The Fed Trifecta : Winners and Losers Beyond Parity

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Yesterday’s Daily Reckoning left off with a tantalising prospect (or so we thought): what the three most likely outcomes of a diarrhetic Federal Reserve opening the monetary floodgates and covering the word with its counterfeit filth?

Today we take up those three outcomes. There are probably more than three. And out treatment isn’t exhaustive. But it’s Melbourne Cup Day. From our past experience, we have reason to believe you may not be reading this now anyway, unless you are. But if you’re not punting on the ponies, let’s take a look at U.S. dollar devaluation and what it may mean for you.

One obvious consequence of a much weaker dollar is a much stronger Australian dollar. Aside from the increased purchasing power Aussie tourists will get in Los Angeles hair salons and New York delis, the strong Aussie dollar is a clear loser for some Aussie firms and a less clear winner for others.

The strong dollar, generally speaking, hurts exporters of finished goods. Billabong, for example, could see its margin shrink as the dollar goes to parity and beyond. Other companies that have warned about the effect of a strong dollar on earnings include Worley Parsons, Coca-Cola Amatil, Virgin Blue, and Bluescope Steel.

Of course when the U.S. dollar goes down against tangible goods – or the raw materials of civilisation as our colleague Dr. Alex Cowie calls them – those tangible goods go up. You can seem from the last RBA Index of Commodity Prices that tangible goods (commodities) are now at new post-Lehman crash highs.

RBA Index of Commodity Prices

Even if these commodity price highs don’t translate into immediate increased earnings for commodity producers (especially in Western Australia and Queensland), they could translate into the price of those future earnings. Higher P/E ratios for commodities producers, in which they are valued more like growth stocks than cyclical stocks, are not out of the question.

And that is just at the mid- and upper tier of the ASX/200 with the larger capitalisation companies. As our colleague Kris Sayce has been pointing out to readers of his small cap letter, the surge of interest in commodity stocks by investors fleeing the dollar (or those speculating on massive amounts of Fed liquidity making its way to “risk asset”) has already inexplicably floated many small cap shares higher.

That’s how the weight of money argument works, at a simple level. The surging liquidity lifts the smallest shares the fastest. It’s this “torrent” that Kris is banking on in the next few months, although he acknowledges this has become a pure speculator’s market.

For Aussie stocks, then, the possibilities are that a much stronger dollar is bearish for exporters but bullish for commodity producers, explorers, and developers. But let’s also consider another possibility. It’s what we call, the “short-term stay scenario.”

This idea is simple, although not as easy to profit from directly. The idea is that the desire to own Chinese Yuan increases directly in proportion to the U.S. dollar’s decline. It doesn’t look like anything will immediately replace the U.S. dollar as a stable reserve currency (which adds to gold’s allure, by the way). But nearly everyone is convinced that China’s currency will benefit the most, once it’s unpegged from the greenback.

For years traders have tried to find ways to benefit from Yuan appreciation. But up until now, not only has it been difficult, the timing has been off. However Business week reports that Yuan deposits at Hong Kong banks have more than doubled in the last six months to $22 billion. Hong Kong IS one place you cage exposure to the (probably rising) Yuan. But the market is still too small, illiquid, and inaccessible to big money (or retail money) to present you with a viable strategy.

If you want exposure to the rising (probably) Yuan, you have to find a proxy, somewhere you’re money can enjoy a short- to medium-term stay before China’s capital markets liberalise and you can buy Chinese assets directly in a fully convertible currency. That isn’t possible yet for most people, so what’s the next best thing?

The general answer is that emerging market equities, and regional Asian markets specifically, are probably good Chinese proxies, although they aren’t the real thing. These emerging markets are likely to benefit as the great dollar exodus picks up speed. As a trade, it’s worth a look. More China-specific or China-linked assets can be found in places like Malaysia, Singapore, and even here in Australia.

So far we have two outcomes to the Fed’s full embrace of monetary insanity: an Aussie dollar that goes well past parity and a surge of money into emerging market equities. The third and final possibility we’ll discuss is outright deflation.

To be honest, deflation is not our beat. In a world of fiat money, there is no real limit to the amount of liquidity the Fed can create. It won’t reflate the real economy. But as commodity prices are showing, it can inflate the price of real things and thus make its way into the economy in rising producer and consumer prices, even if final demand is stagnant.

But it is possible – given the historic nature of the end of the dollar standard – that the Fed’s policy moves create widespread public loss of confidence in the monetary system. Despite Fed support, asset prices could fall dramatically. This includes stocks, commodities, and gold.

Frankly, if this sort of deflationary shock happens, it will already be too late to decide where to park most of your liquid assets. This may be why you’re seeing so many stories of people who are converting their financial assets into real wealth. Better to have it in something than all locked up in nothing.

The conventional response to a deflationary scenario is to be in cashed and bonds (fixed income). But we have a hard time understanding how buying anyone else’s promises to pay is a good idea right now. As for cash, having some on hand is probably not a bad idea. Or you could win the Trifecta on the Melbourne Cup and call it a day.

Dan Denning
For The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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