huge foreign accumulation could turn into liquidation
bondtalk.com
Not since King George III of England ruled over the American colonies have foreigners had a greater claim on the U.S. than they do today. Then, like now, foreigners were getting a piece of the American pie. But instead of staking their claim by royal proclamation, these days foreigners are getting their pie by buying into the U.S. economy, showing an insatiable appetite for U.S. companies, equities, and bonds. Now that the U.S. economy has slowed and thereby dimmed investment prospects here, the risks of capital flight out of the U.S. have grown.
The massive inflows of capital into the U.S. over the past few years have helped mask the substantial widening in the U.S. current account deficit. At $400 billion, it recently stood at a record in terms as both dollars and as a percentage of the U.S. economy (4.1%). This basically means that the U.S. is buying far more goods and services from the world than the world is buying from the U.S. In essence, the U.S. is shipping its money abroad at a rate of $400 billion per year.
The saving grace to this quagmire is that the world has been kind enough to return the money to the U.S. by investing in it at an even faster pace. In other words, net-net, more money is coming into the U.S. than is going out.
But now that the economy has slowed, foreign investment in U.S. assets is likely to slow to. This is not to say that the secular trend will reverse, just that cyclical forces could become the dominant influence in the short run. If it does, this would: raise the cost of capital, hurt financial markets, raise the cost of imports, reduce U.S. competitiveness, and weaken the dollar. In fact, shifting capital flows could set off a chain of events that eventually causes the dollar to lose its status as the world’s reserve currency. That would be a major event, indeed.
Capital Flowing All Around
A closer look at U.S. capital flows requires scrutiny of four key areas: equities, fixed income, mergers and acquisitions, and foreign direct investment (FDI). Combined with trade data, these top cash flow areas form a clear picture on the major forces that shape the performance of the U.S. dollar. Currently, all four cash flow “hot spots” point to mammoth capital inflows to the U.S. that seem impossible to sustain in the current economic environment.
Capital Inflows to U.S.:
Year Equities Corporate bonds Agency bonds Foreign Direct Investment
1994 $ 0.9 $38.0 $21.7 $47.4
1995 $16.6 $58.1 $28.7 $59.6
1996 $11.1 $83.7 $41.7 $89.0
1997 $66.8 $84.0 $49.8 $109.3
1998 $43.8 $122.4 $54.6 $193.4
1999 $94.3 $158.9 $94.1 $275.5
2000 $174.9 $184.1 $152.8 $316.5
past 12 mos. $168.9 $245.8 $160.6 $297.4
The equity market has been a big beneficiary of foreign investment in the U.S. From a paltry $900 million in 1994, net foreign purchases of U.S. equities rose sharply to $94.3 billion in 1999 and to a record $175.0 billion last year(see table). For perspective, note that equities saw mutual fund inflows of $187 billion in 1999 and $157 billion in 1998.
Interestingly, some of the stock market’s best months occurred when foreign capital flows surged. In April 1999, for example, foreign purchases of a then-record $17.6 billion helped drive the Dow higher by a whopping 1,003 points. Then, in November 1999, when foreign purchases hit a new record of $18.4 billion, the Nasdaq—the new market leader at that time—rose 12.2%. That was then eclipsed by a surge of 19% in February 2000 when foreign purchases reached yet another record at $27.75 billion. In August of 2000, $24.0 billion of inflows spurred gains of 6.6% in the Dow and 11.7% in the Nasdaq.
Foreign investors have also been big players in the U.S. bond market, particularly in corporate and agency bonds. As the table shows, foreign investment in corporate and agency bonds has grown explosively over the past couple of years. Foreign investors now own over 205 of all corporate bonds compared to about 12.5% five years ago. Foreign investors now hold more corporate bonds than do U.S. households and they rank just behind U.S. insurance companies as the biggest holders of corporate bonds. In addition, foreign investors now own twice as many agency securities ($592.3 billion) as do life insurance companies. That’s a complete switch from six years ago when life insurance companies owned twice as many agencies as foreign investors.
In U.S. Treasuries, foreign ownership has been steady for the past 18 months at about $1.3 trillion, but foreign investors now hold a whopping 40% of publicly held Treasuries. Notably, the next biggest holder of U.S. Treasuries is the Federal Reserve, with roughly $500 billion in holdings.
Foreign Investors Are Buying More Than Stocks and Bonds
The insatiable global appetite for U.S. assets goes gone well beyond stocks and bonds. Foreign direct investments (FDI), for example, which are investments in factories, real estate, etc, has exploded in recent years, from $47.4 billion in 1994 to $316.5 in 2000. This is real proof that foreign investors have are taking a big stake in the U.S. economy.
Responsible for much of the FDI in recent years has been the surge in foreign acquisitions of U.S. businesses. Between 1997 and 1999 they quadrupled to $282.9 billion. A couple of deals that highlight the Great American Sell-a-thon include: Daimler-Chrysler and Deutsche-Telekom/VoiceStream.
Importantly, foreign acquisitions of U.S. companies have flourished in key U.S. growth areas in communications-related industries including fiber-optic, Internet, and communications equipment. This might mean that the competitive advantages that the U.S. now enjoys in these industries will narrow more quickly than many expect, especially now that the U.S. economy is slowing.
Huge foreign investment has lifted the level of foreign assets in the U.S. above the level of U.S. assets held abroad by $1.47 trillion. This is cutting into gains made in recent years by U.S. multi-nationals as more and more foreign companies get a piece of the U.S. economy.
Accumulation Could Turn Into Liquidation
The above factors point to varying risks for the U.S. stock and bond markets. The weakness in the U.S. economy and the correction in the U.S. dollar could provide foreign investors with a rational basis for shifting from accumulation of U.S. assets to liquidation.
Weakness in the dollar, oddly, could be exacerbated by the shrinking supply of Treasuries because, with most foreign reserves held in dollars, foreign investors, especially foreign central banks, are not likely to replace their holdings of Treasuries with U.S. corporate and or agency bonds. After all, can you imagine a central bank, such as the German Bundesbank, opting to invest public money in corporations of any country but their own? Hardly. Therefore, over time, dollar reserves are likely to shift to either euro or yen reserves, where large, liquid government debt markets will remain in place for years to come.
But this inexorable shift away from dollar reserves will be mostly a process, not an event. There is great risk, however, that foreign investors could pull the rug out from U.S. investors during periods when they sour on the relative opportunities here.
The extent of foreign liquidation could potentially be large, and the mere reduction in the level of investment here could have noticeable impact. In the long run, however, the numerous forces that have enabled the U.S. to outgrow most of the industrialized world for so long will almost certainly stymie any sustained period of liquidation.
Nevertheless, as we all witnessed during the Global Financial Crisis of 1998, capital can flow fast and furious at the click of a mouse. Investors should therefore be mindful of the powerful influence that shifting global capital flows can exert upon U.S. markets, especially with foreign holdings of U.S. assets now at unprecedented levels. The risk is that for short but decisive periods, foreign investors can exert more influence upon U.S. markets than any other factor. And without a musket fired! |
