When Investing: First Pick The Currency, Then The Market, Then The Instrument

The Federal Reserve raised rates as expected in December, but retail sales, industrial production and housing starts disappointed. The FOMC’s new forecasts were virtually unchanged from their previous estimates and projected more of the 2% growth, 2% inflation that a Clinton-led Obama 3 scenario would produce. When harangued by questions about what President-elect Trump would do and how the Fed would react, Chair Yellen stood her ground indicating they would wait for actual policy changes – and that she was strongly in support of the independence of the Federal Reserve.

Retail sales rose a tepid 0.1% in November with downward revisions cutting October’s 0.8% jump to 0.6%. Sales are now 3.8% higher than a year ago, and it really doesn’t matter much if one throws out autos (3.3%), building materials (4.1%) or even all food (up 3.9% — with stores up 3.1% and restaurants 4.9%). Bottom line, sales are well in line with income growth and indicate neither a shift in saving or borrowing. As we watch Christmas sales, they also appear to be following the same mediocre path – including luxury goods, which should be enjoying some benefit from the Trump rally.

Meanwhile, industrial production fell 0.4% on warm weather, with factory output down 0.1% in November – and up just 0.1% in the past year. Housing starts plunged from their October spike – to a nine year high — leaving the three month average for overall starts relatively flat during 2016. Yet, single family permits improved from an already strong October level, suggesting more value than volume. The 1% post-election spike in long term rates is still not reflected in this data. We believe the top is in for housing for this cycle – which still has two more years to run.

Overall, the data suggest an economy that continued to trundle along under the old rules. The Atlanta Fed’s GDP Now estimate is for 2.6% growth in the fourth quarter. Meanwhile, the markets continue to reflect the expectation of significant improvement under the coming new rules. The NFIB’s expectations confirm business’ optimism. Even the Federal Reserve’s three tightenings in 2017 – up from two previously despite a similar forecast – suggest that risks are decidedly on the high side for growth, inflation and interest rates if Trump hits the ground running as hard as he has promised.

While we (like the Fed) await actual policy moves, we will continue with some observations on how we look at the world.

This missive’s focus is the first rule I was taught when joining Shearson Lehman Brothers in early 1987. When investing, first pick the currency, then the market, then the instrument. This observation drove home the importance of money flows in getting the big picture right.

Shifting between instruments (corporates to government bonds, or between sectors in the equities market) is common – and is primarily trading. Shifts between markets – stocks to bonds, or into real estate – tend to reflect significant underlying policy changes like rising rates or tax cuts. Getting the country right is critical, because currencies tend to move in long arcs reflecting global approval or disapproval of a leader’s policies.

Lots of money is stuck with a home bias (more than is stuck with a sectoral or market commitment) so there is significant comparative advantage for those who can shift from nation to nation. Moreover, where it takes money — and a lot of it — to move most markets, relatively modest shifts in international flows can produce significant changes in currency values – and they are far more significant in balancing international investment returns than domestic changes.

With the dollar as the reserve currency, at the margin all decisions are made relative to the deep US financial markets. Investors often look at the DYX, effectively a G-7 currency index, since they are most interest in developed countries with alternative investment markets.

Economist focus more on the broad trade weighted index to determine how global growth is developing. The difference is striking as the US is effectively holding its own against the rest of the G-7, while enjoying a vast rise in buying power relative to all of its trade partners. That rise comes because for the US to remain competitive with the rest of the G-7, it has relied more on the cheaper labor of emerging markets.

While the shares of US trade with Asia, Europe and the rest of the world have been fairly stable for decades, there has been a persistent march down the cost curve leading to broader global development. China and Mexico standout within Asia and NAFTA, but smaller players have benefited as well.

Critically, there is a strong positive correlation between the strength of the trade weighted dollar and US real wages. As US leadership expands the global economy into emerging markets through both investment and consumption (even when somebody else produces the goods), US real wages tend to rise. This is the feedback loop from being the suburbs of the world.

