additional interest rate stimulus to be gained from quantitative easing. Some countries have been able to sell long- term bonds at what seem like extraordinarily low rates, which will help the long-term fiscal health of those countries. The ECB's plans to further develop the eurozone's asset-backed securities (ABS) market could prove particularly helpful to small- and medium-sized European countries, which are especially dependent on their local bank for access to credit. However, it will take many months to organize, standardize terms and pass country-specific legislation as there are 18 different countries involved. The ABS market in the U.S. is $8 trillion, four times the size of the eurozone's. This will limit the amount and type of assets the ECB can purchase through.

The eurozone will make progress on all these issues in coming months, but economic growth is likely to remain stagnant in France and Italy. Overall we expect eurozone GDP growth to remain under 1.5% in 2015. Fears within the eurozone of a Japanese-style lost decade will likely increase, which will limit business investment, consumer spending and risk-taking in general. Many banks have strengthened their balance sheets in 2014 in preparation of the ECB's AQR, but more needs to be done. As noted in the September MSR, there are 10 to 15 banks whose Texas ratio is well above 100% and in desperate need of capital infusions. The Texas ratio measures a bank's nonperforming loans as a percent of equity and funds set aside to cover bad loans, and when it exceeds 100% that bank is technically bust. If growth in the eurozone remains as moribund as we expect, even healthy banks won't be comfortable increasing their lending. The ECB's efforts to force-feed liquidity into the eurozone economy through the banks will amount to the proverbial pushing on a string. The one policy option that the ECB has the most direct control over is the exchange rate of the euro, so we believe it will pursue lowering the euro's value and will continue to communicate its acceptance of a cheaper euro. For this and technical reasons, the euro has the potential to fall significantly from current levels.

The euro almost doubled from its low of €82.30 in October 2000 to its high in July 2008 of €160.08, an increase of €77.78. A 50% retracement of this huge rally would have been achieved with a decline to €121.19. The euro bottomed at €118.70 in June 2010 and again at €120.00 in July 2012. The overshoot of the €121.19 target is understandable since Greece was imploding in June 2010 and concerns whether the European Union would hold together were rampant in July 2012, prior to ECB President Mario Draghi's "whatever it takes" comment. Since the July 2008 top, each euro rally has made a lower high, which is a sign of longer term diminishing strength. The lows in 2010 and 2012 near €120.00 will likely be retested, and probably result in a decent short covering rally. We suspect this short covering rally will not represent "the pause that refreshes," but rather a failing dead cat bounce, which will set up an unsettling plunge well below €120.00. A decline of 40 points from the high of €139.93 in May would be consistent with the 40 point fall from €160.00 to €120.00, so we see €100.00 as one possible target.

A decline from the September 19 close of €128.52 to €100.00 would represent a 22.2% decline. Since the euro represents 57.6% of the dollar index, the dollar would receive a boost of 12.8% from the euro's decline, lifting the dollar to 95.58 from its September 19 close of 84.73. Since we expect additional weakness in the Japanese yen and a number of emerging market (EM) currencies, it is easy to see how the dollar index could reach 100.00-101.97 over the next nine to 18 months. Although these targets for the euro and dollar indices may seem a bit extreme, the fundamentals and chart analysis are aligned, which raises our confidence.

Emerging Markets

The iShares MSCI Emerging Markets Index (EEM)3 recently failed to break above the trendline that connects the highs in 2007 and 2011, then fell below intermediate support at $43.25. This failure suggests equity markets in emerging countries could be vulnerable to a decline of more than 10% since EEM could decline below $39.00 before reaching trend support. Combined with our stronger dollar outlook, it seems timely to review. EM economies will be buffeted if the dollar index climbs to 89.00-90.00 and especially impacted if it reaches 100.00-101.97. The impact will vary and will depend on a number of factors, including domestic current account deficit, domestic budget deficit as a percentage of GDP, dependency on imports of food and energy and domestic subsidies of food and energy purchases for the poor. Barring shortages, a stronger dollar is likely to weigh on commodity prices, which will be painful for countries like Brazil, Australia and Indonesia that rely on the export of commodities. Since most commodities are priced in U.S. dollars, those countries whose currency declines relative to the dollar will experience more inflation. Higher inflation and a weakening domestic currency could force the central banks of a further decline in currency. Even if the boost in interest rates stems the outflow of capital and stabilizes the domestic currency, higher rates punish domestic companies and consumers and often lead to slower economic growth. Currency crises are born when higher interest rates produce a weaker economy without stemming the outflow of money. This often forces the country's central bank to increase rates even more to stabilize its currency. Currency crises build slowly and then explode overnight, as money flees the country irrespective of the level of interest rates. They are not pretty or easy to contain and frequently lead to riots and revolutions. In today's global economy, a currency crisis could be especially dangerous and difficult to contain.

