It has been my contention that the speculative rise in the US stock and bond markets from 1995 to mid 1997 was fueled by about 60 billion a month in new money. The 60 billion per month was composed of 15-17 in domestic Mutual Fund Inflows and 3-5 billion in US Corporate buy back schemes. The rest was from foreign sources. Supporting the bond markets was large and continuous Central Bank purchases that resulted from the Plaza Accords. The Central Bank purchases halted the long term decline in the dollar and drove significant private foreign investment into the US.
Central Bank purchases of treasury paper and currency stopped completely in July (at least partially due to the obnoxious gloating and lecturing by Clinton at the G7 meeting in Denver). Hashimoto got mad enough to threaten to undermine the dollar after the meeting. The French and Germans went home and accelerated the introduction of the first phase of the EMU. The French delegation, in particular, had very unkind public words for Clinton. Actually the inflows had slowed earlier (this was my cue to exit the stock market in June of this year). To validate this take a look at the custodial account here and the net US denominated foreign reserves of the worlds major economic powers. What you will find is - net zero.
I contend that the end of Central Bank purchases will eventually bring an end to the private inflows over the next 6 months as well, but not immediately. We had Phase 1 decline money exiting South Asia during July and August and Phase 2 decline money exiting South Asia in Late September and early October. Phase 1 Exits from South and Central America have started and Phase 2 is about 1-2 months away. South Korea exits look like they will roughly coincide with South America. In any case, the rush to the US paper is nearing an end because the fear money has already moved or will move shortly.
The rest of the foreign money flows are primarily base upon the worlds 5 great spread plays. The sum total of these will be a topping and then a return to the long term decline of the dollar.
The first and largest is the yen carry trade. This involves borrowing in yen at around 1% and investing in U.S. Treasury notes at around 6%. The yield spread can and is being amplified with leverage. It worked very well for awhile, but an anticipated decline in the dollar will keep new money from entering and will eventually cause existing investors to exit very quickly or face horrendous losses once the return to the long term trend resumes.
The second is the gold carry trade, in which hedge funds borrow at the gold interest which was around 1-2% (now 2-3%) rate and invest in higher-yielding Treasury notes at around 6%. This is done by borrowing the gold from central banks, selling it forward and using the proceeds to invest in Treasuries, or through futures, forwards and other derivatives. Once the long term decline of the dollar resumes and gold presumably rises then these investors will have to make hasty exits as well. The risk for central banks is that their leased out gold might vanish in a financial crisis as it did for Portugal when Drexel went
bankrupt.
The third spread is emerging market debt. Issuers like Brazil and Mexico have issued billions of dollars in 30 year bonds with no collateral. The majority of these issues have found their way into US money market funds. Now that Brazil's stock exchange has declined by 30% in the past week and the fact that the government has ascertained that a recession is inevitable, payment is becoming doubtful. Mexico's 15% devaluation of the peso in the last few weeks and underlying economic weakness also points to an inability to pay. Investor's greed for a fraction of a percent will lead to considerable pain. The choices are becoming very simple, let investors lose their shirts in money market funds or bail out our Latin American friends yet again. If the bail out option is taken then the jolt to the dollar will be significant.
The next example is our old friend junk bonds. Wall Street has cleverly packaged these up to look safe and now uses them as a component of many money market funds. Junk, is junk, in a recession, even a mild one these will not be paid. It's another example of a taxpayer financed bailout waiting to happen. This will be aggravated by the clever 150% home equity loans and uncollateralized credit card debt. The effect on the dollar will be negative.
US Equities are extremely overvalued in terms of fundamental values like PE's, PSR's etc. The stock market is priced for blue skies. As a simple example, consider the collapse of Asian banks trapped in a classic financial meltdown and the ramifications to US banks with their many financial ties. This has not been accounted for in the blue skies scenario. Fed Chairman Alan Greenspan was led to call the current condition "irrational exuberance" This reminds me very much of Fed Chairman Paul Warburg's pronouncement in 1929 when he made reference to the markets as "unrestrained speculation". Twice in this century the Fed has warned of dangerous economic currents and twice the public has failed to heed the warning. It is my contention that jittery foreign investors (especially the recent fear entrants) will rush out just as quickly as they rushed in on the first sign of trouble.
Foreign Affairs, has recently published an analysis in which the sum of $US 1 TRILLION was estimated as the global portfolio shift From Dollars to the Euro. For example, Europe's Central Banks alone already have an excess of $US 280-300 Billion assuming that they capture only a _ of the worlds reserve assets and commercial transactions relative to their size in relation to the US (US 19.6% and Europe 22.2% of worlds GDP) . The first phase begins in April of 98. Even if they are only partially successful the dollar will cease to be the worlds only reserve currency. Japan and the rest of Asia will have to sell at least part of their dollar holdings for Euro's for trade purposes. Why do they have to sell dollars? They won't have the financial strength to hold the current dollars as well as buy new Euro's - don't forget the financial meltdown that is taking place in Asia today.
Now, finally back to the main point. The 35-40 billion a month in foreign lending and investing that has supported and sustained our stock and bond markets as well as our currency over the past two years is over IMHO. So the problem for bulls is where will this kind of money come from? How are we going go to 10,000 on the Dow like the talking heads keep proclaiming? How can we even stay where we are? A partial answer is the Fed. Anyone notice that money supply is running at record levels (12.5% M3)? This is just enough to support the Dow at 6,500 like Greenspan wants. Read the 20% overvaluation papers and look at the models on various Fed web sights. Although this is fine in the short term, the long term result of this kind of electronic printing will be the decline of the dollar - which will lead to less foreign investment - which then cycles back upon its self. The end result will be a decade much like the 70's where the market stayed relatively flat in nominal terms (there were a couple of short bears) but lost 75% of it's value in constant dollar terms.
No economy has been able to sustain markets that exceed GDP on a sustained basis without foreign investment. The US market is no exception and this is no new era. The dramatic rise in the stock market, low interest rates, reasonable growth rates and low inflation can be easily explained in terms of world wide money flows without resorting to some sort of mystical explanation like the new era crowd resorts to on a regular basis. The magical productivity gains (that can't be measured) are crap, plain and simple. Mystical and supremacy of our system explanations for a 30% rise in equity markets while the economy is growing at 2-3% is just plain crap. Last time I checked Toyota and Honda still make better cars (check out the new electric/gas Toyota combo or the low emission Honda cars). How about electronics? The incredible Sony entry into Mobil communications market spells fear, panic and doom for Motorola investors. The list goes on and on - we are not supreme in any market other than CPU processors and software. We have simply had the good fortune of being propped up by foreign investors.
A final though - the loss of single reserve status for the dollar means that we probably won't be able to pay for those Honda's, Toyota's and Sony's by printing paper to cover the trade deficit - Yeek.
If this kind stuff is too long or of no interest - let me know and I'll stop. Thanks for your time and patience. |
