The Dollar is not Weak

Essay: As in late 2004, we witnessed in late 2007 a crescendo of negative sentiment toward the US dollar. With everyone from Warren Buffett and George Soros to Mahmoud Amahdenijad and Hugo Chavez to model Giselle Bundchen and rapper Jay-Z maligning the dropping dollar, it doesn’t take much of a leap of contrarian analysis to call a near-term bottom in the dollar. As with many things, I think more clarity can be derived from stepping back and examining the long-term trend.

Since 1968, when the Bretton Woods gold-linked currency system first started breaking down, the dollar has had remarkably regular long term cycles. From 1968 to 1978, it weakened; from 1978 to 1985, it strengthened; from 1985 to 1995, it weakened; from 1995 to 2002, it strengthened; since 2002 it has weakened. So far each cycle has been 17 years: 6 ½ years up and 10 ½ years down.

The following chart depicts the nominal value of the dollar versus a basket of major trading partners:

The 17 year pattern can be broken into three phases: (i) the fast drop, (ii) the trading range, and (iii) the spike. The fast drop occurs when the dollar falls from an overvalued position, evidenced by a wide current account deficit. The government (Treasury and the Fed) take actions to devalue the dollar, whether it be Nixon’s delinking the dollar from gold in 1971, the Plaza Accord in 1985 or Greenspan’s 1% interest rates in 2003. Usually during the fast drop phase, the US experiences a debt-fuelled LBO/conglomeration boom and a commodity price spike, and the global economy experiences a strong boom. Eventually, however, the Fed and Treasury are forced to take action to defend the dollar and limit inflation. These actions generally result in a market dislocation: the market crash of ’73-’74, the Louvre Accords and the ’87 market crash, the subprime crisis today. An increase in interest rates reduces domestic demand, while the continued low value of the dollar spurs exports, thus resulting in an elimination of the current account deficit.

During the second phase, the dollar trades sideways-to-slightly-down in the long-term channel. During this phase the current account deficit is small and manageable and the real economy does ok. Inflation, however, remains elevated, eventually leading to policies that increase the value of the dollar.

During the third phase the dollar enters a multi-year spike. High real interest rates and overt support from the Treasury draw an inflow of capital from abroad and an increase in the current account deficit. During the boom phase of the dollar spike, you see the US outperform the world economy. The US experiences a venture capital boom and emerging markets are beset by rolling financial crises. Commodity prices fall sharply. The strong dollar and the high current account deficit eventually lead to deflationary pressures, prompting the government to implement policies to devalue the dollar, and the cycle starts all over again.

The chart shows that we are likely at a point similar to early 1973 and 1990, transitioning between the first phase and the second phase of the cycle. If the pattern holds, the dollar should spend the next four years in a sideways-to-higher trading range prior to one last drop to the bottom of the channel. While the economy has fallen into recession during each of the last two similar transitions, each successive crisis appears to be less severe.

The long term channel does slope downward. Plotting the long term trend, the dollar has been falling at a pace of about 0.5% per year since 1973. Why is it ok for the dollar to fall over the long term? Why shouldn’t it rise? A little historical context is in order.

The value of the dollar prior to 1971 was set during the post World War II Bretton Woods conference. At that time, the US economy was the only major economy still intact following the war, and the US possessed around half of the world’s gold reserves. In addition, a huge chunk of the global economy was walled off behind the iron curtain or under self-imposed isolation like India. The economies of postwar Europe and Japan were a shambles, relying on funds from the US to rebuild. Given this situation, it is hardly a surprise that the US economy was so strong in the 1950s and early 1960s, even with high taxes and business regulation. As Japan and Western Europe recovered, however, the strains of international competition and Great Society and Vietnam era deficit spending created balance of payment pressures, leading Nixon to delink the dollar from the gold standard in 1971.

Against a broad basket of currencies, including emerging market currencies, the dollar has increased on a nominal basis since 1971. On a real basis, it has oscillated sideways, generally staying within a range of 84 to 96 (except during spikes). The chart is below:

If the historical pattern holds, the dollar is likely to rebound off today’s levels and trade modestly higher to sideways for the next several years. When the dollar is in the long term trading range, as it is now, the current account deficit has historically narrowed significantly or been eliminated altogether. In addition, considering where it has come from, it can be said that the dollar has held up remarkably well since 1968, relative to other currencies. There are plenty of things to worry about today, but at today’s levels the dollar need not be one of them.

