by Brian Pretti CFA, Contrary Investor. August 7, 2009
I’m going to spend this discussion imbibing in a little bit of self indulgence. An exercise in sitting back quietly, looking out the window, a few deep breaths, and trying to think very much in big picture and longer time frame terms. Will these comments help with decision making over the remainder of the week or the month? Not likely. It just so happens that a few weeks back the wonderful folks at the US Treasury reported the May international capital flow data, numbers that come to us with a definitive lag. But this go around it’s not necessarily the monthly numbers that prompt a little looking out the window pondering, but rather the more than pronounced change in multi-decade trend that has been and continues to occur right before our eyes. Is this change trying to communicate a message of generational importance to us? I’m not so sure that is not exactly what is happening. Of course in the non-stop go-go world of sound bites, audio/visual media overload, tweets and texts, it’s sometimes hard to see the forest for the trees, let alone force ourselves to make the time simply to quiet down and look out the window.
Generational earthquakes, what the heck does that mean? To the point, it’s simply not often that we collectively find ourselves in the midst of a ubiquitous and coincident global economic and financial market downturn of the magnitude of present circumstances. In fact, I’d characterize it as a generational, or perhaps multi-generational event. Sure, we’ve seen individual country specific examples of deep and meaningful economic and financial market declines in recent decades. Japan in the 1990’s really to the present is a poster child example. But the swirling maelstrom of the post credit bubble Japanese economic and financial market reconciliation period did not exert massive gravitational pull upon the economies of North America, Europe, greater Asia, South America, etc. Same deal goes for the meaningful Asian currency crisis period of 1997. We can turn the clock back further to individual South American issues, the Russian post cold war economic debacle, etc., but really in none of these instances in the greater post war period was a coincident and deep global economic and financial market contraction realized as a result of individual country events. Coincident global economic contractions as we now experience have been quite the rare beasts.
One really has to look back to the 1930’s to see the last period in global history to witness an across the global board simultaneous economic downturn. In other words, the last generational earthquake that shook the entire planet as opposed to specific regions singularly occurred in the ‘30’s. Yes, we know it was the period of the Depression that spread globally. We know that in part a prior US credit bubble that popped in the late 1920’s was a key provocateur of the events of the 1930’s. We know that global protectionist measures only added fuel accelerant to an already open fire. And we can all rant and rave as much as we want about a US Fed that apparently “did too little” and was too slow in action to right the then listing domestic and global economic ship. But is this really the narrow context in which to view these events?
If we think a bit more broadly, there was indeed one massive and ultimately generationally important macro change that occurred in the aftermath of the global economic and financial market earthquake of the 1930’s. It’s very much common or mainstream thinking that the war really brought the US out of the depression, as opposed to the influence of New Deal stimulus. Personally, I agree, but not really as per mainstream thinking or rationale. During the entirety of the war period, we need to remember that so many up until then vitally important global manufacturing areas watched their collective manufacturing infrastructure be destroyed. Unlike Europe and Asia broadly, US manufacturing infrastructure was untouched. As such, the US in many respects became the manufacturer to the world, first to the Allies during the war and then to the planet in the aftermath of the War years. For very bad reasons, an incredible benefit to the US economy at the time. To make a long story short, the US industrial sector both blossomed and flourished. Increased profitability was plowed back into capital investment and profits continued to multiply. Since the US consumer society we know today had not yet taken shape, the US economy at the time enjoyed a virtuous circle of increasing profits and savings begetting increased capital investment, which begat further increased profitability, savings and investment. You get the idea. In addition to profit and investment growth, the US for decades increasingly enjoyed the status of being the world’s largest creditor nation, naturally as a result of its newfound prosperity.
But in the much bigger picture of global economic evolution, what importantly occurred as a result of these global events is that we witnessed the baton hand off of global economic and ultimately military power to the US from the UK. We all know that the UK had become overextended as an economy, ultimately unable to support and service the financial cost of its global reach. In addition to the US surpassing and supplanting the UK as the dominant global economy, to the victor go the spoils, so to speak. The US dollar emerged as the global reserve currency, leaving a much-weakened British pound and indebted British economy in the wake of rapidly growing US prosperity. The dollar’s ascendancy was to be key to US economic and financial market outcomes for decades to come. If you had suggested the US dollar was to become the global reserve currency in the 1920’s or 1930’s, you would have been meet with immediate and deep laughter. And one last VERY important issue is that as a result of this much bigger picture confluence of events, the US economy attracted global capital investment at an ever more rapid pace as the post war decades unfolded.
