Fun With Funding
by Brian Pretti CFA, Contrary Investor. September 12, 2008
The following is an excerpt from a discussion we published about a month back on our subscriber site. In light of events of last weekend, I suggest it’s an especially timely topic right about now. The Fed/Treasury/Administration may believe they have won another credit cycle reconciliation battle with the Fannie and Freddie bailout (our children and grandchildren will be overjoyed), but what about the much bigger picture war?
Fun With Funding...You know that for some time now we have been preaching about what we believe to be one of the most important macro themes of the moment that is deleveraging. Important both for financial market and real world economic outcomes ahead. And, whether we like it or not, it's a theme that we believe will be with us for a good while to come. The ultimate contraction of balance sheets in the financial, household and corporate sectors will be a process, not an event, with plenty of volatility along the way. For those attempting to call interim bottoms with respect to this phenomenon as we travel along this path, as we have already seen this year and will undoubtedly continue to see again, our only comment is good luck. In the much larger picture, it was this very multi-decade expansion of private sector balance sheets in aggregate that in large measure drove corporate profits over the longer cycle. So now that deleveraging and balance sheet shrinkage is destined to play out ahead, all as part of the natural progression of a longer term credit market cycle, the trajectory or rate of change in corporate profit growth is in question. A major issue for the financial markets, especially equities. We believe the markets are just starting to wake up to this long cycle thematic realization.
But perhaps another major issue that is not being given enough attention is the fallout consequences due to the one balance sheet not destined to shrink during this process of deleveraging we have described, and that's the balance sheet of the Federal government. While the financial markets, the household sector and in good part the corporate sector engage in long overdue deleveraging, a natural offset to avoid either the reality or perception of collapse will be the continued expansion of the government's balance sheet. And this process of expanding the Federal balance sheet, as you know full well, has already begun in full force. For now, the de facto bail out of the GSE's and the residential mortgage bail out bill are two poster child examples of this phenomenon at the exact point of acceleration. Even the auto manufacturers have their hands out. Will it be the airlines next? Unfortunately, we expect a lot more where this came from ahead. In one sense, the government really has no choice. This is the price all US taxpayers will bear for years of regulatory self induced blindness. Could our current set of circumstances have been avoided? Of course, but regulatory oversight simply turned a blind eye in deference to the Wall Street and credit cycle driven profit motive. Let's face it, a lot of individuals became very wealthy during the prior credit cycle mania period, now clearly seen to be at the expense of the larger US taxpayer base. Privatizing profits and socializing risk. Sounds like Russia a decade ago, no? Welcome to the USSA. As Jim Grant recently opined, "where is the outrage?" We have no idea.
Enough of the ranting and raving. Let's get to the point. As this process plays out and the Federal government is continually forced to expand its balance sheet as an offset to the leverage contraction occurring largely throughout the remainder of the economy and domestic financial markets ahead, THE big question becomes, where will the funding for this balance sheet expansion come from and what will it ultimately cost? A question near and dear to the hearts of US taxpayers everywhere, to say nothing of the investment community. This, we believe, is now and will continue to become one of the most important questions for our investment activities. We cannot take our eye off of this ball as we move ahead. Point blank, and we could not be more serious when we ask this, will the US face a funding problem at some point?
In at least starting to address this extremely important question, it's time to head east and turn back the clock a bit for a little exercise in compare and contrast. Although no two sets of circumstances are ever identical, the US today is facing a number of major cycle issues comparable to Japan a few decades back. Post the early 1990's Japanese equity bubble collapse came the beginning of a property bubble collapse a number years later that to this day is characterized by values well below what was experienced almost two decades ago. An important comparative phenomenon throughout the 1990's was a Japanese banking system riddled with and literally overwhelmed by bad debt. A financial system immobilized. Sound familiar? In good measure, the official US banking system, and importantly the US shadow banking system, has begun traveling down a very similar path. We expect US financial system reconciliation character to ultimately differ from the historical circumstance of the Japanese banking system as the US system will indeed recognize these losses in a more timely manner, which hopefully will mean total cycle reconciliation will not be multi-decade in nature. The US financial and broader corporate sectors will also act to cut costs (employees) mercilessly as reconciliation plays out. Another huge differentiation factor relative to the Japanese experience. Lastly, throughout the process of leverage reconciliation in the Japanese equity market, property markets and financial system in general over the last few decades, the Japanese government expanded their balance sheet as private and financial sector balance sheets contracted. In all sincerity, we believe the conceptual parallels are very importantly similar between the Japanese experience then and the current circumstance faced by the US at present.
