July 2004

Enough Rope?

Enough Rope?...So, the Fed has gone and done it.  Rate hike numero uno is now under their and our collective belts.  As you know, the suspense has been absolutely chilling, right?  Sure it has.  As you know, this has probably been the most well telegraphed rate hike in history.  Maybe now financial pundits far and wide can finally stop spending inordinate amounts of time and energy pontificating about the ultimate timing of Fed Funds rate hikes.  After all, at 25 basis point increments, monetary policy movement isn't exactly earth shaking stuff right here.  To be honest, we're simply sick and tired of reading about the Fed and potential rate hikes as if nothing else mattered.  In fact, in this discussion, we hope to point out to you something that does matter in a big way when it comes to domestic interest rates.  In our minds, a topic that overshadows the Fed's short term manipulations of the Funds rate by a mile.  Unfortunately, these same pundits completely fixated on Fed minutiae of the moment don't seem to have given much more important determinants of broader interest rate movements even a second thought.  From our standpoint, by focusing solely on the Fed, they're missing the forest for the saplings, to say nothing of the trees.

It just so happens that a few weeks back the 1Q 2004 Fed Flow of Funds report hit the Street.  As always, we find this document relatively indispensable in terms of helping to characterize the modern day economy and financial environment.  If anything stood out glaringly in the recent report, it's the fact that foreign investment in the US has simply been staggering as of late, accelerating relative to already heightened experience over the last two to three years.  In all sincerity, we're simply convinced that our financial markets and real economy would look nothing like they do today without a literal tidal wave of foreign capital washing onto our shores over the recent past.  This time around, we've gone back and looked at some very long term history of flows.  Staggering is about the only characterization that comes to mind when looking at this data over time.  It's absolutely clear to us that the foreign community has "given us enough rope", so to speak.  In fact, more than enough.  Without further adieu, see for yourself.

Every once in a while a set of data comes along that simply takes us aback.  Emotionally, viscerally, philosophically, you name it.  As always, graphical representation of such data is usually a bit awing.  We strongly suggest to you that the following is one of the most important charts we have shown you anywhere in recent memory.  We don't mean this to sound melodramatic, but we simply cannot stress how important we believe this to be in the bigger picture.  Will this data cause the seas to part at the open of trading tomorrow?  Of course not.  But it paints a very simple and very elementally graphic picture of very significant structural imbalance.  The following is a look at net foreign investment in the US as a percentage of US GDP on an annual basis over the period covered.  Just so we're clear, net foreign investment is total foreign ownership of US assets, both hard assets and paper assets, less foreign asset ownership by US investors and less US foreign direct investment in real assets of foreign nations.  Simply, it's the net investment position of foreign interests in US assets versus the US investment position in foreign assets.  We put the number over US GDP (the largest GDP of any country in the world) for sheer perspective on magnitude of this relationship.  Very quickly, we're sure you've often heard that the US, once a former creditor nation, has become the largest net debtor nation on the planet.  Well, here's exactly how it all came to pass.
           

Sometime back, Warren Buffet publicly informed folks that he had taken a significant chunk of Berkshire assets and had purchased foreign currencies.  At the time, his rationale for skepticism regarding the forward relative value of the dollar was at least in part grounded in his perception that the "US was increasingly transferring its net worth offshore by the day".  Of course we've only shown you an annual look at Buffet's message in the chart above, but we're sure you get the picture.  It's no wonder that Buffet, among others, is clearly deeply concerned.  Concerned enough to have again upped his non-dollar financial asset position meaningfully in recent quarters.  Again, stressing the importance of what you see above to the longer term global financial and economic landscape, just how does this total global capital flow imbalance reconcile at some point without causing some type of meaningful disruption to either the real US economy and/or domestic financial markets?  And there is certainly no question that this concept of reconciliation has ramifications for the global economy and financial markets as well.  It's a pretty good bet that Warren is asking himself the same, if not similar questions.

Very quickly, let's look at some subcomponents of what you see above.  First stop?  Foreign direct investment in US assets versus foreign investment in pure US financial assets.  As per the Flow Of Funds report, the Fed very kindly gives us the breakout numbers for foreign direct investment (FDI) and foreign investment in US financial assets.  FDI is usually hard asset investing, but not necessarily such in every single case.  It's a foreign company potentially buying or building plant and equipment in the US, acquiring a US company, etc.  It's a foreign company acquiring physical US assets or the paper representation of physical assets.  The following chart traces the history of both FDI and non-FDI (financial asset) foreign capital flows into US assets.  In very rough terms, hard asset versus paper asset acquisition.  We present the numbers as percentages of total net foreign investment in US assets for perspective on the foreign predilection for US hard or paper based assets at any point in time.
      

