The stock market rallied strongly on Friday when the bond market rallied on a hum-ho January jobs report. As longer term interest fell, the stock market celebrated with over a 100 point gain for the Dow Jones Industrials. We were pleased to see the market rally, but I think youre beginning to understand how important interest rates are to not only the Stock Market Cycle, but the Business Cycle as well.
There is one thing you must keep in mind however; falling interest rates are often a signal of a weakening economy. As we have mentioned before, it is our belief that longer term interest rates are being held down artificially due to China's massive appetite for US bonds. In recent days, you have heard that the US wants China to begin floating their currency (Yuan) to repair the damaged trade deficit. China has all but refused because a leveling of the playing field will temporarily hurt the Chinese economy.
To counteract China's stubbornness, Alan Greenspan continues to ratchet up interest rates to protect the dollar. Last week, the Federal Reserve raised the fed funds (interest banks charge each other) rate .25% to 2.5%, and the discount rate .25% to 3.5%. After the Feds action on Wednesday, commercial banks raised their prime lending rates .25% to 5.25%. Still low by historical measures, we cannot ignore the interest rate trend or the potential borrowing costs for consumers and businesses.
On the Horizon
China is not making many friends with their current policy on the Yuan. Eventually, probably this year, China will discontinue pegging their currency to the US dollar. If China does not allow their currency to float, it will force the US and other countries to alter their monetary policies to protect their currencies. This is not a good way to make friends and influence people.
With all the negative press surrounding the US dollar, an alert contrarian knows that maximum pessimism usually means a reversal of a trend is not far behind. So heres my prediction: The US dollar will rally. In time, the Chinese will float their currency, but the dollar will begin rallying in anticipation of the move. Why?
The US and governments around the world mean business. Already, regulators are prepared to step in and block IBMs proposed $1.25 billion dollar sale of its personal computer business to the Chinese company, the Lenovo Group. In addition, the Committee on Foreign Investments is concerned that selling IBMs computer business may create a national security problem, specifically potential espionage.
US Companies gearing up for the Dollars Rally
You might have heard about the massive cash hoards US companies have in overseas banks. These companies have been reluctant to bring the cash back to the United States due to unfavorable US tax consequences. Well, for a short time, those tax consequences will be relaxed, and companies converting higher valued currencies for the dollar will be buying them on the cheap. When the dollar rallies, corporations will reap windfall profits from the dollars rise.
Consequences of a Stronger Dollar
The trade deficit will improve, the dollar will rise, and the price consumers are paying for oil will decline. Since oil is priced in dollars, the consumer have been paying a premium due to the dollars decline. The stock market will celebrate the new found life of the dollar, and for a while everything will be great.
The Federal Reserve has been raising short term interest rates to support the dollar but now they may have to continue raising rates to fight off inflation. Since many U.S corporations have sent manufacturing and apparel jobs to China, the items produced overseas will cost more in the U.S creating inflationary pressures on our economy. In addition, U.S corporations that rely heavily on China for revenue will see their profit margins decline if prices rise and demand decreases.
Eventually, longer term interest rates will begin to rise. We are approaching a peak in the Business & Stock Market Cycle that will end with a big rally in the stock market. It is during this period that we will get defensive and prepare for a period a weakness in the economy. Until then, enjoy the ride.
What to do Now:
I would like to reiterate my opinion to underweight sectors of the market that may be severely impacted by a downturn in the economy. Specifically, I will be underweighting Consumer Discretionary (Retail, Homebuilding, Home Improvement, Leisure, Appliances, Hotels & Restaurants, and Auto manufacturers), Financials (Banks, Brokers, and Insurance), Technology (with the exception of select software companies), Utilities, and Industrials (except for Aerospace & Defense, and Railroads).
We will overweight the Telecommunications Sector (Integrated Telecom Services), Healthcare (Pharmaceuticals, Managed Health Care, Health Care Facilities, Equipment, and Biotech), Consumer Staples (Soft Drinks, Food Chains, Packaged Food).
Lastly, I will continue with a neutral weighting on the Materials and Energy Sectors with every intention of adding to positions on weakness.
