March 2002

At The Margin 

At The Margin...Our February Monthly Market Observations discussion primarily addressed current US equity mutual fund characteristics in this country.  Characteristics including net cash inflows, current asset allocation, what is perceived in the mainstream as a mountain of money market fund cash relative to equity market values, etc.  From our perspective, the importance of tracking these characteristics being that the US public has been a major source of incremental demand for equities during the prior bull market.  Truly indicative of a "main street mania".  A mania that seems to be waning at the moment.  Mom and pop America have not liquidated equity fund assets on a net basis, but have slowed purchases to a ten year low as registered during 2001 in its entirety.  We thought we'd spend this discussion looking at what we believe have been the two other significant incremental buyers of equities during the prior bull and how they currently fare in terms of prospects for sustained marginal equity consumption strength ahead.  As you know, change at the margin is usually the first signpost of cyclical and/or secular change.  For ourselves, attempting to correctly anticipate and identify marginal change is what the investment game is all about.   

Strangers In A Strange Land...In the aftermath of the September 11 incidents and the ongoing efforts in the war against terrorism, levels of foreign travel remain an open question in the year ahead.  For both domestic citizens traveling abroad and foreigners willing to visit the US.  Luckily for the US financial markets, foreign capital has absolutely no compunction whatsoever about going "on holiday".  While it is crystal clear that US investors have toned down their purchases of equity mutual fund assets, foreign purchases of US equities has remained a significant source of incremental demand.  A purchaser whose intensity has grown and become quite meaningful to US financial markets over the last half decade at least.  Through the third quarter of 2001, foreign purchases of US equities outstripped net domestic equity fund inflows by 290%.  And it's not just equities.  Foreign purchases of US fixed income assets has dwarfed US domestic bond fund inflows over the last few years.  For the sake of US financial asset prices, we can only hope that foreign capital "on holiday" in the States at the present time has not made other plans for the summer behind our collective backs.

It's surely no mystery as to why the US has been the destination location of choice for foreign capital.  We have discussed the rationales many a time.  Foreign accumulation of US dollars and the resulting recycling effort back into US financial assets, as the US trade deficit has expanded, are virtual graphic mirror images of each other:     

Up to this point it has been a virtuous circle of pleasantry for the US financial markets.  In fact, much more than just a pleasantry.  Foreign flows of capital, recycling trade driven dollars, has become one of the most important underpinning of US financial asset prices during the last few years.  Let's have a brief look at the numbers to see just how important.  Here is the historical spread of foreign net purchases of US securities by asset class that literally encompasses the entire "new era" (in $ billions):

Relative to the domestic purchase of mutual funds by asset class, these numbers stand out as incredibly meaningful.  During 2000, domestic net inflows to equity mutual funds totaled nearly $300 billion, while foreign purchases of US equities totaled $174 billion.  As you know, 2000 was a record setting year of US equity fund inflows.  The peak of the domestic mania.  But, during 2001, foreigners accounted for an estimated $114 billion (based on annualized experience through 3Q of '01) of US common stock purchases while net domestic inflows to US equity mutual funds totaled $39 billion.  On the bond side of the equation, the numbers simply speak for themselves in terms of meaning and support to prices.  During 2000, foreigners purchased a net $436 billion of Treasuries, Agencies and Corporates.  Net flows (net outflows) to domestic bond funds that year totaled $(49.8) billion.  The spread has one-half a trillion dollars.  We can directly thank the foreign community for supporting the US yield curve across bond asset classes.  During 2001, despite a very heavy net domestic bond fund inflow experience, estimated foreign purchases of US fixed income product outstripped domestic fund inflows almost six to one.

In addition to supporting US financial asset prices, it is clear as a bell that foreigners have contributed to the strength (mania?) in the US housing market vis-à-vis their significantly incremental increase in government agency issues purchased annually.  Certainly yield spread in agency paper relative to Treasuries is a prime motivating factor in the foreign purchase allocation decision, but from an economic standpoint this has helped underpin an attractive cost of capital for the GSE's, who are in turn providing mega amounts of liquidity into the US mortgage markets and greater financial system.

We cannot overstate the significance of the foreign buyer of US assets during this cycle.  It seems more than clear that the foreign community holds more than a few cards in terms of potential US financial asset directional price change ahead.  Since change at the margin is such a powerful indicator, continued demand for US assets among the foreign community deserves close monitoring.  At the moment, foreigners own significant portions of various US financial asset classes.

Soldiers Of Fortune...It is surely more than the US trade deficit that affects foreign flows of capital.  The domestic banking situation in Japan, as an example, may influence early year 2002 holiday travel plans for incremental Japanese capital.  The synchronous global economic downturn and concurrent relative currency movements may send increasing foreign capital to US shores seeking to bask in the warmth of the heat given off by what seems an ever rising dollar.  At least during the economic winter in foreign homelands.  But, it seems pretty clear from the earlier charts that there is a high degree of directional correlation between the widening of the US trade deficit and the incrementally higher annual purchases of US securities by foreigners.  On an absolute dollar basis, the following chart argues that fortunes just may be in for a bit of a reversal at some point:

After hitting a peak in late 2000, absolute dollar US imports are contracting.  At the moment, less dollars flowing out of the US on a monthly basis.  In sympathy with the synchronous global economic softening.  At the margin, the absolute level of dollars supporting the recycling effort of foreign trade reserves being reinvested back into US financial assets is changing.  It is slowing.  Coincidentally, the global economic community is still dangerously dependent on US import growth.  With the slowing in absolute trade dollar flow, currency pressures are reigniting globally.  Potentially forcing the US dollar higher on a relative basis and, in turn, temporarily attracting more capital to US assets even as trade activity slows.  Increasing US financial market price dependency on foreign capital flows.  

