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Weak Dollar: Curse or Blessing?
The USD seems to be on a path of further inevitable slide after a recent run of weak U.S. data. In his January 29 testimony to Congress, Fed Chairman Bernanke reiterated downside risk to the economy and did not discourage expectations for rate cuts. Markets have increasingly priced in a cut of at least 50 to 75 basis points when the Federal Reserve holds its policy meeting next week.
In contrast, European Central Bank President Trichet gave only lip service to the strong EUR after its decision last week to leave the key EUR refi rate unchanged at 4 percent. Instead, he emphasized the ECB's "current policy to fight inflation" and "not underwriting" investors' expectations for lower rates. The hard line taken on inflation by the ECB has pushed back any expectation of a EUR rate cut until Q4 this year. Trichet has, in fact, given the green light for the EUR to move higher as the rate differential is expected to be tilting in favor of the single currency.
Most will think a weak USD is a bad thing because a strong currency symbolizes a strong economy. However, a weak USD is not necessarily bad. Exporters typically do well when the USD drops, as the price of U.S. products become more competitive in local currency terms. To wit, the U.S. Q3 current account deficit narrowed to $178.5 billion, the smallest deficit in two years, helped by the strength in global growth and a weakening USD.
As the USD declines, companies that have a majority of their sales overseas benefit as these revenues in stronger currencies are converted into more USD. Hewlett Packard, with over 60 percent of its revenue derived from international sales, saw its latest quarterly revenues rise by an annualized 13 percent, of which 5 percent was due to favorable currency effects. Autodesk, another company with 65 percent of revenues from overseas markets, registered revenue growth of 20 percent in its latest January quarter, driven by 52 percent growth in emerging markets and favorable foreign exchange gain.
On the contrary, companies in countries that have experienced strong appreciation of its currency are negatively affected. Agfa-Gevaert, a Belgium company that develops, produces, and distributes an extensive range of analog and digital imaging systems and IT solutions, has suffered from the declining USD. Its Q4 2007 group sales declined 6.8 percent, of which 3.6 percent is due to the adverse impact of a strong EUR.
The strong EUR is causing pains to companies that incurred their cost of production in EUR but receive their revenues outside Europe. According to a New York Times report, BMW announced last week that it was eliminating 8,100 jobs, as the rising EUR pushed the company into the kind of tough cost-cutting that it had resisted. Roughly 80 thousand of its 108 thousand employees are in Germany, while 80 percent of its sales are in overseas markets. That creates a problem because the bulk of its costs are denominated in EUR, but its revenue is heavily USD-based as a result of robust American sales, making it particularly vulnerable to a strong EUR.
To counter the strengthening single currency, European car companies such as BMW, Volkswagen, and Daimler Benz are expanding the production capacity of their U.S. plants. These German manufacturers are also looking to increase the share of parts produced in North America. The key is to match the revenues with expenses of the same currency. Sounds familiar? The Japanese car manufacturers took the same strategy in late 80s when USD weakened dramatically against the JPY after the 1985 Plaza Accord, when the G5 countries agreed on concerted intervention to depreciate the USD. As a result, the USD declined by 51 percent against the JPY in the subsequent two years. Japanese carmakers, like Toyota and Honda, started manufacturing faculties here in the U.S. to mitigate the impact of a strong JPY on the USD margins. In retrospect, the Plaza Accord was successful in reducing the U.S. trade deficit with Western European nations though it failed to alleviate the deficit with Japan. This was mainly because of the strict import restriction imposed by Japan.
Not surprisingly, the two periods of large U.S. current account deficits occurred following the two major USD peaks of the last three decades — in 1985 and in 2002. But both periods saw the deficits decline as the USD fell from its peaks. The current account deficit soared from $118 billion in 1985 to $161 billion in 1987; but since then declined notably, corresponding to the sharp reversal in the USD after 1985. The sharp drop seen in the USD in 2002 to 2006 revealed little immediate deficit reduction impact due to soaring imports as a result of U.S. economic out-performance relative to our major trading partners during that period. But in 2007, as the U.S. economy slowed down, a more substantial improvement in the trade figures has been noticed, as continued USD weakness and strong global growth have kept export growth strong, while slower U.S. growth has curbed imports.
