1st Quarter 2004: Global markets 1st quarter 2004 - the weak US dollar

Is it really America’s problem at the moment? Well, if you think about it carefully – not really. But let’s first look at what caused the US Dollar to weaken. Over the past number of years, as growth in the USA has often exceeded the average growth achieved in many other countries, American consumers have relied more heavily on imports. As a result, America needs to borrow more in order to finance the trade account deficit that has come about as a result of these increased imports. American exports grew by 4.6% in 2003, while imports grew by some 8.3%. So pressure has been put on the US Dollar because cash flowed out of the country to pay for imports, while goods and services kept flowing in – the result; a weaker currency. For example, in December the overall deficit with China increased to $124 billion. In addition, remember that interest rates in the USA are at levels well below many of its trading partners (except, of course, Japan) making it an unattractive destination for foreign investment cash flows – another factor that keeps the US Dollar under pressure.

How does a weak US Dollar impact on American corporates? A weak US Dollar is good news for American manufacturers in that it promotes US exports because they become cheaper to countries that import American goods. Stronger exports from the USA (because American companies become more competitive with a weaker US Dollar) improve domestic growth in America and stimulate job creation. The more America exports, the more cash flow that flows in to offset against the current account deficit. All this, of course, is especially good news in an election year, with domestic growth and job creation being two strategic issues for the Bush administration.

So, we’ve established that currently a weak US Dollar is by and large favourable for corporate and manufacturing America, but what about the impact on American citizens themselves? The US dollar has recently touched 3 year lows against the Japanese Yen, 11 year lows against the Pound and all time lows against the Euro. International tourists to the United States are finding it much cheaper on their pockets - American tourists are finding it a lot more expensive. Take the following example – where it would have cost an American tourist some $1 500 to spend a weekend at an upmarket hotel in London just one year ago, this same weekend will now cost an additional $175. On the other hand, as a result of a combination of a weak US Dollar and the fear of flying that exists amongst many since the events of 911, the price of accommodation in New York has reduced by more than a third – good news for incoming tourists? Of course it is – and it is also good news for the USA in that an increasing number of tourists boost job creation.

So, where is the major impact of the weak US Dollar being felt the most? Take Europe, as an example – a company like Volkswagen that exports over 250 thousand vehicles a year to the United States will now find it more cost effective at current exchange rates, to manufacture these vehicles in Mexico, rather than back at home in Germany. Japan, for instance, has spent over $187 billion participating in the foreign exchange markets in an attempt to stem the effects of a weak US Dollar. Why would Japan do this – again, they are an export driven economy and consequently cannot afford to be priced out of the market. Regions like Asia, too, are finding it difficult to have their exports to the USA remain competitive.

In summary, the benefits for America brought about currently by a weak US Dollar, especially with 2004 being an election year, make a weak US Dollar an appealing option. So, is a weak US Dollar America’s problem right now? Not really, unfortunately it becomes the rest of the world’s problem.

The Federal Reserve kept interest rates on hold at 1% at their January meeting. A rate of 1% was last seen in 1962. Subtle changes, however, were made to the wording of their statement following this announcement. They substituted the wording from previous reports where they indicated that rates would be kept on hold for “a considerable period” with saying that they could be “patient” with rates. Following on from this announcement, Ethan Harris, chief economist for Lehman Brothers stated: “they keep fiddling with the language, and the general tone of the directive keeps getting a little less dovish”.

Being “patient” sounds a little less like they’re keeping rates on hold than a “considerable period” – though you’d need to study a dictionary closely to figure that out.” Many investors are of the opinion that the change to the Federal Reserve’s language “was a hint that the central bank was moving closer to raising rates”. In its most recent statement “the Fed painted a mixed picture of the economy saying output was “expanding briskly” but that new hiring was “subdued” and that inflation was “muted”.”

Despite increasing evidence that prices are likely to start rising (due to the declining value of the dollar, the rise in gold, oil and other commodity prices) many economists still believe that the Federal Reserve are unlikely to raise short-term rates until there is clear evidence of consistent job growth and an indication that inflation is rising. According to recent figures released by the Commerce Department, the US economy grew by 3.1% in 2003, which is the best growth level since 2000.

No changes were made to interest rates during the quarter under review. This is the eighth consecutive month where rates have remained unchanged. At the moment interest rates in the Eurozone are at half the levels of those in the United Kingdom (2% versus 4%). While economists expected no change over the quarter, some still believe that a cut in rates is likely to curb the rise of the Euro. The ECB is widely known for its conservatism, and this has been questioned more closely in recent weeks, with the Euro reaching levels unprecedented since its launch some five years ago.

Recent economic data in the region has improved, however the pace has been weak The most recent 2004 growth forecasts by the European Central Bank are between 1.1% and 2.1%. According to Germany’s Economics Minister, Wolfgang Clement, “the Euro’s strength and the Dollar’s weakness are the biggest risk to growth at the moment.”

The Bank of England increased interest rates to 4% at their February meeting, after announcing a 0.25% increase. The increase was widely expected in light of recent economic data that had pointed to the fact that the UK economy has been growing at a good pace. Despite expectations that the November rate increase would put a dampener on ever-increasing house prices, few signs of this have been evident. Reacting to the news of the most recent rate increase, David Frost, director general of the British Chamber of Commerce, expressed his disappointment saying “This rise is premature and is likely to hit recovery over the head before it gains momentum.”
He also stated that it is difficult to justify the increase in rates when the inflation rate is currently below the target level. You will recall from our last report that the primary reason given for the November rate hike was that inflation had moved slightly above the target level. The Treasury appear to support the stance of pre-emptive rate increases that are aimed at curbing the economy from “overheating”. In essence, the view is that the Bank of England, “while not looking to shackle growth, want it to proceed at a more sustainable pace.” The latest figures released by the Office for National Statistics indicate that the UK economy grew by 2.1% in 2003. It is interesting to note that in January the jobless rate declined to 2.9% - a 30 year low.