Looking beyond a potential short term currency pop to foreign capital inflows, what we have witnessed in terms of foreign inflows over the last half decade is simply unsustainable longer term.  Just as a massive foreign trade imbalance on the part of the US is ultimately unsustainable.  Because we have not experienced the dark side of this trade and fund flow relationship up until this point does not mean that the imbalance is somehow institutionalized or represents a new state of normalcy.  Quite the opposite.  It represents incredible potential for change at the margin.  The only question is timing.  As you know, we have not yet once mentioned either the word "sell" or "repatriation" of capital.  In our book, asset prices can experience profound change not only with outright selling, but first with reduced demand.  Rarely do bull markets change stripes to bear with rabid buying becoming rabid selling overnight.  The usually essential interim perceptual giveaway is an initial reduction in demand.  We do not expect the foreign community to sell their US financial assets en masse.  But rather at some point we expect a deceleration in rate of change in terms of purchase.  Although the numbers we show in the above table are annualized through 3Q 2001, it appears as though that process may have already begun.  With the US mom and pop mutual fund investor taking one step back from the financial asset party over the last 24 months, any marginal change in foreign flows takes on ever more increasing importance.

NOBODY Expects The Spanish Inquisition!!!...The last incremental buyer of equities quite important in terms of overall demand during the last half decade at least has been the corporate buyer.  Corporate buyers have "retired" common equity on a net basis annually since 1995.  As you know, common equity can be taken out of circulation, so to speak, in a number of ways.  Cash acquisitions, whether debt financed or otherwise.  And stock buybacks, likewise whether debt financed or otherwise.  It just so happens that despite all of the IPO and secondary activity of the late 1990's, corporate America in the aggregate was retiring far more common equity than it was issuing on a net basis:

Most folks tend to think that IPO's flooded the equity markets with new shares during the new era craze.  Unfortunately this is a perceptual phenomenon as opposed to the reality of the matter.  Most tech related IPO's were floated with rather small market caps.  It was the mania market action itself that ballooned these caps to the astronomical levels that are so well remembered by the story tellers.  It is our belief that what you see in the chart above in terms of net equity shrinkage was in large part driven by the levering of corporate America.

Although we certainly cannot say that the two major periods of common stock shrinkage shown in the above chart were 100% driven by debt accumulation, there is no question that leverage was a large underpinning in this shrinkage activity.  Non-financial corporate debt relative to a simple measure such as GDP spiked upward during the two periods of significant net equity reductions seen above.  Corporate leverage was clearly on the rise as macro equity outstanding was contracting.  Corporate balance sheets were being reconfigured on average during these periods:

And likewise this phenomenon coincided with significant price appreciation in market averages during these interludes:

Along with public investors and foreign buyers ever more flush with trade driven dollar reserves, corporate America was certainly an important incremental marginal purchaser of equities during the last half decade.  The question we now pose is whether this activity on the part of corporations can continue as we move ahead?  During a period of falling profits and declining cash flow, will corporations allocate precious cash resources to what is essentially a financial rebalancing act?  After all, they've already largely done that, haven't they?

As you know, major companies such as IBM are coming under increasing mainstream criticism for levering the balance sheet significantly to engineer higher earnings per share over the last half decade.  Gerstner is waltzing out the front door leaving the IBM balance sheet in one of its most levered conditions in its entire history as a public company.  Of course he has about 600 million personal reasons why significant levering was a pretty good idea during his tenure.

We now find ourselves in a less hospitable environment for corporate liquidity.  The Spanish Inquisition on the part of the bond rating agencies is in full force.  The commercial paper market, bank lenders and the US bond market are increasingly taking one step back from what has been an aggressive liquidity stance of the past ten years.  Certainly not surprising in that liquidity is inherently a coward.  Vanishing in times of stress.  The economic cost of potential future stock buybacks is rising.  Likewise the implicit cost of debt financed acquisitions.  Both drivers of the equity shrinkage phenomenon.

Is corporate America about to abandon its status as important purchaser of common equity at the margin?  It may just be an implicit sanction that the capital markets will impose on corporations themselves vis-à-vis the cost of debt capital.  If they weaken ahead in this activity, which certainly seems a solid bet at this point, they will join the ranks of the equity mutual fund participants in slowed purchasing activity.  If corporate liquidity needs become great enough in this environment, it's a good bet that they will have no trouble whatsoever in becoming net equity issuers.  The experience of the early 1990's is primary evidence that the corporate mindset is ultimately one of survival.

Suffice it to say that many of the substantial supporters of common equity prices over the last decade are showing increasing signs of stress.  Importantly, incremental stress at the margin.  The signs of potentially significant marginal change for these important sources of prior bull market equity demand are currently flashing in neon red right before our eyes.  This may not directly affect short term rallies or sell offs, but from a secular standpoint, supply and demand in the economic jungle remains a rather immutable force, new era or no new era.