threatening Federal Reserve independence

trying to intimidate the Fed?

Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post.  The purported reason:  Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation.  In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional).  The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo.  This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy.  That resulted in runaway inflation and a plunging currency.  By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase.   The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly.  This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.







currency effects on US companies’ 1Q16 earnings

Over the past year or more, the international portion of the earnings results of US publicly traded companies has suffered from the strength of the US dollar.

Data dump:

-By and large, US products sold in foreign countries are priced in local currency.  When the dollar rises, the dollar value of foreign sales falls.  Speaking in the most general terms, firms can raise prices without damaging sales volumes only at the rate of local inflation, meaning that it can take quite a while for a US company to recoup a currency-driven loss through price increases.

-The rise in the dollar has come from two sources:

–the collapse of the currencies of emerging countries with unsound government finances and radically dependent on exports of natural resources like oil and base metals, and

–the greater strength of the US economy vs. trading partners like the EU and Japan.

-What appears on the income statement as a currency gain or loss is the result of a complex process with two components:  cash flows; and an adjustment of balance sheet asset values. There’s no easy way to figure out what the exact number will be.

-We do know, however, the very important fact that the dollar has been weakening against the euro and the yen for the past several months.  If the quarter were to end today, the euro would be 3.2% stronger vs. the dollar than at the end of 1Q15.  The yen is now 5% stronger than it was at the end of last March.  The Chinese renminbi is 5% weaker against the dollar than this time a year ago, but there’s much greater scope to raise prices in China.

My conclusion:  US companies with mainly and EU or Japanese assets/earnings will likely post modest foreign exchange gains during 1Q16 vs. large losses in 1Q15.

Hedging?  Many international  firms try, more or less successfully, to smooth their foreign earnings by hedging.  This activity is crucial for an exporter with long lead times, cosmetic for everyone else.  The key point, however, is that in my experience when hedging results in a gain, this is recognized in operating profit and companies say nothing.  When the hedging makes a loss, companies disclose the figure and argue that this is a non-recurring item.  For whatever reason, Wall Street usually ignores a loss of this type.

So, ex emerging markets, currency can be a significant positive surprise for internationally-oriented firms this quarter, instead of the earnings drag it has been in recent quarters.  My guess is that Wall Street hasn’t factored this likelihood into prices yet.





recent world currency movements: stock market implications

dramatic changes

Although currency movements sometimes can often be overlooked by a stock market investor immersed in the hustle and bustle of day-to-day trading action, there have been a couple of whopping big moves in major currencies over the past half-year.

Since late July 2012, the euro has risen by 12.5% against the dollar.  Over the same time span, the yen has fallen by about 16.5% against the greenback.  A quick bit of multiplication tells us this also means that the euro has risen by about 30% against the Japanese currency.

To my mind, there’s no really satisfactory general economic theory about how currencies work.  But to give a sense of perspective, inflation in Japan has been, say, -1% on an annual basis over the second half of 2012.  We’ve had +1.5% in the US.  Euroland has experienced a 2.5% rise in the price level.  Inflation differentials imply that the yen should be rising against the dollar at a 2.5% annual rate and against the euro by 3.5%.  The euro, in turn, should have weakened by 1% against the dollar and 3.5% against the yen.  The actual outcome has been far different.

Of course, there are reasons for the spectacular assent of the euro and the plunge of the yen.  Until around mid-year, many observers thought Euroland was coming apart at the seams and rushed to get their money out before the demise.  I’m sure there was more than a touch of flight capital mixed in the outflows.  Thanks to Mario Monti’s and Angela Merkel’s actions indicating the political will to save the euro, capital flows have reversed in spectacular fashion.

Newly-elected Japanese Prime Minister Shinzo Abe made it a central plank of his campaign for office that he intends to force the Bank of Japan to print lots of money.  Why?   …to weaken the yen and to create inflation.  The move could easily end in eventual economic disaster, but for now its main effect has been to drive the Japanese currency down a lot versus its trading partners’.

stock market implications

Generally speaking, a rising currency acts to slow down the domestic economy.  A falling currency gives the economy a temporary boost.

Currency changes can also rearrange the relative growth rates of different sectors.  The best-positioned companies will be those that have their sales in the strongest currencies and their costs (e.g., labor, raw materials, manufacturing) in the weakest.


The decline of the yen has given Japanese export-oriented firms a gigantic relative cost advantage against European competitors, and a significant, though smaller, one against US rivals–or those located in any country that ties its currency to the US$.  Anyone who sells products in Japan that are imported, or made with imported raw materials, has been crushed.

We’ve seen this movie before, however, on a couple of occasions.  It’s ugly.  Domestic firms lose.  Exporters will make substantial profit gains in the local currency.  But from a stock market view, that plus–with the possible exception of the autos–will be offset for foreigners by currency losses they have/will endure on their holdings.  Stocks in even the most advantaged sectors will deliver little better than breakeven to a $ investor, and will certainly rack up large losses to anyone interested in € returns, in my view.


The EU has already had a return-from-the-dead rally, where stocks of all stripes in the economically challenged areas of southern Europe have done well.  The message of the stronger currency is that importers, or purely domestic firms in defensive industries will fare the best from here.    Although I think the preferred place to be from a long-term perspective is owning high quality export-oriented industrials, the rise of the euro has blunted their near-term attractiveness.  One exception:  multinationals based in the UK, because sterling hasn’t participated in the euro’s rocketship ride.