Countries that have large current account deficits are more vulnerable to a sudden depreciation in their currency's value should foreign investors decide to pull money out, since they must first sell the local currency in order to buy another currency. Countries that subsidize the cost of energy and food for their poor citizens are vulnerable to a sharp increase in their budget deficit if the global cost of food and energy materially rises or their currency declines. Large current account and budget deficits can lead to currency weakness that can undermine foreign investors' confidence.

Leaders of countries facing this quandary are confronted with a difficult choice: they can maintain the subsidies and the resulting higher budget deficit, risking a further decline in their currency that only worsens the deficit problem, or, they can lower the subsidies. If they lower the subsidies too much, however, they risk riots and even a revolution. In many developing countries, millions of people subsist on a handful of dollars a day and food and energy comprise a huge portion of their income and spending. Even a modest decrease in energy or food subsidies has the potential of making the difference between survival and starvation.

The variable domino in these outcomes is the relative strength of a country's currency. The factors that most contribute to a currency's direction are GDP growth, current account surplus or deficit, fiscal budget surplus or deficit and the rate of inflation. In general, a country with good GDP growth, a current account and budget surplus and low inflation is more likely to have a stable or rising currency. Conversely, countries with weak or negative GDP growth, current account and budget deficits and higher inflation are more likely to have a weaker currency. Countries with current since those deficits must be funded by international inflows. We ranked 12 EM countries by combining these four variables using data provided in a September 8 J.P. Morgan Securities report entitled "Emerging Markets and Outlook Strategy." As the nearby table shows, the best-performing countries have solid GDP growth, positive current account surpluses, positive or only modestly negative fiscal balances and low inflation. The reverse is true for those countries at the bottom.

Let's review four of the weaker countries in this table and their currencies. The Brazilian real (BRL) and Indonesian rupiah (IDR) peaked in the first quarter of 2011, began a gradual descent and then plunged after Fed Chairman Ben Bernanke's tapering comments in May 2013. Both currencies are hovering just above their 2008 and 2013 lows. The Turkish lira (TRY) has been in an ongoing downtrend since 2007 and continues to make lower lows.

The Indian rupee (INR) has also trended lower since 2007, but in a more controlled stair-step decline, and is currently comfortably above its low in 2013. Of these four currencies, the Turkish lira is weakest and the Indian rupee strongest, with the Indonesian rupiah and the Brazilian real on the edge of a breakdown below their 2008 and 2013 lows.

Needless to say, there are plenty of countries that may be negatively impacted if the dollar index strengthens as much as we think possible by the end of 2015. The impact will vary widely with those countries with the weakest currency and largest current account deficits most at risk. If you are invested in specific emerging markets, this would be a good time to evaluate them on the four metrics discussed.


Dollar strength in recent months has weighed on gold and resulted in a decline from around $1,350 in late 2013 to $1,208.2 on September 22. The combination of dollar strength and gold weakness has caused sentiment toward gold to become very negative, which creates the potential for a decent short covering rally. As noted previously, a modest correction of the dollar's recent rally should be supportive for a gold rally. The price pattern also offers hope for a rally from just above $1,200 an ounce to $1,300-$1,325, which would represent wave E of the triangle that has formed since the June 2013 low of $1,179.40. A close below $1,192 an ounce would greatly reduce the probabilities that a wave E rally was developing. If the long-term analysis on the dollar is correct, once the upcoming bounce is over, gold would be vulnerable to a decline well below $1,180.


On September 18, the S&P 500 Index made a new closing high, but a number of technical indicators are warning that a 5%-7% correction is coming soon. Our proprietary Major Trend Indicator (MTI) has continued to fade after topping out on September 8 at 2.87, closing on September 22 at 2.73. It is worth noting that the MTI peaked at 4.38 on January 2 and 3.77 on July 7. The pattern from the January 2 high shows that the recent rally was the third drive to a new high in the S&P 500 that registered a lower peak in the MTI. Market tops have often occurred after the third drive with lower momentum. Since September 2, the number of stocks making new 52-week highs has contracted from 231 to only 128 on September 19, when the S&P 500 made a new intraday high.

These figures are well below the 364 new highs on July 1. The new high/new low stock data on the Nasdaq have been far weaker.

On September 19, as the Nasdaq was making a new intraday high, there were only 90 stocks with new 52-week highs but 119 with new lows. For the week ending September 19, 174 stocks on the Nasdaq made new 52-week highs, but 232 stocks made new 52-week lows. That week, the Dow Jones Industrial Average was up 1.7%, the S&P 500 gained 1.3%, the Nasdaq was flat and the Russell 2000 Index was down 1.1%. One-third of Russell 2000 stocks are down by more than 10% year-to-date, according to Bespoke Research. Market breadth on the New York Stock Exchange (NYSE) made a new high on August 29 but did not on September 18 when the S&P 500 made a new closing high. This is the largest market breadth divergence since July 2011. Nasdaq breadth has been deteriorating since the Nasdaq advance-decline (A/D) line topped in early March. Breadth divergences that last six months or more are usually meaningful. The Nasdaq made a new high during the week ending September 19, but the Nasdaq A/D line peaked more than six months ago. As an example, the 1987, seven months before the October crash. It also peaked in the spring of 1972, eight months before the devastating 1973-74 bear market. In 2007, the NYSE A/D line topped on June 4, four months before the S&P 500 peak on October 9.

