Slowly I Turned, Step By Step, Inch By Inch
by Brian Pretti CFA, Contrary Investor. , 2008
It has been quite some time since we've had a little check in on foreign sector buying of US financial assets. We have a fair number of charts here that will kick things off and do most of the talking, so we'll try to keep discussion commentary relatively brief. Here's how we see this important topic. Yes, foreign purchasing of US financial assets is indeed an investment decision in probably its most pure form. Yes, relative currency cross rates can indeed importantly influence that decision. And yes, nominal rates of return, especially as that applies to fixed income financial market vehicles, is an important consideration in what is literally a growing world of alternative financial asset investment choices.
But if we had to choose probably the most important rationale in foreign decision making regarding the purchase of US financial assets, that would be confidence. Plain and simple, trust and confidence in the US financial system. Yes, as we've even emphasized ourselves many a time in the past, recycling of US trade deficit dollars back into US financial assets has been seen as both a bit of a default choice as well as supportive of keeping US interest rates low (so US consumers would continue spending on foreign imports to the US). It cannot be denied that mercantilist economics has been a driver of this phenomenon. But in the end game, confidence in the US capital markets has been an absolutely huge selling point for foreign investment in US financial assets. Time to see where we stand at the moment relative to historical experience.
As one quick caveat, please remember that this data comes to us with a lag. What you see below is historical experience with numbers updated through February of this year. What we've also done to provide much broader perspective regarding what we see as the very meaningful importance of this topic is show you the history of foreign ownership of each US financial asset class as a percentage of that total asset class outstanding as of the end of 2007. Let's get to it.
We know the foreign community has been large buyers of US Treasury securities for many, many years now. What has changed over time is the complexion of the ownership base. As we've documented to you in the past, in recent years both China and petro money have been the most meaningful buyers at the margin. From near $50 billion in 2000, China is now the proud owner of just shy of $500 billion in UST's. As you can see below, on a twelve month rate of change basis, foreign buying of Treasuries has been in slow decline for some time now. Over the last few years this really has not been an issue for the Treasury market as a slowing US economy has created an environment where there has been plenty of domestic sponsorship for Treasuries as an asset class holding for sheer performance reasons. As you already know, this has accelerated meaningfully since the summer of last year as broader US credit market troubles have witnessed an anomalistic move into Treasuries simply for the reason of capital preservation, the most primary investment rationale of them all.
But what has also happened as of late, as credit market turmoil continues to boil, is that Treasury auctions of the last month or so have experienced a paucity of foreign buyers show up to bid. Let's put it this way, if this trend of lackluster response to Treasury auctions on the part of the foreign community were to continue near term for whatever reason, we could indeed be looking at a serious issue for Treasury yields (meaning they have fallen too far to the downside to attract foreign interest). We'll just have to see what happens.
Although we know this is review, of all the US financial asset classes available to the foreign community as investments, the foreign crowd owns more Treasuries as a percentage of the total value us UST's outstanding than any other asset class. Please remember that the true number is closer to the 50-55% level when looking true tradable UST's outstanding, excluding the non-tradable Treasuries stuck in places like the Social Security Fund. That's funny money.
Next are really two of the most important asset classes of this discussion. Again, please remember that the important numbers to focus upon are the twelve month moving average amounts. These are the numbers that are really showing us trend and potentially important trend change from a historical perspective. In fact, although it's just our opinion, we believe what you'll see below is not being given enough attention in financial market circles these days. First up is foreign purchases of US government agency securities. In the past, what has attracted foreign interest, at least we believe so, has been the yield spread differential between government agency paper and Treasuries. You can clearly see that since the summer of last year, foreign community purchasing of US government agency paper has cooled down meaningfully. The last time we saw this type of a drop off was when it became known that Freddie, and then Fannie a short while later, were no longer able to file audited financial statements.
Remember, these are numbers through February. What had not yet transpired when these numbers were reported was the revelation of increased lending limits for Fannie and Freddie in conventional mortgage lending from $417K to $729K. Moreover, the OFHEO had also not yet allowed lowered capital requirements for these two mortgage paper behemoths, further allowing them to mushroom their balance sheets relative to total capital should they choose to do so in the future (which they will choose to do so - count on it). The question becomes, what will foreign community reaction to these two news items be come the March and April numbers for foreign purchases of US agency paper? Implicit with the hike in nominal dollar lending limits and the allowance of balance sheet growth on what will be a defacto smaller capital base is increased financial risk. You already know we'll be sure to let you know foreign reaction vis-à-vis forward purchasing of agency paper. The bottom line being? The answer will be a matter of confidence. And it sure as heck appears clear that confidence in US financial paper has already become a very meaningful issue for the foreign community really since last summer.
As you'll see below, to suggest that the foreign community has been an important support to cost of capital at the government agency level, and ultimately the cost of mortgage debt in the US over time, is a wild understatement.