So although the depression period is known for on the ground character issues such as high unemployment, soup lines, global protectionism, a credit bust, etc., could it possibly be that the bigger picture global economic and financial market earthquake of the 1930’s was really all about the massive shift in global economic and financial power that was in the clarity of hindsight about to take place? In summation, in the aftermath of the 1930’s coincident economic and financial market “earthquake”, and war influenced change in geographically specific global economic and financial leadership, the US dominated global manufacturing, achieved enviable profit acceleration that was reinvested in capital assets (further enhancing profit opportunities), became the key beneficiary of sponsoring the globe’s new reserve currency, and consistently and continually attracted global investment at an ever increasing pace decade by decade. Was this dramatic change really what the global financial markets of the 1930’s were trying to “see” and discount as they moved through convulsive episodes? Again, this is an exercise in just looking out the window and trying to think about the meaning and messages of global economic and financial market earthquakes. Generational earthquakes.
Fast-forward to the present and the ground has been shaking violently across the entire planet over the last year to year and one-half. Although it may sound simplistic, the present is another globally coincident economic earthquake. This time around the high frequency day-to-day “trees” most folks have been focusing upon are subprime debt, credit default swaps, global central bank quantitative easing, massive and unprecedented monetary stimulus, etc. But is there a bigger picture message here? Are the global economies and financial markets of the moment rather trying to discount a message of generational change? Of generational importance? Is there yet another global economic power and leadership baton hand off process occurring in slow motion, as was exactly the case in the 1930’s? Of course no one has the exact answer at this point. Our job as investors is simply to hope to attempt to frame the correct discussion and ask the right questions.
It’s a bit too simple and trite to suggest China is about to take over the world. But China is clearly not alone in terms of being characterized as a potential very meaningful change agent. The BRIC countries (and a few select friends) met as a block really for the first time ever a month or so back. There has been plenty of heightened debate recently about the future role of the US dollar on the world stage. From the BRIC shindig came comments about "possibly placing part of reserves in the financial instruments of partner countries" (BRIC countries buying each others bonds). Of course also mentioned was increasing currency swap arrangements and the potential for a "supranational" currency (basically sidestepping the dollar in trade arrangements). But secular global change such as occurred in the Depression and post-Depression period does not fully transpire in a month, a year or even perhaps a few years. So as we sit back and look out the window, we need to contemplate and watch for the “fingerprints” of potential secular global economic and financial market change that resulted from the last global earthquake – currency realignment and dominance, global capital flows, and the character of net creditor and net debtor nations. For now, we all know that the greater Asian community is the greatest net creditor bloc globally, while the US stands as the planet’s largest net debtor nation, a complete juxtaposition to circumstances in the war and post war period some seventy years ago. We know the US dollar is not about to lose its global reserve currency status tomorrow. But we are simultaneously watching open global debate and questioning regarding the future role of the greenback. In like manner we are watching these very same BRIC countries forge trade agreements outside of the common currency that has been the dollar for so long. These are the fingerprints of change.
We are now watching the US government leverage up at a rate unprecedented in the country’s history in order to mute the fallout from a generation credit bust. And of course it was a massive credit bust that heralded the arrival of the last generational earthquake in the 1930’s. Current actions will only heighten US financial character as being the world’s largest net debtor nation. And so finally we need to watch global capital flows. Without question, history has taught us one very consistent message over the true long term. Global capital flows to net creditor nations and ultimately flows away from net debtor nations. And so this brings us to the international capital flow data of the moment and the change in trend that has been clearly occurring during the current generational earthquake.
Since I spent so much time in self-indulgence above, let's look at a quick series of charts. The message(s) of the charts is clear, straightforward and without argument. At least over the past year to two, global capital flows to US financial markets have slowed in a magnitude never seen in the modern period. It’s the very fingerprint of global capital no longer flowing strongly to the increasingly net debtor nation. It is what it is.
I’ve presented these charts in the past, but the current update represents very significant historical change. To be honest, the best of the bunch is a longer term look at foreign purchasing of US Treasury bonds. In no way has the foreign community abandoned Treasuries. Not even close. The spike up in the twelve-month moving average of foreign purchases of UST's during 2008 certainly symbolized the global flight to quality trade at the time that is now reversing. The recent decline in the moving average represents that reversal plus the heightened domestic and global questioning of US monetary and fiscal policy.