Large declines don't just occur because a few technical indicators are exhibiting weakness, as they are now; there must be a reason for buy-and-hold institutional money managers to abandon the bullish outlook they currently hold. This is why a decline of about 7% is likely, rather than a more significant bear market. As this is being written on September 22, we expect the S&P 500 to decline to its fourth wave in lesser degree, which in this case is the early August low of 1,905, at a minimum. A 50% retracement of the 281.34 point rally from the February 5 low would bring the S&P 500 down to 1,878. During March, April and May there were several short-term highs recorded in the S&P 500 between 1,883 and 1,897, so this is also an area of support that could preclude a deeper decline. The S&P 500's 200-day average is 1,894. Lower prices are certainly possible given the levels of technical weakness; it will just depend on whether reasons to sell are strong enough to measurably increase selling pressure.

Treasury Bonds

As discussed in the September MSR, we thought the 10-year Treasury yield was making a low near 2.30%, and expected it to subsequently rise to 2.65%. The yield reached 2.642% on September 18. As this is being written on September 22, we think the 10-year Treasury yield will retest the 2.64% level, after closing a gap at 2.54%. If our analysis is correct, the stronger dollar should have positive implications for longer-term Treasury yields. The Treasury market is likely to benefit from international money moving out of the euro, yen and emerging market currencies and into the dollar, especially since U.S. yields are comfortably higher than those in Europe. This suggests it is unlikely that the 10-year Treasury yield will exceed the highs reached on March 7 at 2.821% for the rest of 2014.

  1. As quoted in: To provide for amendment of the Bretton Woods agreements act, U.S. Govt. Print. Off., 1976
  2. Source: William Drozdiak, Washington Post, Page A31, February 18, 2001
  3. Carefully consider the Fund's investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Fund's prospectus, and if available, summary prospectus, which may be obtained by calling 1-800-iShares (1-800-474-27371-800-474-2737) or by visiting Read the prospectus carefully before investing.

Definition of Terms

10-year Treasury is a debt obligation issued by the U.S. Treasury that has a term of more than one year, but not more than 10 years.

An advance-decline line is a technical indicator that plots changes in the value of the advance-decline index over a certain time period.

Asset-backed security is a financial security backed by loans, leases, credit card debt or receivables against assets other than real estate and mortgage-backed securities.

Capacity utilization rate measures the rate at which potential output levels are being met.

Consumer Price Index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation.

Debt-to-GDP ratio is a measure of a country's federal debt in relation to its gross domestic product (GDP). By comparing what a country owes to what it produces, the debt-to-GDP ratio indicates the country's ability to pay back its debt.

Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry and are listed on the New York Stock Exchange.

Federal funds rate is the interest rate at which a depository institution lends immediately available funds to another depository institution overnight.

Federal Open Market Committee (FOMC) is a branch of the Federal Reserve Board that determines the direction of monetary policy.

A Fibonacci number refers to a number sequence in which each number is the sum of the previous two numbers. The concept was introduced to the West by Italian mathematician Leonardo Fibonacci.

Full Employment and Balanced Growth Act of 1978 is federal legislation that, among other things, specifies the primary objectives of U.S. economic policy as maximum employment, stable prices and moderate long-term interest rates.

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a given year, equal to total consumer, investment and government spending, plus the value of exports, minus the value of imports. The GDP of a country is one of the ways of measuring the size of its

A liar loan is a category of mortgages, also known as low-documentation or no-documentation mortgages, that have been abused to the point where the loans are sometimes referred to as liar loans.

M2 money supply is a measure of money supply that includes cash and checking deposits (M1) as well as near money, which include savings deposits, money market mutual funds and other time deposits.

The Major Trend Indicator is a proprietary technical tool that measures the strength or weakness of the market and helps identify bull and bear phases. During bull markets it helps indicate when the market may be vulnerable to a correction, and during bear markets it helps identify a potential rally.

Mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans.

The Nasdaq is a capitalization-weighted index designed to measure the performance of all NASDAQ stocks in the industrial sector.

Quantitative easing refers to a form of monetary policy used to stimulate an economy where interest rates are either at, or close to, zero.

Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe, representing approximately 10% of the total market capitalization of the Russell 3000. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

S&P 500 Index is an unmanaged index of 500 common stocks chosen to reflect the industries in the U.S. economy.

Texas ratio is a measure of a bank's credit troubles and is used to identify potential problems.

Valuation is the process of determining the value of an asset or company based on earnings and the market value of assets.

Volatility is a statistical measure of the dispersion of returns for a given security or market index.


Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

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