“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” -Sam Ewing
While most investors are familiar with the Dollar Index, it is actually a poor tool in gauging the strength of the USD given its weightings and only being a six currency basket. To truly see how the greenback is performing on a global scale one needs to look at more than six currencies and include precious metals. When one does this it is truly amazing how much the purchasing power of the USD has declined since 2009 after two rounds of quantitative easing (QE), and it is this loss of purchasing power that has the potential to at least cause another growth scare like 2010 or even a bear market.
The Biggest Loser
As I pointed out in a recent article, the USD Index has broken a three year trend line, which largely resembles a similar setup in the 1970s. When that break occurred stocks suffered in real terms and commodities went screaming higher with gold advancing more than 350% in two years. Whenever the USD Index has approached this 3-year trend line support I take a look at how it is performing versus world currencies over different time periods to see if it is beginning to strengthen and indicate a change in trend.
What you see below is the USD versus 30 world currencies and 4 precious metals over 6 different time periods. If the USD was in the process of staging an intermediate bottom you would begin to see more and more currencies and precious metals declining relative to the USD on a short term basis (1 day, 5 day, 1 month) but we simply aren't seeing that. Shown below, only 8 currencies/metals are declining relative to the USD yesterday and over the 5 day , 1 month, and 3 month horizons, the USD is still declining against 2/3 of the currencies below.
Source: Bloomberg
Stepping back just a bit further in time we can see that the USD has lost a great deal of its purchasing power from a global perspective, particularly versus precious metals. Since 2009 and after two rounds of quantitative easing the USD has declined more than 75% versus palladium, 69% versus silver, and 39% versus gold. The USD has also lost a great deal of purchasing power versus commodity currencies like the Australian Dollar, Brazilian Real, and Canadian Dollar. Clearly, when looking at the USD from a global perspective, cash has been trash thanks to Helicopter Ben Bernanke and a Congress and President that have extended U.S. debt to the stratosphere.
What a Weak USD Means to You
Given the U.S. economy is now primarily a service economy by exporting its manufacturing base overseas, it is important to keep in mind that we are far more susceptible to import inflation. Thus, one of the major trend components in import inflation is the USD as commodities are priced in dollars. Shown below is the inflation rate for import prices (blue line) along side the annual rate of change in the USD Trade-Weighted Index (orange line—shown inverted for directional similarity and advanced several months). The close relationship between the USD and import price inflation could not be more clear with the recent weakness in the USD hinting at even higher import prices in the months ahead. This is certainly not going to be good news to consumers already struggling with high food and energy prices.
Source: BLS
What a Weak USD Means to Corporations
One of the things I argued for as to why there was still pain ahead in the middle of 2008 was the extremely high level of corporate profits relative to their normalized levels (“The Worst Is Yet to Come”). Essentially, corporate profit margins tend to reverse and move back towards the long run average, and we were still well above historical norms back in the summer of 2008—a strong reason for why I was not ready to turn bullish on the markets.
Yet again, the extreme in corporate profits is causing me to turn more cautious on the economy and stock market as the drivers that helped corporations boost their margins (shedding payrolls while sales recovered) is largely behind us as payrolls are now being added again. Additionally, while inflation was quite tame in 2009 and for most of 2010 it is picking up momentum and a weak USD ahead will only exacerbate the problem. Shown below are current corporate profits relative to normalized levels (historical average times Gross Domestic Product), which imply significant downside risk for the earnings seasons ahead. As of the end of last year, corporate profit margins were more than two standard deviations above normalized levels (see red line in second chart below), with 2007 representing the last time this occurred.
Source: BEA
Source: BEA
What a Weak USD Means to the Economy & Stock Market
The current rising inflationary pressures we are seeing are coming from the 15% decline seen in the USD Index since last summer, and further USD weakness ahead will only compound the problem. Higher inflation cuts into corporate profit margins as well as reduces consumer’s discretionary spending levels as they are forced to pay more for less. Inflation levels are leading economic indicators as it takes time for consumers to respond from ticker shock and change their spending habits, and current inflationary trends portend a decelerating shift for the economy ahead.
Seen below are three different Federal Reserve regional surveys with both the headline index and the price index for the surveys shown together, with the price index shown inverted for directional similarity and advanced owing to their leading tendencies. As you can see all three price indexes (red lines) haved moved sharply higher (lower in chart since inverted) and indicate we are likely to see lower national ISM and regional ISM numbers ahead.
Source: Bloomberg
Why is this important to you as an investor? Well, there is a strong correlation between the ISM numbers and the year-over-year rate of change in the S&P 500 as seen below. Given the price indices for regional ISM’s are forecasting lower headline ISM numbers in the months ahead, we can also expect the stock market to be at risk with flat to negative returns. That said, with QE 2 still in force the price weakness forecasted by the regional ISM price indexes may have to wait until QE 2 comes to a close in June.
Source: ISM, Standard & Poor’s
What Does it All Mean?
The last time we were in a similar scenario was late 2007 to early 2008. While I am not forecasting another crash like the one seen in late 2008, I do believe we can see the same trends. What were the characteristics of that time period? A weak USD, rising inflationary pressures, lower retail sales, lower corporate profit margins, and outperformance by commodities in general and precious metals in particular. If the USD accelerates its current decline then commodity based investments would be the most likely beneficiaries. Additionally, defensive sectors like consumer staples, health care, utilities, and telecommunications will likely outperform the more cyclical sectors such as technology, consumer discretionary, and financials.
