October 3, 2011
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Key Points
- Recession fears have mounted, but the picture is still mixed and it's not yet conclusive.
- The US dollar is winning the "least ugly" currency contest, but isn't helping stocks or commodities.
- Short-term, a stronger dollar is a negative for riskier assets … but not necessarily longer-term, if history's a guide.
No matter the subject to be tackled, it's appropriate these days to update readers on the latest economic reports and what they say about the likelihood of recession. After that I'll tackle the subject of recent strength in the dollar and what it may mean for the economy and markets.
Recession fears mount
Recession fears grew last week when the chief economist of the Economic Cycle Research Institute (ECRI), which has a weekly leading index (WLI), wrote that the US economy was dipping into recession. Their index has been right in calling for recessions over the past three cycles, but doesn't have a long history. It also dipped to an even lower level last year and no recession was forthcoming, as you can see in the chart below—so it has given false signals.
ECRI's WLI Double Dips
Source: ECRI and FactSet, as of September 23, 2011.
The Conference Board's index of leading economic indicators has a longer track record, and it's been stellar. I've written about the yield curve and money-supply biases of the LEI and why you need to discount their strength. Even so, the Conference Board has its own recession probability model and it's still reading sub-50%, though not by much. For what it's worth, that's close to my assessment of the situation.
Mixed bag
Here's an update on the latest economic readings, which I believe support the mixed picture outlook for the economy (but don't support a definitive recession):
- The ISM manufacturing index for September increased from 50.6 to 51.4, which was better than the 50.5 consensus, and keeps the index above the 50 line dividing expansion from contraction. Within the report, the employment and export orders indexes rebounded nicely, but the recent strengthening of the dollar (addressed below) suggests some damage to come in the latter.
- Construction spending in August increased 1.4%, much better than the -0.2% consensus, with the jump coming from a 3.1% increase in public construction (hugely volatile) … but private sector activity rose, too. Construction will likely be additive to gross domestic product (GDP) growth in the third and fourth quarters of 2011.
- Real GDP growth for the second quarter of 2011 was revised upward from 1.0% to 1.3%. The Blue Chip Consensus expectations for the third- and fourth-quarter GDP growth are 1.9% and 2.1%, respectively.
- Corporate profits increased to a record high of $1.517 billion and corporate cash flow also increased to a record high of $1.773 billion during the second quarter; up 9.4% and 5.5%, respectively.
- Personal income edged down 0.1% in August as personal spending increased 0.2%, both slightly better than expectations.
- The Chicago purchasing managers' index came in at 60, much better than expected.
- The Case-Shiller home price index was down 4.1% on a year-over-year basis (better than the -4.4% expectation) in July, but on a monthly basis, the index was unchanged (supporting the bottoming case for housing).
- Durable goods orders decreased 0.1% in August, better than the -0.2% expectation.
- Consumer confidence has stabilized, albeit at a very low level.
- Initial jobless claims declined sharply to 391,000, but due to seasonal factors, they're likely to move up again.
The bottom line, as noted by The Conference Board: "Whether the National Bureau of Economic Research at a later date officially decides that the current slow growth constitutes a recession, however, is somewhat academic to business leaders and investors who already are dealing with growth that is uncomfortably slow. The one silver lining is that any recession in the next few months is likely to be short and shallow, since it would not be a typical business-cycle downturn characterized by high-capacity utilization rates in the labor and product. In other words, the sluggish expansion to date means that output should have less to fall in a downturn." That last part is the tune I've been singing for some time.
Dollar: winning the "least ugly" contest
Accompanying the latest economic weakness has been a strengthening US dollar, as you can see below.
US Dollar Breaks Out
Source: FactSet, as of September 30, 2011.
Its rally has been triggered partly by the Federal Reserve's recent announcement of Operation Twist, which—unlike quantitative easing (QE), which was dollar negative—didn't expand the Fed's balance sheet, which has been dollar positive. The dollar has also gotten a boost from the narrowing gap between US and foreign policies. The former has had loose fiscal and monetary policies for some time, but foreign policies are quickly becoming looser as well as they combat slowing economic growth and lessening inflation risk.
I asked Tatjana Michel, Schwab's currency analyst, for her thoughts, and here's what she had to say: "In addition to the European crisis, the slowdown in global economic growth is increasingly worrying investors and driving them into the safety of the US dollar. Slowing global growth implies weakening demand for goods and services, which is likely to hit currencies of countries most dependent on exports to generate growth. Less demand for exported goods also means less demand and more weakening for the currencies of those countries. As their growth falters, they're also likely to ease monetary policy and lower interest rates, which adds pressure on their currencies."
Dollar strength hurts exports but helps consumers
The US economy has the biggest spread between exports and consumption as economic drivers. US GDP can reap rewards from dollar rallies as they feeds into lower inflation and better consumption. You can see this visually below.
Source: Wolfe Trahan & Co.
Strong dollar = weak riskier asset classes … for now
The rub is that the benefit of a stronger dollar will unlikely be felt in short order. At present, and since the financial crisis erupted in 2008, most risk assets—including stocks and commodities, as well as exports and manufacturing—have had inverse correlations with the dollar. Assuming present trends continue, dollar strength in the short term would have a negative effect on the euro, emerging-market stocks, the S&P 500 Index and all commodities (including gold), but be beneficial to corporate bonds and other fixed income assets.
But these correlations haven't always been negative. Take a look at the chart below, which shows the correlation between the S&P 500 and US dollar.
Negative Correlation Between Stocks and Dollar
Source: FactSet, as of September 30, 2011. Chart shows one-year rolling correlation of daily percentage changes in S&P 500 and US Dollar Index.
Only since 2008 did the correlation plunge into negative territory; prior to that, the correlation was largely positive. You can also see what could be a bottoming pattern in the correlation—similar to what occurred in the mid-2000s.
Looking further back, as you can see in the table below, stocks historically performed better overall in dollar bull markets than in dollar bear markets.
Source: Bespoke Investment Group and FactSet, as of September 30, 2011.
Given that lower commodity prices are good for US consumers, and US consumers drive the US economy, why the current negative correlation? It's probably a function of the "risk-on, risk-off" trading environment that's had all risk assets moving largely in tandem. That may not be permanent, and you can already see that the correlation between stocks and commodities is starting to turn back down.
Positive Correlation Between Stocks and Commodities
Source: FactSet, as of September 30, 2011. Chart shows one-year rolling correlation of daily percentage changes in S&P 500 and Commodity Research Bureau Index.
The path the dollar takes from here will depend on several factors. As Tatjana mentioned to me, "there are one or two question marks concerning the dollar in the future. The current global growth slowdown is also being felt in the United States. Depending on whether and how much the US economy weakens from here will affect Fed policy. This might come in the form of QE3, which would likely put renewed downward pressure on the dollar (and upward pressure on riskier asset classes). In addition, the US debt crisis is not off the table and any flare-up, political or otherwise, could prove to be a stumbling block for the dollar."
In sum
I think there's risk of a pullback in the dollar if the economy weakens further and additional Fed stimulus is put back on the table. Were that to occur, I'd expect a rally in risk assets. However, if recession risk is overblown, the dollar could keep a bid under it. In the short term, that would likely continue to hit riskier asset classes, including stocks and commodities. Longer-term, though, a stronger dollar is in the best interest of the US economy, and probably even the stock market.