10 Potential Surprises for 2008 & Predictions

Essay: The following 10 surprises are not predictions.  They are 10 potential surprises, the odds of which occuring are underestimated by the current "convential wisdom".  If a few of these come true I will feel pretty smart.  If more than 5 come true, I will proclaim myself a soothsayer.

1.  The West (namely the US) and Russia will have a major standoff over the fate of Kosovo.  The magnitude of the crisis will surprise the Western media.  Georgia will be sucked into the crisis somehow.

2.  The US and North Korea will sign a treaty officially ending the Korean War.

3.  The US and Iran will have a high-profile detente.

4.  The Chinese stock market will crash by more than 30% from its peak. 

5.  At some point in 2008, the Fed Funds rate will be at or below 3%.

6.  The US current account deficit will end the year at less than 3% of GDP.

7.  The US dollar will rally by more than 10% against the Euro and the Pound.

8.  Russia will effectively merge with Belarus.

9.  John Edwards will be the Democratic presidential nominee.

10.  John McCain will be the Republican presidential nominee.

Ok, so I’ll admit that posing my predictions this way is a bit of a cop out in that I don’t have to hang my hat on any of them.  These are my out of the box surprises that I think could happen, but do not put greater than 50/50 odds on any one individually. 

My base case prediction for 2008 is as follows:

Despite the subprime-driven credit market crisis, 2008 will be a good year for the world economy.  The US will avoid a recession, with economic growth driven by exports and business investment.  The technology and capital goods industrials sectors will do well.  Commodity prices will stay strong, so the mining and oil sectors will also remain strong.  Expect continued M&A in all of these sectors, with the ultimate end game being the formation of global oligopolies.  For these and other reasons, 2008 could actually end up being a good year for the equity markets, but I expect credit risk spreads to remain elevated.

Interest-rate sensitive, consumer-driven sectors will continue to suffer, with autos hit especially hard.  Some time before the end of 2009, it will become obvious that Cerberus’ investment in Chrysler is in serious trouble.  The housing market will continue to weaken, too.  No surprise there.   Housing is in for a long slump.  The huge run up in prices and supply/demand imbalance are bad enough.  Add in declining demographics with the baby boom generation past their home-buying years, and we’re looking at a long, Japan-style real estate deflation.  The demographics are bad for commercial real estate, too.

The US current account and budget deficits will continue to narrow.  Because economic growth driven by a narrowing current account deficit doesn’t feel as good as growth driven by a widening deficit, consumer sentiment on the economy will stay low.  High CPI increases will continue, but will likely start slowing markedly near the end of the year.  The US dollar has likely put in an intermediate term bottom in late 2007 and should rise modestly in 2008.

The cracks in the foundation of global growth will really start to show in 2008, particularly in the form of runaway inflation in China and the Petro-states.  China will be forced to clamp down, probably just after or around the time of the Olympics, starting a chain of events that will lead to a real estate and stock market crash.  The problems in the Chinese economy will likely be overshadowed by Olympics hype, however.  In 2009, deflation will start to spread from China to the rest of the world.

All in all I expect the current trends to continue into 2008, but for it to ultimately be a transition year.  I expect 2008 to represent the peak year of the global expansion.   

Assessing the 2008 Presidential Race

Essay: We are in the midst of one of the most wide-open and unpredictable presidential races in modern US history.  Based on my understanding of the American electorate, I believe that the media fundamentally and consistently misreads the electorate due to its inherently cosmopolitan bias.  Before I delve into the candidates, here are what I believe to be the fundamental truths of the electorate (not all of which conform to my personal views, by the way…this is meant to be analysis, not advocacy):

          As a whole, the electorate is sensible and moderate.  The people believe in “strong reciprocity”…that people should be treated equally and fairly.  They favor policies that benefit the hard-working middle class and that reward well-earned success, but come down hard on those, whether rich or poor, that break the rules or are given special benefits.  (i.e. they were happy to see corporate wrong-doers go to jail, they hate “corporate welfare”, they are tough on crime and they disapprove of welfare and affirmative action by wide margins.)

