... unfortunately, I can not copy the charts in, but the text will give you an idea of the important content on ContraryInvestor.com yesterday ... along with The Economist and Morgan Stanley's Board of Economic Advisors, my three most valuable macro tools in getting market direction correctly since 1998 ... a big help to me ...
Ken Wilson
ContraryInvestor.com
Market Observations
06/27/02
Out Of Balance...As you remember, in the Tuesday discussion we took a little look at foreign investment in US dollar denominated financial assets. In our minds, a crucial component of the overall supply and demand balance that is the ultimate determinant of asset prices at any point in time. Clearly, one of the key reasons that foreign ownership and current involvement in US financial market assets is so meaningful is the following. After all, how could foreigners have found themselves with so many dollars to invest had we not so eagerly placed those dollars in their hands in the first place.
At least for now (pending potential revision), the monthly US trade deficit for April was a record experience. This fact is due entirely to the voracious stateside appetite for foreign goods, as services are actually a net US export positive. Likewise, excluding the influence of higher oil prices, the trade deficit really expanded by $1.2 billion as opposed to the reported $3.4 billion. (But clearly oil is a major factor in the US economic equation.) As we have discussed many a time, the US has been the incredible beneficiary of deflationary pressures emanating from foreign shores. In dollar terms, the recent historical relationship between US imports and exports is as follows:
As you can see in the chart above, the dollar for dollar relationship between US imports and exports was relatively constant from early in the last decade until about 1997. 1997, of course, being the beginning of what Jim Grant has euphemistically called the bonfire of the currencies. As you remember, Asian and Latin American currencies were put through the wringer during that period (and at the moment for the poor folks in Brazil, it's tragedy revisited). The Russian debacle was close on the heels of the late 1997 period and ultimately the initially ill fated inauguration of the Euro was soon to follow. And through it all the US dollar plodded roughly steadily forward. But as the dollar remained well on the outer edges of the slow but sure global currency bonfire expansion, the relationship between US dollar imports and exports changed significantly. As you can see in the above chart, US exports in dollar terms remain today at a level quite near what was seen a half decade ago, while US imports are easily 35%+ higher. In fact, the current spread between US imports and exports on an absolute dollar basis rests at a record extreme:
Certainly the sourcing of more and more goods consumed in this country is foreign based. As you can see in the above chart, the acceleration in this trend over the last half decade has been significant to say the least. This type of relationship may be absolutely fantastic for the likes of the WalMart's and Target's of the world, but what about for the US labor base? As you can see in the above chart, the period of trade recovery post the September '01 lows has witnessed acceleration in the import/export spread on a rate of change basis with no comparable similar compressed time period seen anywhere during the last eight plus years. There is no question that this relationship is weighing on current labor market conditions. As you know, manufacturing was hard hit in terms of employment during the recent downturn. For manufacturing employees, this was anything but a mild recession:
Not only do the dynamics of the trade deficit have implications for current labor strength, or lack thereof, but represents the continuation of the dissaving phenomenon in America as a whole. We are essentially "borrowing" close to $1 billion per day from our friends and neighbors abroad. It has been almost axiomatic in the past global economic experience of many a country that once a current account balance reaches a deficit circumstance representing 3% to 4% of GDP, currency markets start to take notice. Usually in a pretty big way. (Just as a quick note, the current account balance is dominated by the influence of the trade deficit, but also includes such items as net interest and investment income.) The following is a brief retrospective of the US current account balance as a percentage of benchmark GDP over the last four decades. As is more than noticeable, during every recession of the last 40 years, the current account balance in terms of GDP was positive. Every recession except for the most recent one, that is.
Just as the recent household sector data revealed that households continued to lever ever higher during the recent downturn, so too did America as a whole continue its borrowing from the foreign community. Borrowing from the collective savings of the foreign community. In much the same manner as our questioning the asset class saturation point of foreigners in holding US dollar denominated financial securities in Tuesday's discussion, we again question the saturation tolerance level of the foreign community in terms of allowing the US to borrow the surplus of global savings. It just so happens that we have recently pushed up against the historical high water mark of the last few decades:
As you can see in the above chart, the US single handedly borrowed a little over 60% of the world's collective savings in 2001, down from close to 70% in 2000. We have to believe that the 2002 experience is an acceleration relative to 2001 as the trade deficit and current account balance have continued to grow anew this year. It's not that we haven't been here before, but rather that this area has represented resistance in the past two decades. If, or most likely more properly when, foreigners decide to lend us less of their collective savings, the US economy will feel the direct impact. A weaker currency, higher interest rates domestically, and as of now an unknown impact on financial prices. The recent weakness in the dollar may be the very harbinger that this process has begun. Certainly foreigners are intently watching the US economic recovery in terms of deciding whether to continue "lending" their precious savings to us. But we are convinced that the larger issue now lies with the integrity of US financial reporting. For years, US investors have decried lack of transparency in foreign financial reporting. It seems that now the shoe is on the other foot, now isn't it?
