February 14, 2015 War, What Is It Good For?

Risk/Reward Vol. 254

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"Tell me why
Why, tell me why."---lyrics from "Tell Me Why" sung by Taylor Swift

"War, huh Good God
What is it good for?"---lyrics from "War" sung by Edwin Starr

"Like electricity, electricity
Sparks inside of me and I'm free, I am free."---lyrics from "Electricity" sung by Elton John

As the March meeting of the Federal Reserve approaches look for a shift away from employment and toward deflation as the key determinant of if and when the Fed begins to raise interest rates. As discussed here over the past two years (See e.g. Vols. 201 and 204 www.riskrewardblog.blogspot.com ) deflation is a central banker's greatest fear. And we appear to be headed in that direction. This week the Commerce Department announced that aggregate consumer spending (read, demand) dropped for the second consecutive month. So, "tell me why/Why tell me why" this is to be feared? The best explanation is contained in a speech given in 2002 by then Fed Chair Ben Bernanke ( www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm ) . As explained by Bernanke, deflation almost always results from a collapse in aggregate demand, the economic effects of which are recession, rising unemployment and financial stress. The Great Depression is the most recent example of sustained deflation, and it haunts this generation of central bankers like no other historical event. Why? Because central bankers have very few conventional tools to combat deflation. Indeed, the solution of the Great Depression had nothing to do with central banks. It was WWII which spurred unprecedented economic activity; first in arming the world and then in its wake, rebuilding virtually every city and town in Europe and Japan.

So, Edwin Starr, in answer to your question, "war is good for" for something---spurring economic activity Admittedly, the human cost is too great to desire a physical war. But wars come in many varieties, and we are in the midst of one right now---a currency war. Allow me to explain. One remedy for deflation in any one country is what Adam Smith phrased "beggaring thy neighbor": that is, in a world beset by lessening demand adopting economic policies that worsen other countries' ability to compete in comparison to yours. The easiest and most obvious means of accomplishing this is devaluing one's currency. Here is an example. If one wants more tourists to visit the Eurozone (tourism is Italy's largest industry and constitutes 7% of France's gross domestic product), devaluing the Euro from $1.40 to $1.14, as has occurred in the past twelve months, makes European travel very attractive to those outside the Eurozone. Indeed, a friend of ours is renting a beautiful three bedroom apartment in Grenada, Spain for $1000/month---much cheaper than living comparably in the US! And how does one devalue the Euro? The easiest way is to set interest rates at zero or below thereby punishing anyone who elects to hold Euros---just as the ECB has done. Savers of euros become losers. The thinking quickly becomes: "dump Euros and buy dollars even below the prevailing exchange rate because it will be worse tomorrow." And, this approach is spreading. Sweden's central bank announced this week that it will charge depositor institutions for retaining cash, a penalty which will trickle down to individual depositors in short order. In sum, a currency war is now fully underway with the US dollar appreciating versus every other major currency. That is not good news for US domestic industries. As a consequence and to complete the point made in the first paragraph, if for no reason other than to remain competitive in a deflationary world plagued by lessening aggregate demand, I do not see the Federal Reserve raising interest rates (and thereby strengthening the dollar even more) any time soon.

What does this mean for investors? I believe that the recent upward trend in the yield on the bellwether 10Year Treasury (from 1.6 % to 2% in two weeks) occasioned by the belief of many that the continuing improvement in employment numbers alone will cause to Fed to raise interest rates will abate or even reverse once the Fed's focus switches away from employment and toward deflation. I see that happening as soon as the Fed's March meeting. If I am right and the yield on the 10Year stabilizes near 2% or drops, a buying opportunity for interest rate sensitive stocks will present. One sector negatively impacted by the recent spike in rates has been utilities---"like electricity, electricity". Utilities as a group have experienced a 5% or more decline this month despite the broader market registering record highs. This sector did very well last year, and utilities are still relatively expensive. They are by no means "free." But, the dividends paid on some are now above 4%. If and when they approach 5%, they will be a bargain and will send "sparks inside of me." (Remember the higher the yield on dividend paying stocks, like bonds, the lower the price.)

We are at war---no doubt. But I have faith that our Federal Reserve will do the right thing and will keep interest rates low. Like Taylor Swift, Janet Yellen sees deflation for what it is:
"Trouble, trouble, trouble."