But standing out like the proverbial sore thumb are differences related to our important issue in this discussion - the character and circumstances surrounding the forward funding of the expansion in the government balance sheet that necessarily needs to take place. It's here where this compare and contrast exercise diverges in a very meaningful manner. Getting right to the point, with the clear benefit and clarity of hindsight, Japan was able to fund government balance sheet expansion during its period of reconciliation from internal or domestic sources. It was not beholden to and dependent upon outside funding sources. This is THE crucial difference between Japan then and the US now. As you can see in the chart below, Japan began its decent into systemic non-governmental balance sheet reconciliation with a national savings rate near 15% in 1990. As we've shown you many a time, for all intents and purposes the US savings rate is non-existent. Quite the contrast.
Once again, in the clarity of hindsight, the initial Japanese response to the equity and, several years later, property bubble peaks and subsequent busts was to lower interest rates. Classic monetary policy 101. As the decade of the 1990's wore on, the cost of what was accelerating government spending (expansion in the government balance sheet), was indeed in very good part supported and able to be accomplished by a lower interest rate structure. As Japanese government funding needs expanded, the cost of that funding declined. Why? It was financed internally. Just what the doctor ordered. The following chart is a proxy for longer-term interest rates in Japan over the identical period covered in the chart above.
The important point and true dissimilarity with the current funding need situation in the US is that back in the early part of the 1990's, Japan as a financial and economic system had the benefit of a very high internal savings rate. Savings that were able to be tapped even within the context of a declining interest rate environment to fund the needed counter cyclical expansion of the Japanese government balance sheet. Savers were able to purchase increased issuance of government bonds. As is clear in looking at the two charts above, savings declined along with interest rates over the entire period of the 1990's. The last, again in hindsight, benefit to the Japanese at the time was that inflation was clearly not an issue. Deflation was the issue confronted by the Japanese economy. As such, Japanese investors/savers were accepting of an ever declining nominal interest rate structure as government spending accelerated as a necessary counterpoint to contraction in the remainder of the Japanese economy.
Fast-forward to the present and circumstances faced by the US could not be more different. As mentioned, current domestic internal savings is lacking completely. Set against historical context, macro US interest rates are already low. It's hard to see how they could decline meaningfully from here as they already sit near half-century lows. The ten-year US Treasury yield today is literally identical to what was seen in 1959. The secular decline in interest rates in the US has already taken place. In 1990, the secular decline in interest rates was still to come for Japan. In stark contrast to Japan in 1990, today the US is crucially dependent on foreign funding and will not be the forward beneficiary of a declining cost of funds. The only way in which the US could develop its own internal funding sources for the counter cyclical Federal balance sheet expansion that necessarily needs to take place ahead, and has essentially really already started to take place, is to have the domestic savings rate accelerate markedly. And the only possibility the US has of accomplishing something like this is if domestic consumption almost literally collapses. Japan was able to fund both ongoing consumption AND government balance expansion throughout the 1990's specifically because it already had a very significant prior period build up in internal savings which could be tapped. The US has no such asset or flexibility in funding choice. In other words, the question now becomes who will be the incremental buyer at the margin of what is surely to be increased US government bond issuance ahead? Again, unless consumption literally collapses in the US in deference to increased savings, it will not be domestic buyers. This very circumstance leaves the US much more vulnerable than were the Japanese in addressing the process of credit cycle and asset value reconciliation.
I'll Gladly Pay You Tuesday For A Hamburger Today
Let's have a quick review look at US long-term capital flows. Specifically, we want to look at net foreign purchases of US financial assets. This is where we are going to see the importance and magnitude of non-domestic funding sources to overall US capital/funding needs. In the following chart we are detailing by year net foreign buying of US financial assets. As you can see, since the middle of the 1990's, the annual number has grown from a little over $200 billion to over $1 trillion as of the end of 2007. But we believe the more important line is the blue line that details annual net foreign purchases of US financial assets as a percentage of the year over year change in total US credit market debt outstanding. The annualized number as of the first quarter of this year is 31% of total US capital/credit market needs. Please remember that Japan's need for foreign capital in 1990 was essentially zero.