In 1988, foreign direct investment in US assets comprised 89.6% of the total foreign flow of capital into the US.  Foreign capital flows into paper assets represented all of 10.4% of total flows.  As of the first quarter of 2004, foreign capital flows into US paper investments totaled 69% of total foreign capital flows to US shores.  It was really back in 1994 and 1995 when  foreign capital flowing to the US was split relatively evenly between paper and real assets.  Since that time, paper has dominated foreign investment activities stateside.  In fact, in absolute terms, foreign direct investment was actually down in 1Q 2004 relative to the fourth quarter of last year.  Although it's only one quarter's experience, we believe it is very important to note that in no year of the last three decades at least has absolute dollar FDI in the US been negative.  If this continues into 2004, it will be a relatively huge statement on the part of the foreign community.  We'll just have to see what happens.  Clearly, absolute dollar FDI in US assets has run well below prior peak levels over the last few years.  And maybe what is most striking of all is that at least over the last few years, the value of the dollar has been falling meaningfully against foreign currencies.  The relative trade weighted value of the dollar today is where it stood in early 1997.  Certainly below the level seen in 1998 and 1999, the peak years for FDI in the US.  Quite a juxtaposition.  In 1998 and 1999 with the value of the US dollar much higher than we experience today, the foreign community apparently could not throw money at the US fast enough in terms of direct investments in real assets.  Yet today with a much lower dollar, they simply won't touch them.  As you know, foreign direct investments cannot be sold at the open.  They can't receive the price protection of limit or stop orders.  Very often, they're not liquid at all.  In our minds, it's a very big statement that the foreign community has only chosen to buy theoretically liquid US assets on a net basis as of late.  Are they watching over their shoulders while buying up those Treasuries at each auction?  It would appear so.  If we didn't know better, we might just take foreign lack of interest in US direct investment as a statement regarding forward return opportunities on US capital assets.  That couldn't be, could it?
       

Of course this turn of events is simply corroboration in its most pure form that Asia, specifically China, and India are the primary beneficiaries of the bulk of global FDI at the moment.  So we know that the bulk of current foreign investment in the US is in the form of paper.  Here's a quick history of net foreign purchases of US financial assets over the last decade.  We've annualized the numbers for the first quarter of 2004.

Please be warned that annualizing quarterly data can be quite dangerous at any point in time.  Yet for now, the annualized '04 data to date look as if foreign buying of US financial assets is going parabolic.  We need to see what future quarters bring prior to passing judgment at this point.  The 1Q 2004 increase in gross foreign holdings of US financial assets on an absolute dollar basis (not annualized or adjusted) was $422.9 billion.  As you know, that annualizes at close to $1.7 trillion.  Again, although annualizing one quarter's data should be viewed for what it is, the following chart gives you a feel for the acceleration in the gross foreign accumulation of US assets (unlike the table and graphs above, these are not net figures) in 1Q.
      

One last look at 1Q foreign capital flows into the US.  This time it's the net accumulation of US assets by the foreign community on a year over year rate of change basis.  The historical rate of change numbers tells us that the foreign community has been turning on the heat over the last few years in a big way in terms of funding current American "prosperity", so to speak.  Here's a quick question for you.  Just where do you believe the US dollar would be today without so much support from foreign buying of US dollar denominated assets over the last few years?
      

There is absolutely no two ways about it.  The foreign community has given the US miles and miles of financial rope.  Of course the ultimate question is, at some point will this rope become a noose around the neck of US financial and economic flexibility?  At least for now, the hang man isn't hanging.  Not today.  Let's just hope we're so lucky moving forward.  Just how much more of our domestic net worth do we need to transfer offshore before the Buffet's of the world are vindicated?  Perhaps now more than ever, keeping tabs on global capital flows is critical in trying to assess forward conditions in the US financial markets and economy.  In our minds, given the incredible and unprecedented magnitude of foreign capital flows into the US markets and the real economy over the last three to four years, foreign central bank policies at any point in time are of much greater importance to us than wildly over dramatized 25 basis point Fed Funds rate increases.  For now, foreign capital flows are influencing the shape of the US interest rate forest in which the Fed is attempting to germinate saplings. 

I Love Playin' Two Hand Touch , Eatin' Way Too Much , Watchin' My Team Win....AND TWINS!!!...If there was only one piece of what we believe to be very meaningful advice we could impart to investors as we look ahead five to ten years and beyond, it would be to think globally.  Think globally really as never before.  As we try to reinforce this little message in ourselves daily, it becomes striking how the domestic financial press virtually myopically focuses on US specific economic and financial circumstances of the moment.  The data above tell us that the destiny of the US economy and financial markets will be determined both from within and importantly from events beyond domestic shores.  Yet how many of today's Street cognoscenti are either focusing upon or trying to incorporate global capital flow statistics into their thinking and analysis?  Not many.  At least not from our vantage point.  Instead, we find so many apparent Street seers spending inordinate amounts of time and energy attempting to guess what the Fed will do in a few months.  Crazy in that the bond market has already moved well out in front of Fed action at this point.  Actual Fed action this week was largely an afterthought given what has already occurred in US fixed income markets YTD.

