Federal Reserve poised to determine economic fate
Major stock indices have failed to find a trend in the past few sessions. There has been lots of up one day and down the next. With the next regularly scheduled meeting of the Federal Open Market Committee on Aug. 8, expect more of the same until then. Traders and investors were hoping that this would be the meeting where the Fed announced that it is done raising interest rates for a season. But recent economic reports have raised a dilemma: Although economic growth is slowing, inflation continues to rise.
Second quarter GDP was 2.5%, according to last week’s report. That compares to 5.6% in the first quarter. That was a much lower number than economists predicted. So it would appear the Fed’s attempts to slow the economy by raising interest rates is having the desired effect. Not so fast. According to the Bureau of Labor Statistics (www.bls.gov), inflation grew at 5.1% in the second quarter. That compares to a 3.4% annual rate in 2005.
Because the Fed’s primary objective is to control inflation, another rate hike appears likely. Historically the pattern has been for the Fed to continue raising rates too much and too long, eventually pushing the economy into recession. These latest reports provide ample ammunition for the Fed to keep the pattern in place.
How will Wall Street react if the Fed raises rates again? We won’t know for sure until next week, but it will be difficult to sustain a market advance if traders believe a recession is on the horizon.
An international view
I get frequent questions about investing in international positions. Usually the queries are prompted by poor performance by the U.S. markets. While investing internationally has some benefits, it can also pose real perils.
International investing adds a currency component that can enhance potential reward but also increases risk. During portions of my life I’ve spent significant periods overseas, mostly in Europe. Here in the U.S. we usually pay little attention to currency fluctuations. That isn’t true elsewhere. In many countries, changes in exchange rates will have clerks busily repricing all the goods on store shelves. A few pennies difference in the exchange rate can be magnified many times in other parts of the world.
International markets are also influenced by the same fundamental factors that impact the U.S. In recent months, that has included things like higher energy prices, interest rates and inflation. In general, countries with abundant natural resources like oil or precious metals have prospered. Countries forced to buy those goods on the world markets have struggled.
Here is the overriding caveat of international investing: The United States is the world’s dominant customer. U.S. consumption is the engine that drives world markets. As long as the U.S. economy is doing well, other world markets are also going to advance–some of them at a faster pace than the U.S. But when the U.S. economy stalls, it is difficult for any market in the world to significantly advance.
Weakness of the U.S. dollar has been a common theme of investment gurus for a couple of years. But a weak dollar is not necessarily a bad thing. A weak dollar helps make many U.S. companies more competitive and U.S. goods more attractive. It boosts tourism to the U.S. And it helps those international funds earn higher returns.
Below is a chart of ProFunds Rising Dollar Fund (RDPIX). This fund mirrors the U.S. Dollar Index (USDX). The gold line is the S&P 500. Notice that neither the dollar nor the S&P 500 have shown much of a trend over the past year. Notice also that the two are generally inversely correlated. In other words, when the dollar falls, the stock market advances. The bottom portion of the chart is a relative strength index of RDPIX.
While these positions appear choppy and volatile on this chart, that is a little deceptive. When you look at the scale on the chart, you see that both of these positions traded within about a 12% range over the past year. For comparison, look at the chart below.
The blue line is RDPIX. The gold line is iShares MSCI - Brazil Index Fund (EWZ), a fund we wrote about quite often during the past year. The black line is EUROX, a fund that invests in companies in Eastern Europe. I hold a position in that fund. The trading range of these two funds over the past year is nearly 80%. Compared to these two funds, RDPIX is relatively tame.
EWZ and EUROX are both considered emerging market funds. That means they focus on companies in parts of the world where markets are still developing. That means companies in those regions have an opportunity for accelerated growth. Emerging market funds tend to be among the most volatile of international funds. When things are good, these funds can make money quickly. But they can lose it even faster when the economy falters. They are not generally suited for conservative investors or only as a very small percentage of one’s overall portfolio.
As long as the U.S. economy continues to grow, most international funds will continue to do well, as they have over the past couple of years. But good things don’t last forever and the run of dominance by international funds will end if we see the U.S. economy move closer to recession. In the meantime, if you choose to dabble in international funds, you might not want to leave this country for an extended vacation.