As you look at the above chart, we believe one very important additional characteristic needs to be kept in mind. Over the 1995 to 2007 period, the US experienced probably the apex of long term credit cycle mania in terms of nominal dollar credit creation. Both the US banking system and Wall Street driven shadow banking system were simply working overtime to provide "funding" to the greater US economy and financial system in general. And yes, in part that "funding" was sold to the foreign community in terms of "investments" (debt securitizations). But the data you see above measures only foreign buying of Treasury debt, agency debt, corporate debt and equities. Plenty of foreign investors also provided investment funds for CDO's, CLO's, subprime debt packages, etc. But THE important point as we look forward is that "funding" provided by the US banking system and shadow banking system is now in serious question, if not an outright freeze. Just look at the uptick in the 1Q data in the prior chart for how meaningful foreign funding has become to the US. Although foreign buying of US financial assets in nominal dollars is falling, there has been a big up tick in the magnitude of that funding as a percentage of total credit market growth. Bottom line being? Magnitude of foreign funding for total system US capital needs will become ever more important as the banking and shadow banking system continue on the path of balance sheet repair really over the years that lay in front of us. Again, a completely dichotomous circumstance relative to Japanese situation of a few decades back.
One last point of character that we believe deserves more than a bit of attention and reflection as we look ahead and contemplate is the very important need of foreign capital funding to the US during the process of balance sheet reconciliation the US system as a whole must live through. Given our major thematic contention that the US Federal government balance sheet must expand ahead as an offset to private sector balance sheet contraction, just who have been the key buyers of US Treasury debt at the margin recently? Let's have a quick peek.
|Major Holders Of US Treasuries (billions)|
|Country||Current Holdings As Of June 2008||Holdings As Of May 2006||Difference|
|Russia||65.3||Not Even On The List||65.3(?)|
|Total Of Above||$1,877.7||$1,324.6||$553.1|
|TOTAL Foreign Holders||$2,646.5||$2,071.4||$575.1|
As you can see, we're looking back across the last two years for a bit of perspective. Traditionally the largest holder of US Treasuries has not been buying over the last few years, quite the opposite. It seems that in terms of Japan, they own enough, thank you. It's no surprise at all that China has been the largest incremental nominal dollar buyer of UST's over the last few years. Clearly the Chinese are recycling trade related dollars as well as managing their currency cross rate with the buck (printing renminbi, selling it and buying US Treasuries to support the dollar against the yuan) as their accumulation of UST's has zoomed skyward. Maybe a bit surprisingly, the second largest buyer has been Brazil. As we mention in the chart, Russia has simply come out of nowhere to become the eighth largest owner of UST's at the present time. And as we have mentioned to you in the past, we are convinced that the UK numbers are really petro money (floating through London) in disguise. Total purchases by these folks seen in the table, inclusive of the Japanese sales, accounts for very close to 100% of the total foreign buying of US Treasuries over this period in totality. You can see the punch line coming after looking at this table, right? Of course you can. It's the BRIC countries and petro money that has been THE key support to Treasury prices and suppressor of Treasury yields over the last two years. These are the very folks who have been "funding" the US in terms of our increasing reliance on foreign capital. So as we look ahead, we need to ask ourselves, will these very folks be so willing to continue funding the expanding US Federal balance sheet (through purchasing Treasuries), perhaps at a greatly accelerated rate as we move forward? Yes or no?
You don't need us to tell you that foreign current account surpluses in these countries that has allowed this reinvestment in Treasuries has been driven largely by two phenomenon. First is the US trade deficit in terms of consumer goods, and secondly it's commodity prices, especially as this applies to the price of energy. As you know, we have witnessed commodity and energy prices come down as of late. Secondly, although we have not discussed this recently, the non-energy component of the US trade deficit has been contracting in recent months. No surprise at all as the US consumer remains under increasing pressure. So as we look forward, if indeed the global economy, necessarily inclusive of the BRICs, slows AND commodity prices remain relatively subdued, will the very important incremental buyers of US Treasuries seen in the table above have the financial wherewithal to continue funding US government capital needs? And potentially fund those needs at an accelerating pace?
We hope that by now you can see why we believe the forward US funding issue is so important. We believe the question mark is huge as to who will be willing to meet these funding needs during a period of greater US non-government sector balance sheet contraction. Will the US continue to be able to procure low nominal cost funding as its already very large balance sheet (liability) expands ever further by necessity in the coming period? The US faces a series of obstacles that were absent in the similar cycle reconciliation experience of Japan. And THE primary obstacle and question mark is cost of funds. We're not preaching end of the world here. In fact, we're really not even questioning the ability of the US to procure continued foreign funding. THE critical issue looking ahead is COST OF FUNDING. At the outset we asked the question, will the US face a funding problem at some point, given that the US is beholden to foreign financing? It's the cost of funding that will be key to forward outcomes both in the real US economy and financial markets.
© 2008 Brian Pretti