          On average, given the current definitions of “left” and “right”, the American electorate is left-of-center (“LoC”) on economic issues and right-of-center (“RoC”) on social and defense issues (in direct contrast to the media’s presumption that the country is right-of-center on economic issues and left-of-center on social issues).

          In presidential candidates personality matters a lot – the “more likeable” candidate (from the perspective of a political independent) almost always wins.  Being comfortable in one’s own skin and an optimist is of primary importance.

          Even though the electorate is LoC on economic issues, it is fundamentally anti-tax.  The American electorate rarely elects a candidate pledging to raise taxes in any form, and state ballot initiatives to raise taxes to pay for popular programs routinely get voted down, even in the bluest-of-blue states.  If the federal government’s revenue as a percent of GDP exceeds 20%, (it is currently just above 18% of GDP) the electorate will almost always vote for a candidate that runs on a big tax cut.

          While the electorate pays lip service to deficit-reduction as a priority, when it comes time to vote, it is not.

          The electorate has rarely sustained enthusiasm for a conflict that not deemed to be in the national defense, and all wartime presidents have left office in disgrace, as one-termers or dead.  History has generally rehabilitated those that left office alive, with the exceptions of Lyndon Johnson and Richard Nixon.  That said, the electorate is fiercely nationalist and not internationalist in temperament, which makes it more rightist than leftist.

          The Iraq War is not a traditional right-left issue.  There are rightist reasons against the war and leftist reason in favor.  It was hardly a purely “conservative” decision to launch a pre-emptive strike on Iraq and engage in “nation-building” after the conflict.

          Given the current party structure, a Democrat from New England (and potentially NY and NJ) or a Republican from the Deep South states of MS, AL, GA, LA or SC would have a very steep hill to climb to get elected president.

          The electorate’s views are relatively stable.  What changes are the timing of when certain issues rise in importance (i.e. just because the electorate will vote for a cut in taxes when taxes are high, doesn’t mean they are always looking for tax cuts) and the form of the coalitions built by the political parties (the shift on social issues with Republicans going after tradionally-Democratic blue collar workers and the Democrats making inroads with traditionally-Republican suburban voters).

          There is a long economic cycle (~70 years) that affects the general mood of the electorate.  I won’t go into too much detail about that now, but it results in a shift from progressive politics (economic liberalism, increasing social liberalism) to cosmopolitan (increasing economic conservatism, social liberalism) to conservative (economic conservatism, increasing social conservatism) to populist (social conservatism, increasing economic liberalism).  While the 2000 election was fought during the conservative phase, I would argue that that the 2002-2006 elections were fought on more populist themes, many of which were traditional right-wing populist themes.)  The 2008 election will also be fought and won on populist themes.

          The American electorate rarely grants liberals or conservatives unfettered control of government for periods of more than 2 or maybe 4 years.  It never grants unfettered control for more than 6 years, and those 6-year periods have occurred infrequently, but regularly, since the start of the current two-party system (1868-1974 (conservative), 1896-1902 (conservative), 1912-1918 (liberal), 1932-1938 (liberal), 1960-1966 (liberal), 1980-1986 (conservative), 2000-2006 (conservative)).  It should be noted that from the Civil War to the 1980s, the Democratic Party contained both Southern conservatives and Northern liberals.

          Since the Civil War, with the exception of the period between 1932 and 1968, the Republican Party has had a natural and underestimated advantage in presidential races.  This is a vestige of the Civil War, where the Republican Party was the Union Party and the Democrats were the opposition.  Since that time, the Republicans have generally felt that they kept the flame of American tradition on defense, social issues and economics (although the definition of those traditions have changed over time), and the Democrats have usually been structured as an array of special interests that oppose the Republican agenda.  (That is evident even now, where the Democratic platform, with the exception of health care, is mostly an anti-Bush platform.)  The exception came in the 1930s when the Republican Party’s advantage collapsed during the FDR years of the Depression and World War II and the Democrats could more or less unite on economic issues.  The Democratic coalition fell apart in the late 1960s when the pressure on social and defense issues overwhelmed the glue that held them together on economics.