Quite unfortunately, and at least for now, we see very little focus upon what is happening in Japan.  We strongly suggest that circumstances in Japan are crucial to forward US investment thinking as the Japanese central bank, along with the US Fed, has been the key provocateur in the global creation of liquidity over the last three to four years.  In one sense, the US and Japan are twins when it comes to liquidity creation and the current direction of their respective longer dated domestic interest rates.  In the data presented above regarding global capital flows into the US, by far Japan has been the ringleader among its foreign brethren.  Although we read reams of commentary regarding US interest rates and the outlook for rate movement ahead, we do not see much analysis regarding the significant change in Japanese interest rates over the past year and one half.  Along with the US 10 year Treasury, 10 year JGB (Japanese Government Bond) yields bottomed in May of 2003 and have been climbing ever since.  After bottoming at an incredible yield of 0.43% last year, 10 year JGB yields have risen to a level near 1.95% at the moment.  That's almost a five fold increase.  In like period terms, US 10 year Treasury yields bottomed near 3.1% and now stand near 4.7%, an increase of 52%.  Although the bubble in Japanese government bonds has been and continues as perhaps the bubble of a lifetime, on a price basis, interest rate driven bond value destruction in Japan has been much worse since May of '03 than has been the case in US fixed income markets.  Very much unlike the US, though, 97% of JGB's are owned domestically within Japan itself.  As of last count, 47% of total US Treasuries are currently held by the foreign community.
       

Much like circumstances in the US, interest rates in Japan have moved higher along with a resurgence in GDP growth.  As of the latest reading, year over year Japanese GDP growth is at a level last seen in the early 1990's.  Certainly the significant lift in Japanese GDP is in good part due to what has been happening in China over the last few years, which in and of itself is in at least some part due to the very hospitable global liquidity environment of the last few years.  But IF Japan is to continue to move ahead as an economy, we need to keep our eye on a few indicators.
       

First, as economic growth in Japan expands, the demand for money and credit accelerates.  This is basically an economics 101 truism.  Secondly, so much of the liquidity creation that has happened in Japan over the last few years has been directed at global intervention activity in foreign exchange markets, specifically addressing the US dollar via the purchase of dollar denominated financial assets (think US Treasuries).  The global capital flow numbers we discussed above would look nothing like they do without Japan.  In fact, they'd be a fraction of what has actually transpired.  Will forward growth in the Japanese economy "compete" for total liquidity being created in Japan at any point in time?  Of course it will.

As mentioned, roughly 97% of current JGB's outstanding are held domestically inside of Japan.  Just who are the owners?  Japanese banks, pension funds, insurance companies, individuals, etc.  Just like owners of US Treasuries, higher government bond yields in Japan are already eating into the principal value of existing bond holdings.  And much as is the case in the US, it remains an open question mark as to how higher interest rates will ultimately influence the real economy, especially in light of the fact that China is also clearly slowing to some extent.  Let's put it simply, we have a hard time seeing how higher rates will be a positive influence for either country.  That being said, will the Japanese authorities at some point decide to buy JGB's (essentially monetize their own debt) in an effort to hold down their own domestic interest rate levels?  An act of supporting their own economy.  After all, the Japanese monetary authorities have a definable history of financial intervention.  Capital flows to the US over the past three to four years are simply a dramatic example of such a philosophy.  The bottom line is that Japan may definitely need its ability to create liquidity for internal or domestic financial and economic purposes looking ahead as opposed to the international manipulation of foreign exchange markets that has been the primary target for Japanese liquidity creation of the last few years especially.  Internal demand for money and credit in Japan is growing, as might be the need to attempt to cap domestic interest rate levels at some point.  This may very well test Japan's currently key role as global financial liquidity co-master of ceremonies.  And, as you already know, these possibilities for redirection of Japanese monetary liquidity would have direct and relatively dark implications for US financial asset prices (primarily Treasury bonds) and the value of the US dollar. 

Maybe one chart to watch that will hopefully give us clues to or help corroborate the need for liquidity inside of Japan due to economic growth is the Nikkei itself.  As you can see in the following chart, directional movement between the Nikkei and the year over year change in Japanese GDP has been relatively coincident over the last decade.
       

So, will the Fed raise rates again in August?  Do you think?  Well, by how much?  Do you think they'll wait until after the election?  Will we be at a 2% Funds rate by yearend?  Do you think they'll really push the Funds rate beyond 3.5% during this cycle?  Quite unfortunately, these and similar questions will most likely be pontificated upon thousands of times over by hundreds of financial media tabloid writers in the weeks and months ahead.  But no worries at this point.  You know what to do.  Ignore the white noise and focus on the much larger and significantly more important issue - global flows of capital.  Remember, think globally like never before.