Investor uncertainty regarding the Federal Reserve's next move has manifest itself in a pause in the dollar's seemingly unending downward spiral on the world's foreign exchanges.
At the same time, poorly correlated assets, such as commodities, appear to have reached a plateau after a parabolic run over the course of the past five years. Whilst we accept that the sole cause of prevailing inflationary pressures is unlikely to be found deep in the futures' pits of Chicago (food riots around the world are clear evidence of the fact that stocks are dwindling, which might not be the case if this was purely a speculative bubble), speculation has undoubtedly helped drive both soft and hard commodity prices to these stratospheric levels.
So severe are the travails of the US economy that dollar devaluation has been inevitable for a long time and (pleasingly) Charles Stanley has been right on top of this story from the start. Given the inevitability of the dollar's date with destiny it was equally certain that investors would seek ways of insulating themselves from its impact.
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Buoyed by significant incremental demand from the fast-growing economies of south and east Asia (thus ensuring a fair degree of protection from the Western economic malaise), commodities seemed as good a place as any to park the bike.
In the wake of the 30th April Open Markets Committee decision we remain unconvinced by market speculation that the Fed's work is done. Certainly the chances of a further reduction in Fed Funds at the 24th-25th June meeting appear to have lessened, but the accompanying communiqu did little to suggest that the central bank is overly concerned by spiking near-term inflationary pressure.
In fact the Fed is looking forward to a moderation in pricing pressure in the future. We wholeheartedly concur. We believe that Dr Bernanke (but not voters Fisher and Plosser who dissented from the latest decision) fully understands what is happening in the global economy sufficient to see that changes in global demand, coupled with inelastic supply curves, has created a boom in resource prices that acts, essentially, as an exogenously applied deflationary tax increase.
Yes, rising global resource prices are inflationary, but only insofar as they impact on certain aspects of the consumer price index. Elsewhere the index is deflating aggressively as higher prices on the forecourts and in the supermarket trolleys are creating a severe drain on already aggressively indebted households' purchasing power. Needless to say, we do not view the prevailing environment as particularly inflationary in the round.
Our position is supported by the fact that, in the United States, the highly regarded and closely watched University of Michigan consumer confidence survey showed that, on the ground, householders perception of inflation has risen to a 12-year high at 3.2%. Just a second! Inflation at 3.2%! This at a time when gasoline prices have just rocketed through $3.60 a gallon! The last time US households were this nervous about inflation (1996) a gallon of gasoline cost just $1.20! So the fact that inflation expectations are no worse than they were when a gallon of petrol was one third of its
current price must mean that falling prices elsewhere are mitigating the gloom (just check out the falling price of flat screen TVs!).
One major imponderable remains the extent to which US households will spend the tax rebates which are already beginning to flop through letterboxes across the country. Of course when companies such as Wal-Mart are offering to cash the cheques instore one might be under the impression that the money will be spent, not saved. However, as the US savings ratio chart (see below) makes clear, the scope for households to save the money or pay down debt is equally enormous and our best guess at this stage is that the savings ratio will indeed rise over the coming months.
US household savings ratio is expected to rise sharply
This takes us on to examine the growth outlook. Optimists may have been buoyed by a first estimate of Q1 GDP which appeared to show that the US economy narrowly avoided recession over the first three months of 2008. An annualised increase of 0.6% (the same as that recorded over Q4 2007) is, of course, far from vibrant and once the detail is pored over it actually looks even worse.
First off, the number was supported by c$20bn of inventory stock piling and secondly (and as expected), by the strength of US exports itself partly the function of the weak dollar. Secondly, residential construction collapsed by 26.7% year on year (from -25.2% over Q4 2007) and the worst back to back read out since the deep depression of 1981.
Consumer spending was also in negative territory for the second successive quarter and grew by just 1% year on year over Q1 08, capital spending fell by 0.7% as companies cut back in the profit recession already well upon us and non-residential construction, previously robust while residential activity declined, recorded its first fall in thirteen years.
Digging even further into the detail it transpires that real final sales to domestic purchasers (i.e. excluding inventory and net overseas trade) fell by 0.4% annualised over Q1, again the worst performance since the 1991 recession. Whilst the headline data may provide scope for the National Bureau of Economic Research to say that the US economy has avoided recession, the underlying detail makes it quite clear that it certainly doesn't feel that way to US householders.
The combination of weak growth and an inflation mirage leave us of the view that a prolonged period of lacklustre activity is now in prospect and that to suggest that the Fed's base rate activities are now over would be very premature.
Conclusion
What this means, in practical terms for the financial markets, is that the dollar's trade weighted decline is far from over. Some solace may be gleaned from deteriorating European activity and the fact that the UK economic position is just as dire as that of the US (implying that sterling could yet stumble against the dollar on the foreign exchanges).
Government bond yields, particularly US Treasury yields, which have backed up from over-bought levels in recent days retain the scope to fall back again and that, turning to the equity market, the rally that has seen the FTSE 100 rise by c13% from the capitulation low of 17th March may be vulnerable to further earnings disappointment.
The prospect of further dollar weakness is, however, a shot in the arm for commodity prices and a further boost to the Basic Materials sector which proved the second best performer (behind energy) over April. This is significant as the combined weight of energy and basic materials stocks in the UK equity market, by capitalisation, is c30%. This implies much greater cyclicality and much less defensiveness to the UK equity market than had hitherto been the case. Are we nearly there yet? The answer is we're getting there but it's not quite time to undo the seat belt.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
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