 

Japan has been one of the major beneficiaries of increased investor confidence over the past year. With Japan largely being an export driven economy, the region has continued to benefit from ongoing demand from Asia, the United States and China. As a result, in the last quarter of 2003 the Japanese economy grew at its fastest pace in 13 years. The increased demand for Japanese exports has impacted positively on employment in the region, which in turn bodes well for increased consumer spending. Kazumasa Iwata, the deputy governor of the Bank of Japan, said at a recent conference in Kobe that the GDP numbers may suggest that the economy is reaching a “turning point”.

The authorities, being very aware of the risk posed by an appreciating Yen, have intervened on a number of occasions to curb this trend (the Yen rose by 10% against the US Dollar last year). With the Japanese financial year-end only a number of weeks away a strengthening Yen would not be good news for corporate profits. The Bank of Japan have made it clear that it will not make the same mistakes as it has in the past i.e. by smothering a economic recovery due to tightening policy too early.

Prime Minister Koizumi continues to focus at lot of attention on solving the problems of the banking sector.

The Monetary Policy Committee reduced interest rates by 0.50% at their December 2003 meeting, bringing the total interest rate reductions during 2003 to 5.50%. No changes were made to interest rates at the February 26th and 27th meeting, so the Repo Rate and Prime remain at 8% and 11.5%, respectively. The general view is that we are at the end of this declining interest rate cycle and there is even speculation that we could be in for interest rate increases during the last quarter of this year and on into 2005. This is supported by the opinion that CPIX inflation is likely to have bottomed and is expected to rise over the next two years. However, if CPIX inflation declines further (with possible underpinning from the Rand), this would be supportive of further interest rate cuts. Other factors, such as the stability of the oil price, food prices (consider the drought currently being experienced in the northern regions of South Africa) and the level of international interest rates are likely to play a part in this decision. According to a recent Reuters Econometer Survey, economists have revised their 2004 CPIX inflation average to 4.84% from a previous view of 4.72%. They expect CPIX inflation to average 5.6% for 2005.

The Rand, which remained volatile over the quarter, depreciated against the US Dollar, Pound and Euro by 3.42%, 12.29% and 7.78% respectively.

Domestic growth for 2003 came in at a disappointing 1.9%. This is well below 2002 (3.6%) and 2001 (2.7%) growth levels. The National Treasury forecast 2004 growth at 2.9%. The impact of a firmer Rand on exports is clearly evidenced by this number.

2004/5 BUDGET

The Budget Speech delivered in Cape Town on the 18th February held few surprises. Personal income taxes were reduced by some R4 billion, with the largest benefit (49%) going to taxpayers who earn between R60 000 and R150 000. The interest exemption for under 65’s was raised from R10 000 to R11 000, while for taxpayers over the age of 65 the exemption was increased from R15 000 to R16 000. In addition the tax brackets were adjusted, with the top threshold increasing from R255 000 to R270 000. The Primary Rebate was increased to R5 800 from R5 400.

No changes were made to Exchange Controls applicable to individuals – it was mentioned that some 14 000 amnesty applications had already been processed.

The price of Brent crude oil increased during the quarter to end the period at $33.24 per barrel, from $30.39 per barrel at the end of the previous quarter. OPEC, in a surprise move, announced at its February 10th meeting that it would cut production by 4% (1 million barrels per day). The main reason given for this move was that OPEC anticipates a “seasonal downturn in demand”. However, there is another possible interpretation of their latest move. OPEC, more specifically over recent months, but in fact over the past few years, have been careful not to let the oil price rise too much so as not to push the global economy into a recession. A global recession would not be good news for OPEC as, demand for oil would decline, and consequently so would the price. However, this stance is likely to have cost them dearly in terms of lost revenues. With the global economic environment having improved in recent months, the Federal Reserve likely to keep rates low for the foreseeable future and a commodity run that has been underway for the past several months, could it simply be a case of OPEC wanting to participate in this upturn in the commodity cycle?

The gold price increased sharply over the quarter – ending the quarter at $398.90 an ounce, compared to $376.50 an ounce at the end of November 2003. As highlighted previously, the current upward trend in the gold price began in early 2001 after the Federal Reserve began its series of interest rates cuts. The gold price has continued to climb as USA short-term interest rates have remained low – low interest rates make the opportunity cost of holding gold low. A weak US Dollar, together with low short-term interest rates, have provided support for the gold price at these higher levels.

Equities surprised on the upside in 2003 (from early March), with the various indices posting the following base currency returns:

While the base currency returns posted during 2003 were encouraging, it is important that we remind ourselves of the fact that these returns came off of a very low base, and accordingly, we need to modify our expectations in respect of returns in 2004 and not base them on the performances exhibited in 2003.

We encourage you to visit our website www.finlaw.co.za where you will find a range of interesting articles updated daily. In addition you will be able to access our quarterly economic reports.

QUARTERLY QUOTE
"For myself I am an optimist – it does not seem to be much use being anything else."
Sir Winston Churchill

his report is based on information sourced from various institutions, both local and international. The report reflects a variety of views and is not intended to convey investment advice. Please consult us to obtain specific advice relevant to your investment portfolio.