Dollar

interesting question in the comment to my recent post on the Fed. The impact on the dollar... and inflation. Hmmmm.... Its not an easy question to answer. As you will see be prepared for quite the ramble. Obviously the knee jerk reaction is to assume the dollar will continue to fall in value and it very well might (you will notice I am far less certain in my currency pronouncements vs. stock comments given the abysmal track record of currecy predictors, excluding Mr. Soros of course).

Other hands....

I read a story this week that said the Canadian dollar had reached levels not seen since 1976 vs. the dollar -- and was very close to trading at parity. Seems like the dollar has fallen quite a bit already -- our economy and our inflation are SO MUCH better now than in 1976 that its not worth arguing over (I should clarify that I am thinking of the 70's in general and not that one specific year which could have been a very good one). Maybe we will fall some more but no market moves in a straight line all the time.

I am not one that subscribes to the Buffett view of the world that we have been outliving our means and that our trade deficit is evil and the only answer is a collapse in the dollar. First, the amounts involved are relatively trivial -- a few percent of GDP on an annual basis, which is a negligible percent of our total asset values. Are they big numbers vs. annual trading volumes in our markets? probably but currency volumes are pretty darn big -- check out CME's numbers (their comments on OTC currency markets not those that trade on globex). Second, I don't believe any numbers published by any government -- there is no way anyone could reliably keep up with all the trading that occurs around the world and the very lengthy route most goods take to their final destination. Big currency moves occur when countries do things that are unsustainble -- I'm not convinced that we are in that situation now.

I subscribe to the Milton Friedman school of rates -- floating is best. Why? which makes more sense to change the price of currency exchange or keep that one stable and change every other price in the US or Europe or wherever to reflect the changing values of the currency? one price or millions and millions of prices? Yet smart folks like the WSJ editorial staff like stable exchange rates (well so do I, but the world is dynamic so which do you change -- one price or billions of prices?). The WSJ would have the US change monetary or fiscal policies to keep the dollar flat because this way businesses can plan for the future better including making investment decisions.

While we have this deficit thing and our rates are different from other countries interest rates we have also had faster economic growth than the rest of the developed world -- where do you want to invest? where the growth is. The housing and credit issues are likely to slow our economy over the next year so that argues for a lower dollar too unless our economy still beats the others (Germany, France, UK, Japan, etc), which is quite likely.

All that said -- longer term why do you think I have about 1/4 of my assets in Asian equity funds? because over time they are very very very very likely to gain market share vs. the US in terms of GDP and the market cap of their stocks. Would not be surprised to see Asian currencies gain vs. the US as that process plays out too.

Now on to inflation -- I don't think we will see a big surge in inflation but a continuing uptick is very likely -- if we see the Congress actually following through with higher tax rates then we can look forward to the very real possibility of stagflation. Yuck. nothing works except maybe energy and other commodities. T Rowe Price saw this coming in the early 70's -- he knew that growth stocks valuations were ridiculous (similar to 2000) and that based on underinvestment to curb supply and growing economies helping demand -- he foresaw the new era in which commodities and other hard assets would dominate -- perfect timing as he introduced the T Rowe Price New Era fund.

Besides energy -- look for companies with strong brand names that are able to raise prices without seeing drop in demand. consumer staples are key. I am hopeful new cycles like FLIR will also be OK.

My energy exposure is wimpy -- the Vanguard energy fund for broad exposure has done reasonably well; ERF has done OK -- pays a good yield but canadian tax laws took a bite out last year; EPD and MMP are not price sensitive but more volume related -- not a very good play on energy per se but still they have been outperformers given their growth and high yield. Services/equipment stocks are the non-wimpy play.

History suggests the Fed is almost never one and done -- more rate cuts coming and the impact on liquidity should drive inflation - falling dollar adds to that. Still, there are ways to improve productivity through capital investments and if labor is an issue -- China and India are adding millions to cities each year -- they need jobs. IF Fed is one and done that could change quite a lot of thinking -- that maybe he isn't following in the footsteps of Burns (70's fed chief).

great question - thanks for the comment. will do some more thinking on it.