The experiences of the USD cycles over the last three decades support the economic theory that a weak dollar is a natural mechanism to correct its trade imbalance. A weaker USD increases the competitiveness of U.S. exports while reducing the attractiveness of imports to U.S. consumers. Over time, increased revenues by corporations will translate to more job creation and domestic spending, and help to boost the U.S. economy. In addition, as the USD weakens, U.S. assets become cheaper to foreign investors, thus attracting capital inflows to invest in U.S. real estate and securities. Increased foreign investment help support U.S. asset prices which is another support for the economy.
Given the many imbalances that the U.S. is facing, the current USD decline is likely to continue further before it stabilizes. One bright spot is that this prolonged USD weakness will force many companies to grow globally to take advantage of growing overseas demand.
— Fernand Kong, Manager of Foreign Exchange Services, SVB Silicon Valley Bank's Global Financial Services
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Social Sites Delay IPOs
Social networking sites LinkedIn, Facebook, and Slide are delaying IPO plans, instead staying busy trying to prove their worth in this slow economy. When any of the three do go public, there is likely to be plenty of interest, although questions abound about the continuing viability of the Internet ad market. Consumer-focused sites like Facebook and Slide have yet to show they can command a premium for the ads they display. There's also the risk that users will retreat from social networks as they age and settle down. (BusinessWeek)
Tech Worker Migration
In growing numbers, tech industry workers are gravitating to larger companies in the hope that they hope can better weather a downturn. Tech start-ups, today, take an average of just over seven years to get to an IPO, up from about three years in 2000, according to VentureOne. The number of tech IPOs remains low, with just 34 tech IPOs in 2007, down from 105 in 2000. By contrast, large companies are currently shedding workers more slowly. According to the Bureau of Labor Statistics, layoffs comprising more than 500 workers at a time — typically those made by large companies — accounted for fewer than a quarter of the country's total layoffs in 2007's fourth quarter, down from about a third of all layoffs in late 2001. (Wall Street Journal)
IP Phones Target Small Biz
Internet-based phone start-ups are targeting small businesses — usually those with fewer than 10 employees — who want a full-featured phone system but usually can't afford one. Offering features like multiple extensions and dial-by-name directories, Internet-phone companies undercut the prices of more traditional business-phone providers. The companies are racking up new users because most traditional office phone systems are just too expensive for the small customer. According to research firm In-Stat, revenue from hosted Internet-phone services for businesses are expected to top $2.1 billion by 2010, up from $476 million last year. (VentureWire)
From Petroleum to Pond Scum
With oil prices topping $100 a barrel and concern about manmade climate change, the search is on for renewable fuels that reduce our dependence on petroleum and cut carbon emissions. Fuels made from algae could provide that replacement for petroleum. Single-celled algae are efficient at converting light, water, and carbon into oily compounds called lipids that can be extracted and processed into diesel fuel, gasoline, and crude oil. The challenge is how to convert algae into usable oil on a massive scale at a price comparable to pumping oil. Scientists estimate that a commercial algae farm could probably produce 5,000 gallons of oil per acre of land, compared to existing biofuels. Soybeans yield about 50 gallons an acre, and palm oil yields 600 gallons an acre. (San Jose Mercury News)
Data in the Clouds
Rather than keeping all corporate data in software programs within the organization, a group of new companies proposes to hold it online. The concept is called cloud computing, after the cloud symbol that techies use for information that is stored on the Web. The attraction for a medium-sized firm is cost savings. Patrick Dolan, of BPO Management, calculates that a company with $100 million in annual revenue, for example, spends about $7 million a year on information technology, whereas his company can reduce that cost by 25 percent, which could add almost $2 million to the customer's bottom line. BPO can achieve such cost savings because it spreads its expenditures for software and servers over 400 customers and, therefore, has a lower unit cost. (New York Times)
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March 10, 2008
Calling Rodney King
At an economic summit dinner I recently attended, I sat and listened attentively to Treasury Secretary Paulson's tortured explanation of the U.S. government's effort to help distressed homeowners. As I watched the crowd, who appeared to possess the same expression of disbelief that I felt, two images inserted themselves into my thoughts. The first was that of Rodney King. Mr. King, as you may recall, became famous the first time when his merciless beating by representatives of the LAPD was caught on video. His fame was made indelible when the trial and exoneration of those officers sparked the LA riots in 1992, and the felonious Mr. King was trotted out to assuage the rioters, stuttering out the question, "Why can't we all just get along?"