          It should be noted that only two Democratic candidates since the Civil War have received 51% or more of the vote.  Those are FDR in four elections and LBJ in one.  Republican presidents have almost always won at least 51% of the vote in one of their elections.

          The Democrats can build winning coalitions on economic issues while downplaying social and defense issues.  Democratic candidates from the South can win because they can eat into the Republicans advantage in that region.  (LBJ, Carter and Clinton)

Ok, through that lens, here’s how I judge the electability of the candidates, based on positioning of canididates and personality:


          Clinton – LoC on social issues, Centrist (“C”) on economics & defense, weak personality

          Obama – LoC on all issues; strong personality

          Edwards – LoC on economics, C on social issues, historically C on defense, but now positioned as LoC; ok to strong personality (I would say ok, but as a Southerner he has an advantage)

          Richardson – C on all issues (I think); strong personality

          Biden – LoC on social and economic issues, C on defense; ok to strong personality (I like him, but he talks too much for his own good…like me)

          Dodd – LoC on all issues; strong personality


          Giuliani – RoC on economics and defense, LoC on social; ok to weak personality

          Romney – RoC on all issues (recently, at least); ok personality

          Thompson – RoC on all issues; strong personality if he can break out of his shell

          McCain – RoC on social and defense; C on economics; ok to strong personality (hindered by his age)

          Huckabee – RoC on social and defense, C on economics; strong personality

          Paul – Quirky…while he claims to be a libertarian, he strikes me more as an old-school right wing populist (an isolationist, anti-immigration, anti-trade, hard money advocate, anti-Washington, anti-elitist tradition in various strains from Andrew Jackson to Calvin Coolidge to Patrick Buchanan)

As I believe we are in a populist, and not a conservative era, the parties would benefit from nominating candidates that move both parties to the left on economic issues and the Democrats to right on social issues.  A nationalist, but centrist, foreign policy would be the most appealing to the electorate as well.  I therefore view the strongest general election candidates to be John Edwards on the Democratic side and Mike Huckabee on the Republican side.  I would give a runner-up mentions to Bill Richardson (who I don’t believe can win the nomination at this point) and John McCain.  In a general election, I would expect John Edwards to beat all Republicans with the possible exception of John McCain.  I would expect Huckabee, McCain or Fred Thompson to beat Hillary Clinton or Barack Obama.  Any other combination would be utterly unpredictable. 

Hillary Clinton and Rudy Giuliani are far weaker candidates for the general election than they appear; both are hindered by their personalities and positions on social issues.  Giuliani’s economic plans are pure Republican orthodoxy and don’t offer innovative ideas for the middle-class (even Bush had the faith-based initiative and no-child-left-behind to soften the edges), and the same goes for Thompson and Romney.  Giuliani is out-of-step with the electorate on economic and social issues, is a super-hawk on defense and can have an erratic and acerbic personality, which I don’t believe is a winning combination.  I think Hillary Clinton may be a stronger candidate than Rudy Giuliani, in fact, with the tiebreaker going to her carefully-cultivated reputation as a centrist on economics and foreign policy, partially offset by his modest advantage in personality and heroic reputation.

Icahn: Break up Motorola

Investing Watch:  I agree with Carl Icahn on breaking up Motorola.  I don’t know if his exact plan is the right one, but I do feel that MOT’s results are overly influenced by the fickle handset market, which creates a volatility that hurts the valutation of the stock.  If the handset business was sold, MOT would be a networking company, selling wireless infrastructure (which I don’t think its highly ranked at, and frankly this should probably be sold, too), cable set top boxes and home networking gear (in which it is highly ranked, but its products could use a great deal of innovation to take advatage of the coming surge in smart home applications…its primary competitor is Cisco/Linksys/Scientific Atlanta), and business mobility (not sure what that is, exactly).

The stock is basically flat from the early 1990s and the company has always seemed directionless.  I wouldn’t be surpised to see it re-test its 2003 low of under $8.00 in the next 6-12 months.  It may be a buy at that point.