April ’07 Bonds Dollar weakness is a function of U.S. monetary policy. Exchange rates for leading dollar alternatives are at levels not seen for a decade or more, as interest rates have risen in these countries. Further raises are promised, resulting in a further dollar decline, producing upward inflation pressure as foreign goods become more expensive. If the Fed doesn’t raise rates, the market will do it for them. How long will foreigners continue to hold dollar bonds which are losing value? This reasoning may be less applicable at the moment to China and Japan, who seem committed to holding the currency line to protect their exports. But China is on record as establishing an alternative to investing in U.S. Treasuries, and increasing domestic demand in Japan could also reduce their Treasury appetite. The outlook for foreign support of the dollar is looking bleaker as time passes. The only counter is a rise in U.S interest rates, but reluctance to take this action is high. The Fed is afraid of tipping the economy into recession, already implied by the inverted yield curve; domestic corporations want the currency advantage to boost exports and multinationals want the benefit of foreign sales being translated into increased earnings. Politics usually trumps intelligent action.
Equities The siren song of catching a buyout target is largely responsible, in our opinion, for the unbridled market advance of the last few weeks. Since nothing succeeds, for a time, like excess, private equity buyers are goosing hoped for returns by loading up their targets with debt, then paying themselves large fees for doing the deal. This practice is apt to end badly for equity holders who do not participate in the large initial payouts. The market appears very richly priced for an economy growing at less than 2% and burdened by a heavy debt load, which is increasing at a double digit annual rate. Rising oil prices are an additional obstacle, as is the ill-advised promotion of ethanol, which yields a net energy deficit, is somewhat to blame for the increase in gasoline prices and raises the price of all manner of foodstuffs. While the weaker dollar will increase earnings of big-cap names which power index returns, increased taxes surely coming at the hands of the Democrats will be an effective offset and further weaken an already underperforming economy. The principal bull argument for equities is an earnings yield about 1% above Treasuries. With all the leverage existing in the market and the economy, this can reverse more rapidly than most investors can respond. Caution is advised.
William Wright