This seems to be a core notion behind the government's "Hope Now Alliance," which brings together, at least on a Web site, "a cooperative effort between counselors, investors, and lenders to maximize outreach efforts to homeowners in distress." This idea has recently been combined with "Project Lifeline," which aims to "extend far beyond the subprime borrowers covered by the Hope Now Alliance." Between the two programs, the government is seeking to solicit concessions by lenders for all borrowers, prime and subprime, who are 90 or more days delinquent on their mortgages. The mortgage servicers involved in the programs cover about 70 percent of all mortgages and 90 percent of subprime loans. The focus of the program, according to Secretary Paulson, is to help those that want to stay in their homes but can't pay as opposed to those that can pay. Well, naturally, if people can pay, they should certainly do so. Cynics may wonder if the recent jump in the total mortgages past due is simply the result of homeowners' preparing themselves to participate in what could be some attractive government largess.
Of course, the government has been helping out in the mortgage business for many years through the auspices of Fannie Mae and Freddie Mac. With all that experience, one would expect them to have calmly stood aside as various fools rushed into the subprime maelstrom. Maybe not. A colorful piece in Barron's this week, "Is Fannie Mae Toast?," implies that there may be some skeptics on the street about the government's skills in intervening in the mortgage market. For the record, Fannie's stock is off some 69 percent since last August, and their bonds — and even the $2.4 trillion mortgages they guarantee — are taking some heat. Yes, that was no typo; it is trillions.
Finally and oddly enough, the good Secretary's speech also brought back an image and memories of Japan in the 1990s. You'll recall, at that time, Japan was also experiencing a rapid decline in asset prices in both real estate and equities. The banks were saddled with bad loans to property developers equal to many times their net worth. As the economy sank, regular businesses began to fail in large numbers. The banks, with the encouragement and assistance from the government, went to extraordinary lengths to pretend that the loans on their books were still good, that their customers were viable, and that they would muddle through. (Can't we all just get along?) As liquidity dried up (banks with phony capital are reluctant to lend, no matter what their regulators say), the country slipped into a deflationary spiral that lasted years. Considering that comparison over my plate of succulent chicken, I struggled to differentiate between what they did in Japan in the 1990s and the process the Treasury Secretary had just described. The difference appears to be more one of nuance than substance.
The Road to the Poorhouse
According to the screaming headlines last week, the poorhouse is where we are all headed, as household net worth dropped $533 billion. While that seems like a huge shift, it represents less than 1 percent of the $57.7 trillion accumulated worth. To save you reaching for your calculator, with 112.8 million households, that is still an average net worth of $511,525 per family. The more alarming news was that home equity has dropped to the lowest level since 1945 — only 47.9 percent. The shocker there, for us, is that the number is so high. I don't know anyone with a loan to value of only 52 percent. Clearly these are data sets where the average is not very descriptive.
As I struggled to squeeze my SUV into the jam-packed Costco parking lot this Saturday, I pondered the state of the U.S. consumer's malaise (to borrow a Carteresque term). They must be here, I reasoned, because they can't afford to pay full price with their local merchants. To sum it all up, I realized that everything I own (cars, houses, and equities) is declining in value, and everything I need to buy is going up in price. We are clearly poorly positioned on this bi-modal inflation/deflation continuum. It must be time to reallocate assets. So, if you stumble across a good deal on a producing oil well or a few hundred acres of corn, drop us a line.
Then there was the odd situation at Guernsey, U.K.-based Carlyle Capital. They courageously took their $300 million in capital, made the rounds to a few banks for loans, and invested the lot in about $22 billion of AAA-rated mortgage-backed bonds. After some quick arithmetic, that seems to be leverage of 73:1. At that stratospheric level, a mere 2 percent decline in the value of the assets reduces the fund's net worth to, well . . . zero. According to news reports, the group had missed a few margin calls and would likely miss some more.