According to the IMF, the following is the year end 2001 distribution of global foreign exchange reserves:
Simplistically, all one has to do is look to Asia to find the world's predominance of savings. Much like valuations in common stocks that were simply out of balance with historical precedent in the late 1990's and into the early part of this decade, for how long will global capital flows remain unbalanced? Virtually every chart above suggests that these imbalances were brought to current extremes largely in the last half decade. Very much like the once bloated market caps of the beloved top S&P were created in a matter of years. Unfortunately, history suggests to us that imbalances are often corrected in much less time than it took to create them in the first place.
Click, Click, Click...If you have not guessed by now, this is simply the sound of the hammer hitting the firing pin in a gun without bullets. Conceptually, the following is a picture of the clicking sound:
As you can see, one year after the sixth rate cut, the market is in worse shape than one year after the first rate cut. There is very little historical precedent in US financial history for Fed monetary accommodation being rather ineffective in rekindling coincident improvement in the real economy and the common equity markets. As you know, we have been "filling in the blanks" on the above table for a good while now. Not only has this in process bear market exceeded the average monthly bear market time cycle as of now, but the less that lackluster reaction of the common equity markets to this type of extreme accommodation is rare indeed. It seems pretty darn clear that reconciliation taking place in the credit markets is largely negating the influence of the Fed this go around. And rightly so given the extremes that were allowed to be created in the first place during this historic credit cycle.
Revealing much the same message as does the table above, in the following table we take a look at performance of the S&P 500 at conclusions of prior monetary easing cycles of the last almost 50 years. Specifically we're looking at S&P performance from the time of the last rate cut to the first rate cut. As you will notice, this time it's different:
Surely we have not yet hit the first rate hike for the next cycle, but in like manner current monetary accommodation must be considered some of the more extreme accommodation we have ever witnessed in US financial history. At least so far, historical precedent of the last 50 years suggests that the only period similar to the present was that of the mid 1970's. A period marked by a subsequent trending of the equity markets for more than half a decade. A period that suggests that valuations do matter...if you can truly get yours hands around the E(arnings), that is. That's simple enough in today's world, isn't it? Haven On Earth?...After looking at trade and global capital related imbalances above, we can't help but address US Treasuries very quickly. The second big accounting scandal stateside in a little over nine months coupled with an approximate 12% drop in the dollar since late January is surely catching the attention of the owners of 34% of our total Treasuries - the foreign community. We're a bit amazed that Treasuries continue to trade as strongly as they have recently. As you know, macro equity and bond performance has diverged for a good while now. And despite today's little quarter end equity respite on the upside, the dollar closed on its lows. We may be able to "dress the window" for quarter end in the domestic equity market, but certainly global players are viewing the dollar from only one window at the moment - the window that continues to frame a rather unrelenting decline.
As many parts of the Treasury yield curve either approach or are nearing their late September 2001 yield lows (and price highs), we need to keep an eye on global yield spreads as we ponder the immediate future of Treasury prices. In the following table we compare the yield spread between 10 year US Treasuries and yields of like maturity government debt denominated in foreign currencies. We've chosen to compare where we are today with September 17 of last year. The 17th being the day the equity markets reopened after the Sept. 11 incidents.
As you know, Treasury prices spiked as the markets reopened post 9/11 leaving huge gaps in the charts. As you will see in the charts of the 30 year, the 10 year and 5 year Treasuries below, yields have retraced to very near or at those opening gap prices. What is different today is that the dollar is approximately 6% lower than was the case on 9/17 of 2001. You can certainly infer from the table above that a continued dollar decline or simply just softness is going to make alternative currency sovereign debt all the more attractive a future investment choice to foreign investors.
In almost mirror image fashion to spiking stock price moves in late 1999 and early 2000, many common equities recently have been spiking to the downside. Significant adjustments are happening in rapid fire fashion. What may have taken six months to a year to create in terms of price appreciation can be taken away in a matter of days or weeks. Will US Treasuries experience a compressed adjustment period at some point? Will complacency regarding the recent move in the dollar all of a sudden turn to concern over a very short space of time? Will another Enron or Worldcom act as an accelerant to foreign confidence destruction and an exodus from US dollar denominated financial assets? Heaven knows there is plenty of fuel available to stoke a wildfire given the lack of forest management in the US financial system over the last decade. |