Ideally, you’d want a firm that imports Japanese goods into the EU.

the US

Americans are less accustomed to thinking about currency effects that investors in other areas, where their effects are more pervasive.  With the dollar being in the middle between an appreciating euro and a depreciating yen, currency effects will be two-sided. Firms with large Japanese businesses, like luxury goods companies, will be losers.  Firms with large European assets and profits, like many staples companies, will be winners.  Tourism from the EU will be up, from Japan, down.  One odd effect, which I don’t see any obvious American publicly listed beneficiary–the decline in the yen is causing the cost of living for ordinary Japanese to rise sharply, since that country imports so many dollar-price raw materials.  To offset that effect, Japan is beginning to weaken protective barriers that have kept much cheaper finished goods (like food) from entering the Japanese market.  Doubly bad for Japanese farmers, though.

watch the currencies!–what they’re saying now

three key pieces of data for investors

Over the last several weeks, two pieces of information have emerged that have potentially great importance for equity investors.  A third may develop from the US Federal Reserve today.

They are:

1.  the Case-Schiller index, which is very influential in the US, despite being a lagging (also called confirming) indicator of the state of the housing market, has finally signalled that overall residential prices have bottomed and are on the mend.  The five-year slump is over.

Although I think the revival of the housing market gives a second wind to the domestic economic expansion, in the counter-intuitive way Wall Street works, it also has a darker side.  Other than Washington suddenly starting to do its fiscal policy job, which would be a huge positive surprise, it’s hard for me to see what new positive market-moving economic development could happen in the US over the coming months.

2.  The European Central Bank has announced a broad support plan for the bond markets of the weaker members of the Eurozone.  Yesterday, the German high court rejected litigants’ assertions that the German government was barred by that country’s constitution from participating in the plan.  Germany is slated to provide over 25% of the financing of the Eurozone rescue plan, so this decision was crucial.

The implication is that EU economies will be stronger over the coming year or so rather than weaker.

3.  The Fed may announce further unconventional measures today to support the US economy.  The Fed has repeatedly said that fiscal policy would be a much more effective engine to spur growth, but apparently sees about the same chance as I do of that happening.

Two measures are possible.  One is additional bond buying, intended to flatten the yield curve.  The second is a commitment to hold short-term interest rates at today’s emergency low levels for the next three years.  Yikes!  Three more years of nearly no income from CDs and money market funds?

I think the second would  have the more significant effect for Wall Street.  It would give two contrary signals:  it would say that there’s no need to flee the bond market anytime soon; and it would imply that the only liquid investment that will provide significant income for savers any time soon is the stock market.

three places to see their effects 

1.  the performance of general stock markets in their local currencies.

The S&P 500 is up 9% over the past three months.  I think the recovery of house prices, which is the major source of wealth for most Americans, is the main reason.  EU growth should also have a positive rub-off effect on US firms involved in foreign trade, as well as the many S&P firms with substantial operations in Europe.

The Eurostoxx 50 is up 19% over the same span.  Broader indices are up in the mid-teens.  Most of the outperformance of the S&P has come in the past month, when Eurozone rescue plans have been publicized. Dollar-based returns on the EU indices are much larger.

2.  You can also changes in the lists of sectoral winners and losers, as I’ve written about on the Keeping Score page on PSI.   Generally, the US investor has shifted away from defensive sectors toward IT and Consumer Discretionary, two moderately bullish areas, while not to sectors like Materials that would benefit from a strong general economic upsurge.

3.  Most US investors generally ignore the third area–currency movements.  I think it’s certainly true this time.  But from mid-July until now, the € has risen from a value of $1.20 each to $1.29, or 7%.  True, the ¥ has been rising since March, when holder had to pay 84 to get $1.  But it has also recently risen above the 78 level that the Tokyo government had been trying to defend.

To my mind, the Japanese economy still has nothing much going for it.  Seeing that currency rise at all–which normally happens only in a healthy country–really says something.

the message?

If we add a currency gain of 7% to, say, a 14% rise in European stocks, the total return to an American investor in the past month is more than 20%.  If we have indeed made a major turn in the EU, the party is far from over, in my judgment.

Many European stocks still have strikingly high dividend yields–certainly a temptation to income-oriented investors but also a warning of potential risk.

I’ve been advocating having a severe underweight in the EU, with exposure only to companies listed there but with significant operations elsewhere.  I haven’t made any changes yet, but I’ve got to at least reconsider my position.

Conversely, US-listed companies with large businesses in the EU may not be having great local currency sales at the moment, but they’re enjoying a big boost in dollar terms.

The rise in the ¥ tells me that at least a part of what is happening is not foreign currency strength.  It’s dollar weakness.  That may be because of continuing fiscal policy failure here, or just the perception that all the potential good news is already out.

The much greater € strength suggests that real economic improvement is expected in the EU.  I’m still mostly convinced that Greece will be forced out of the Eurozone (and the EU).  But markets may not be willing to wait for this final shoe to drop.

To sum up:  we may be in the early stages of a significant shift in the attitude of global equity portfolio managers about where they want to place their clients’ money.  If so, I think the clearest sign is coming from the currency markets–it’s mildly against the US, strongly for the EU.