But when it comes to Treasuries as an asset class and representation of global capital investment in the US, the issue is not the safety trade and the character of its reversal, but rather the forward outlook for US Treasury issuance we know has no equal in US history in terms of magnitude to come. This is common knowledge. The top clip of the following chart documents Treasury issuance in nominal dollars and foreign purchases of UST’s by quarter since 2006. What has occurred in the last three quarters could not be clearer. Treasury issuance has outstripped global buying interest by over two to one. That is completely uncharacteristic of recent US experience. But up to this point (latest data as of 1Q period end), the US has been extremely lucky in that the “safe haven” trade during the financial market upheaval of last summer through the first quarter of this year gravitationally attracted private (non-central bank) global capital to Treasuries in very much knee-jerk reactionary behavior. But in the second quarter of this year we know that is no longer the case as global capital has flowed back into risk assets. And, of course, in the second quarter of this year we have watched ten-year UST yields rise from 2.7% at quarter inception to 4% a few weeks back before backtracking once again (very much in directional rhythm with equities). Again, the official global capital flow data comes to us with a lag. We know Treasury issuance continues fast and furious. We’ll just have to monitor global capital flows ahead as the data become available. But the numbers in the top clip of the chart tell us despite his verbal protestations in public, Mr. Bernanke and company will have no choice except to expand UST related QE ahead. There is no one else large enough to do the job with the issuance that’s to come.
Okay, please remember the comments about the importance of global capital flows as fingerprints of macro global change as you look at the next three charts. In order, foreign purchases of US agency paper, US corporate paper and US equities. All three down for the count, with experience in agency and corporate paper being a historical first in terms of both lack of interest and selling. This is the current trend picture of global capital flowing, or otherwise, to the world’s largest net debtor nation.
In short, on a twelve month moving average basis, the foreign community has become a net seller of US government agency paper. This is a first in historical experience, despite the fact that the agencies are now official members of the government witness protection program (and just think, their names don’t even end in vowels). In terms of US corporate debt, foreign appetite has vanished. The twelve-month moving average of purchases of US corporate debt by the foreign sector went into negative territory as of May. For years it has been well known that to influence change, the foreign community did not need to dump their US financial assets, they merely needed to stop buying. We’re there in terms of agency and corporate paper. Finally, foreign buying of US equities has ticked up a bit in recent months, but of course it’s following the rhythm and direction of US and global equity markets on a short-term basis.
Although the change in foreign purchases of US agency and corporate paper is primarily influencing what you see below, from a bigger picture perspective it’s instructive to look at the aggregate historical rhythm of total foreign purchases of US financial assets. The macro trend is clear. For now, this is a picture of very meaningful change in the rhythm of global capital flows amidst the current generational earthquake.
Lastly, the bottom clip of the chart above is a look at foreign flows of capital into US financial assets set against the longer term trend in the US trade deficit. I’m using twelve month moving averages here for both sets of numbers in order to smooth out the “noise” in monthly results. We know the US trade deficit has been shrinking quite meaningfully over the last six to nine months. Certainly the decline in global energy prices has helped this change of trend. But so has the decline in primarily consumer related imports, most specifically from China. For years, pundits have dismissed the issue of the US trade deficit as being meaningful in that foreign flows of capital into the US have outstripped the nominal dollar trade deficit itself. In other words, the foreign community has been “funding” the US trade gap. But the numbers clearly tell us that as of now, that is no more. In addition to funding the massive economic and banking sector/financial sector stimulus/bailout of the moment, funding the trade deficit absent foreign flows is also now an issue for the US.
So there you have it. A little self-indulgent looking out the window and pondering the current message of a generational earthquake that is now upon us. What does all of this mean to our investing activities ahead? First, these comments are very much about the development of long-term trends as opposed to suggesting outcomes or pointing to conclusions about the short term. We need to watch global flows of capital in that they will influence relative global currency values and country specific domestic interest rates over time, in addition to the ability of specific countries and regions to grow their own economies in terms of rate of change. Perhaps the most important macro issue to remember is that global capital has historically flowed to net creditor nations and away from net debtor nations. Of course this happens as a process as opposed to an event. Given the open and really globalized capital and currency markets of the moment, it will be harder than at any time in recent history for the US to simply inflate away its debt problem. You’ll remember the old market saw oft repeated over the years, follow the money. Amidst the generational earthquake of the moment, this could not be more important. As mentioned, China and the emerging bloc nations are not about to take over the world, as we know it. There will be plenty of economic volatility to go around as we move forward. In like manner, the US dollar is not about to lose its global reserve currency status tomorrow. But watching “fingerprints” of change such as the flows of global capital will allow us to stay in harmony with macro investment themes of importance as we move ahead.
For now, one specific issue to focus upon as a result of these changing flows is the ability of the US to fund its current “economic recovery”. The changing rhythm of cost of domestic capital is a here and now watch point. It will determine the necessity, or otherwise, of the Fed upping the QE ante. Foreign purchasing of Treasury debt is still meaningful, but so are projected US funding amounts. And both the perceptions and reality of how this plays out over time will determine investment outcomes in the fixed income markets, precious metals assets, commodity prices and domestic equity sectors of attraction and avoidance.
© 2009 Brian Pretti