As 63,000 jobs vanished from nonfarm payrolls, investors ran from anything with risk. Short-term Treasury yields dropped like a stone, and the 2-year finished yielding 1.516 percent down 12.4 bps. Four-week bills were pricing to yield 1.66 percent or almost 134 bps below Fed Funds. The market is completely sold (100 percent probability) on a 75 bps cut at the FOMC meeting on March 18. Mr. Bernanke has unleashed the ravenous beast. We suppose the only thing he can do now is feed the beast.
A Different Monica
Army Spc. Monica Lin Brown will be awarded the Silver Star, the nation's third highest medal for valor. The 19-year old medic ran through a hail of insurgent gunfire, pulling five wounded colleagues out of danger after their Humvee was damaged in an ambush. The military said Brown's "bravery, unselfish actions, and medical aid rendered under fire saved the lives of her comrades and represents the finest traditions of heroism in combat." Ms. Brown is only the second woman to receive the Silver Star for actions under fire since WWII.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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Recession Looms: Payrolls Fall by 63,000
In the clearest suggestion yet of a recession, U.S. nonfarm payrolls fell by 63,000 in February, the second straight decline, the Labor Dept. reported Friday. "Turn out the lights the party's over," wrote Joseph Brusuelas, U.S. chief economist for IDEAglobal. "We are in a recession." It was the largest drop in payrolls since March 2003, when the economy was struggling through a jobless recovery. The drop in payrolls was largely unexpected; economists were looking for a tepid gain of about 20,000 in the survey of business establishments. (Reuters)
Fed Throws More Cash in the Mix
Acting to keep renewed dislocation in the credit system from further damaging the economy, the Fed on Friday announced two new steps to add cash to the markets. The Fed will increase the size of its emergency auctions by $40 billion and said it was going to provide $100 billion to primary dealers in U.S. Treasury debt. Analysts said the money was clearly going to be used to prop up mortgage-backed securities. Despite aggressive actions taken in recent months, a fresh wave of apprehension about the health of the U.S. and global financial markets has swept through credit markets this past week. (MarketWatch)
Wholesale Sales, Inventories Way Up
U.S. wholesale inventories rose 0.8 percent in January, while sales leapt 2.7 percent, the largest increase in nearly four years, the Commerce Dept. said on Monday. Strong durable goods and farm product sales helped spur the biggest jump in wholesale sales since a 3.3 percent rise in March 2004. The overall sales increase in January came after a 0.5 percent drop in December, revised from a previously reported 0.7 percent decline. Sales of durable goods increased 2.4 percent from December, and 5.1 percent from January 2007, the department said. Despite the increase in durable goods sales, inventories rose 0.6 percent. Farm product sales, meanwhile, reflected steadily increasing food prices, jumping 16.1 percent over the month and increasing 73.3 percent from a year before. (Reuters)
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Auction-rate Warnings Fell on Deaf Ears
When the auction-rate-securities market collapsed, SVB Asset Management's Joe Morgan wasn't the least bit surprised. As the head of portfolio management at SAM, Joe was warning his corporate clients as far back as 2004 to steer clear of auction-rates. Well before the market's implosion, SVB said that the triple-A rating of most of the auction-rates merely reflected the likelihood of getting back principal when the bonds mature, "and does not reflect the risk of a failed auction." The list of companies learning that lesson the hard way appears to be growing by the day. (Wall Street Journal)
Inverted TIPS' Yield: Inflation Is Out of the Box
Bond investors are so sure that the Federal Reserve will lose control of inflation that they're giving up yields just to buy debt securities that protect against rising consumer prices. The yield on the 5-year Treasury Inflation-Protected Security due in 2012 has been negative since Feb. 29, and traded today at minus 0.17 percent. The notes, which were first sold in 1997, have never before traded below zero. Even so, firms are still saying that TIPS are a bargain. (Bloomberg)
Margin Calls Made Even on Treasuries
The hedge-fund industry is reeling from its worst crisis in a decade as banks are now demanding more money pledged to support outstanding loans even when the investment is backed fully by the United States. Since Feb. 15, at least six hedge funds, totaling over $5 billion, have been forced to liquidate holdings because their lenders raised borrowing rates by as much as tenfold. While lenders are most worried by credit consisting of real estate and consumer debt, bankers are now attempting to raise the rates they charge on Treasuries because of the price fluctuations in the bond market. (Bloomberg)
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