So, it’s Obama versus McCain. A year ago the “experts” told us that Rudy Giuliani and Hillary Clinton would be accepting their party’s nominations this summer. Rudy didn’t make it out of Florida. Clinton stuck around all the way to the last primary, but in the end discovered that her Back to the Future campaign had as much appeal as the movies of the same name. Democratic primary voters opted for “change” which apparently means young, good looking and not named Clinton.

So, once again the experts got it wrong. Predicting the future is impossible and the only way to improve your odds would appear to be choosing the opposite path of the pundits. And so it goes with economic predictions as well. Recession, which seemed a sure thing to the press and the vast majority of economists a few months ago, has still not arrived. The economy, stubborn thing that it is, refuses to roll over despite high oil prices, falling home prices, rising food prices, imploding bank balance sheets and the rhetoric of politicians intent on re-election.

To be fair to the pessimists, there is some debate over the accuracy of the economic statistics that are reported by the government. The tame inflation reported in the official statistics contrasts sharply with the disgusted looks on the faces of real people at the pump or checkout line. And if the inflation numbers are suspect, then the official GDP statistics don’t reflect reality, but rather some funhouse mirror version of the economy. I don’t disagree with this view; the economy is not growing nearly as much as anyone would like and likely less than the official numbers. On the other hand, we aren’t on the precipice of the Great Depression Part II (Buddy Can You Spare a $100) either.

The fact is that the US economy has suffered some severe shocks over the last 9 months and weathered them better than anyone could have predicted. If someone told me last August, “Before next summer we will see oil at $135, the failure of a major investment bank, Fed funds at 2% and we stillwon’t be in recession”, I would have suggested that they be fitted for a new white coat with really long arms.

What some perceive as problems in the economy are actually the very things that have enabled it to weather the storm. Food prices have risen and that hurts the average American, but that unique recipient of government largesse known as the American farmer is generally benefiting from record commodity prices. Farm income is on the rise and while that may not mean much to Macy’s bottom line, it certainly hasn’t hurt Wal Mart or John Deere. Oil prices may be high and Congress is looking for a scapegoat (they ought to try looking in a mirror), but those high oil company profits are at least going to American companies and get recycled into our economy. Falling home prices may mean less spending on single family homes but multi family building (apartments) has picked up some of the slack. And prices are now down to a level that is affordable again for the average family of median income. It’s amazing how markets work; the seeds of recovery are always sown in the correction.

Another source of concern has been the ever shrinking value of the dollar, but even this has a silver lining (take a look at the chart of exports below). One of the first lessons I learned when I started in this business was the easiest money made in stocks was in buying a country’s stock market after a currency devaluation. A broker named Larry Gatto (God rest his soul) gave me that bit of wisdom. Larry wasn’t much for economic theory so when I asked him why, he said simply, “Because it works”. I’ve used that little bit of wisdom several times over the years and it has yet to fail. Korea after the Asian Crisis. Brazil after the devaluation in 1999. Even Argentina after their default. It’s worked every time. Why? Assets in countries that have devalued are seen as cheap by anyone lucky enough not to suffer the consequences of the devaluation. That’s starting to happen now in the US. I read a news story recently about a Chinese company opening a facility in South Carolina because even after considering the higher cost of labor, it was cheaper to expand in the US than China. I’ve also seen numerous stories of foreigners coming here to buy real estate. A Brit holding pounds looks at a South Beach condo and sees a bargain. At this point that is true for just about anyone holding a currency other than Zimbabwe dollars. Investment will flow to cheap US assets as long as our politicians don’t do something stupid (like impose tariffs or attempt to regulate Sovereign Wealth Funds) to stop it.

It appears now as well that the mandarins of the Federal Reserve have finally discovered that a weak dollar may be complicating their policy making. Ben Bernanke delivered a speech recently where he acknowledged, finally, that the falling dollar was having an effect on inflation and pledged to make it part of their future deliberations. The dollar is part of the Treasury Department portfolio and previous Fed Chairmen have assiduously avoided speaking about the value of the dollar lest they step on the wrong toes. That Bernanke even mentioned the dollar tells me that he and Hank Paulson are of a single mind about the future course of the dollar. Don’t be surprised if you see a report soon about the Treasury buying dollars on the open market. Coordination between the Fed and the Treasury could cause a lot of heartburn for speculators who are almost universally short the dollar.

If the Federal Reserve and the Treasury Department are successful in placing a floor under the value of the dollar, markets will respond. Commodity prices should fall as the dollar stabilizes (or even better, rise in value) and stocks could find support as foreign investors start to return to the US market. We’ve already seen a preview of this; oil is down almost 10% from its highs and gold is down 7%. Oil is the more important factor right now. A reduction in energy prices would provide welcome relief to consumers and potentially get growth back on a higher growth path.

This transition will not happen overnight. Investors who missed the commodity boom will look to get in as prices fall and the plethora of stock market bears will look to sell rallies. Economic data may well worsen before it gets better as the drag of higher energy prices shows up in this quarter’s reports. As I discussed in my last update, long term trends are hard to change and the dollar bear market has persisted for most of this decade. Changing attitudes about the dollar will not be easy, but it is critical to our future economic well being. Economic data has been surprisingly strong even after the shocks we’ve faced over the last nine months. A drop in commodity prices would be just the right medicine to complete the recovery.

Selected Charts

The Dollar may be making a bottom:
US Dollar vs Euro

The flight to safety into Treasury Notes seems to be ending:

Export growth has kept the economy afloat:

Imports are still growing, unlike the last recession:

Gold is correcting:

Along with other commodities.

Goldman Sachs Commodity Index:

The death of the US consumer has been greatly exaggerated:

And income is still growing:

Capital Goods orders also show a sharp contrast to the last recession. This bodes well for future growth:

Production is holding up surprisingly well:

Payroll growth has moderated but the slowdown has not been severe:

Stocks have retraced some of their gains from the March lows, but this is fairly typical market action:

REITs are outperforming stocks this year:

International stocks are outperforming US stocks so far this year, but a rise in the dollar may allow the US market to catch up:

Small stocks are outperforming large stocks. As the domestic economy improves, this trend may be reinforced:


Joseph Y. Calhoun III is Chief Investment Officer of Alhambra Investments.

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