Very much in directional harmony with the experience of government agency paper buying by the foreign sector as of late, but much more severe in terms of downside and growing disinterest, is foreign purchasing of US corporate paper. You don't need us to comment on what you see below. Since last summer there has been a very meaningful drop off in foreign interest toward the buying of US corporate paper. Could it be all the credit rating agency downgrades of financial sector corporate paper and the like? Could it be that the foreign community, unlike US economists as a group, foresaw the current US recession much more clearly from abroad? We have not seen a prior period drop off in foreign interest in US corporate debt like this since the last US recession. Even then, the decline was gradual, not cliff like. But absent the last US recession, it has really been a one way street in terms of foreign accumulation of US corporate debt for a good decade and one half now. To suggest the current decline in demand is meaningful and absolutely apparent is a wild understatement. Why isn't this being talked about in the mainstream?
Next to Treasuries, foreign ownership of US corporate paper as a percentage of total outstanding is quite the meaningful number. Does this tell you why we are concerned about these trends that have developed so quickly over the past six to nine months?
Finally as a singular asset class we have a look at foreign buying of US equities over what is close to the last two and one half decades. Although this is just our interpretation of life, we believe it's here where currency cross rates do indeed influence action. The rise in foreign buying of US common stocks since early in this decade really parallels the significant decline in the US dollar over the same period. For now, no real meaningful drop off in nominal dollar buying of US equities. One last comment is that of all US financial asset classes reviewed, the nominal foreign community dollars flowing into equities have not been massive compared to alternative US fixed income asset classes as a whole. Moreover, we see a weak dollar as being an ongoing driver of foreign acquisition of US equities. The foreign community are buying real companies, and perhaps global market share, in the purchase of US equities. Very different than a fixed income vehicle with no equity upside at all, but all of the risk of being entangled in credit market issues of the moment.
As of year end 2007, the foreign community now owns more US equities as a percentage of the total asset class than ever before. Globalization in action.
Okay, let's wrap this up with one final composite view of life that, at least to us, sure as heck appears to be sending one very strong message. If we sum up the foreign sector purchases of all Treasuries, agencies, corporate bonds and US equities, we arrive with exactly what you see below - the total composite of foreign sector purchasing of all US financial asset over time. Again, although it's our interpretation, the message appears crystal clear - a growing lack of confidence. Perhaps a very meaningful diminution of confidence in the US on the part of the foreign community. But quite importantly, to be a bit more specific, what we see below is showing us a growing lack of confidence in US credit markets. That is what is really being displayed below as foreign buying of US equities really has not fallen off all that much as of late.
Although as you saw at the start, the twelve month moving average of foreign buying of US Treasuries peaked literally years ago, the table below gives you a sense for the most recent peaks in the twelve month moving average foreign purchasing trends by non-Treasury US financial asset class.
|Asset Class||Peak In 12 Month MA of Nominal Dollar Foreign Purchases|
|Agency Paper||June 2007|
|Corporate Bonds||May 2007|
|Total US Financial Assets||June 2007|
Let's face it, at least by our reasoning, these roughly coincidental peaks in the foreign buying of US financial asset classes occur around two very important events. The first is the beginning of noticeable and widespread US credit market problems that really began last summer when the former Bear Stearns had to put up billions to backstop losses in two Bear sponsored hedge funds. That really marked, in the clarity of hindsight, the beginning of the current credit market debacle absolutely undeniable even to the mainstream (although credit market issues had been brewing for those who cared to do a little bit of digging and homework long before that time).
The second event, if you will, was really the more than noticeable beginning of the US macro economic downturn currently in progress. At least in hindsight, this now coincides exactly with the beginning of foreign community loss of confidence in US financial assets as investments. Whether it's due to the underlying character of the asset classes themselves, the integrity of the US financial system in general, the southern trajectory of the US economy in terms of its ability to support these asset classes as investments, or a little bit of all of the above, this loss of confidence is a critical undermining feature of both current and forward support of US financial assets. We really do not know why this has not garnered much more attention in the mainstream financial community. You already know by what has happened in recent months stateside that confidence is probably THE most critical support to the investment process and US financial asset prices broadly. We simply cannot emphasize this enough.
Although we have not covered the international capital flow data for some time now, you can trust we'll be checking in regularly from now on and briefly updating you. This change in foreign community sentiment is not to be ignored nor dismissed as unimportant. Without sounding the melodramatic alarm bells, we need to remember that the US economy remains meaningfully dependent on foreign credit and capital availability. In one sense, just like the Carlyle Partnership, Thornburg REIT and Bear Stearns remained very heavily dependent on the ongoing ability of these firms to access liquidity at any time...until, of course, it really didn't matter anymore at all.
© 2008 Brian Pretti