As the world prospers, money comes to the US strengthening our currency and providing the capital gains that make even more expansionary global investment available. Since 1973, the two periods when the trade weighted dollar fell were the mid-1980s when Japan was the primary beneficiary of global (primarily Asian) growth and the early millennium.

When WTO opened China in 2001, 9/11 closed the US — and both Europe and Japan stole a march on the US gaining more from China’s early rise. Facing pressure from the US, China began to appreciate their currency after 2005 making them the biggest beneficiary of globalization. A wealthier China’s booming demand for commodities set off a virtuous feedback loop as materials producers bought inexpensive Chinese goods, replacing the developed world as China’s main customers. The Japanese Tsunami in 2011 capped the commodities boom and economic weakness in Japan, Europe and China allowed the US to reestablish its dominance as the global leader.

Note that while wages are more cyclical than the trade weighted dollar – they change far more gradually. The median real wage rose from $47,000 in 1973 to $58,000 in 1997 – roughly 25%. In the same period the dollar quadrupled against our trade partners – increasing both our international buying power and the value of the US assets that their most successful global entrepreneurs want to buy.

True, a stronger dollar makes US labor more expensive so it is harder to sell our current production – but it is also increasing the value of the nation’s entire capital stock including all the non-productive land and buildings.

Which is greater, the wealth of a nation or the value of its labor? Adam Smith won out over Karl Marx on that one many, many, years ago. Let’s not reinvent the wheel – poorly. Both the dollar and wages have been on the rise again since 2012. With trading partner currencies, like the Mexican peso and Chinese yuan, under pressure that trend should continue in 2017.

Most Americans are unaware of how well off they are on a global scale. The median income in the US was over $56,000 in 2015. The poorest region of the US – the South (with 79 million residents) – had a median income of $46,000. The 47 million living in the Boston to Washington corridor had a median of $70,000.

By comparison, the UK median fell below $44,000 due to recent devaluation – yet remains the highest of any large nation in Europe. Scandinavia’s collective 26 million inhabitants enjoy a median income just under $54,000. Italy is under $30,000 and Spain under $26,000.

By comparison, the impoverished US territory of Puerto Rico — on the brink of default — rivals Italy (also on the brink of default) in terms of median income. In Asia, Japan’s median is just $32,500, while South Korea is below Puerto Rico. It is only small countries (like Switzerland, Ireland and Qatar) that exceed the US (currently 6th on the global list).

Given picking a currency is critical, we would stick with the dollar for now. It has already been rising despite our troubled government and moribund policies – because they are better than anywhere else on the planet. The real secret to keeping America great is continuing to be the most desirable final destination for wealth – no matter where it is earned.

An important corollary to the currency rule is to understand that within a currency bloc, land – the one immovable asset – takes on the role of foreign exchange. As successful people seek to move to more desirable areas, they drive up land prices creating the capital gains that support investment. In less desirable areas, land values will rise more slowly than inflation and may fall, reducing intermediation lending, investment and growth.

It will come as no surprise that the strongest appreciation this century has been on the technology oriented West Coast and in Florida where retirement wealth flows. Boston also benefits from technology (and finance) while DC is a perennial attraction to money for some reason. The six lowest ranking cities are all heavier in manufacturing.

Similarly, in Europe, land values rise in Germany while they plunge in Greece. Land values don’t move as fast as FX, because it takes physical purchases rather than more fungible electronic ownership. However, capital flows are still as important as actual labor mobility.

A major dilemma for China is that residual communism forces them to resist the inevitable rise in land values in major cities like Beijing and Shanghai. However, given the trapped wealth in China, these values should continue to skyrocket relative to second and third tier cities based on productivity and desirability. While they endeavor to stoke growth far from the capitols of capital, success still wants a Beijing pied a tier.

You can’t beat living in the suburbs. That is how the system works.

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