Minyan Mailbag: John Mauldin
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next article, written by Minyan John Mauldin, with that very intent.
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This week we finish with our series on the U.S. trade deficit. When will we see a real problem? What are the likely results from a balancing of global trade? Where are the investment opportunities, and where are the pitfalls? It should make for an interesting conclusion and hopefully an interesting letter.
Let's start this letter by noting that this week is the anniversary of the all- time high of the NASDAQ. Five years ago this week the NASDAQ topped at 5,048. It eventually dropped to around 1100 before "recovering" to today's close at 2,041.
I remember writing in the fall of 1998 that the NASDAQ was overpriced. Eventually, time has shown that view to be correct. But in 1999, I looked like I didn't have a clue. And I confess at the time, I didn't have a clue. I couldn't figure out what was making the market go up. To me it was clearly a bubble. As a value investor, I couldn't bring myself to participate, other than through money managers who were market timers.
It was perilous to short the market. To paraphrase Keynes, the market can be irrational longer than you can remain solvent. People convinced themselves that we were in a New Paradigm. Except for a brief bump in 1998, the markets had been smooth and continuous for quite a long time. The stability of the economy had led to an increasingly optimistic attitude among market players. That stability had led them to project the then current growth in earnings and stock prices far into the future.
One of my deepest concerns is that the current complacency with the trade deficit which stems from the relative stability of the U.S. economy and markets will lead to an event as dramatic as the fall of the NASDAQ. The U.S. economy is growing handily, thank you very much, and unemployment is slowly beginning to drop. The trade deficit has caused no problems. Is it, I wonder, a replay of the 1990s where the stability of the era created further complacency and a continued growth in the imbalance of market valuations? As a reminder, it was Hyman Minsky who told us that the longer things remain stable the greater the period of instability that will follow it.
There is simply no way to know how far along the process we are. Is it 1996, and Greenspan is muttering "irrational exuberance" or is it 1999 and a New Paradigm?
There are many who now suggest we are in a New Paradigm. This time, we're told, things are different. Every time I hear those words I remind myself of Mauldin's Fourth Rule: It is almost never different. And if it really is different, we won't know it is until long after. You can't alter the basic economic equations of mankind. Value always trumps speculation. Government meddling in the marketplace will lead to imbalance and grief. As I argued last week, it is government interference in the currency markets that is creating the environment for the U.S. trade deficit. And by government interference, I mean primarily Asian governments who are willing to sacrifice profits in their dollar currency portfolios for a growing economy. I can certainly understand their desires and motives, but I'm not certain that it will turn out the way they hope.
The argument for a New Paradigm goes something like this: It's in everybody's interest, and especially that of Asia, to keep the game going. They would be risking political instability if they did not fund the U.S. trade deficit. To stop the game would mean that the U.S. would not be able to buy as much of their goods and services. And we know that Asian governments do not want political instability. Therefore, the circular reasoning goes, the game will continue.
Further, the United States is still the best place in the world to invest money. Our assets far outweigh our liabilities, and our companies are the most profitable and highest margin companies in the world. While many who make these arguments would concede that some adjustment needs to be made, they think that the adjustments will be mostly of a benign nature and not roil the economy.
Alan Greenspan is one who thinks the current global imbalances can be brought into balance without great disruption. Indeed, his experience in dealing with the last bubble reinforces his argument. On this note, I agree with this comment by Stephen Roach of Morgan Stanley:
"Global rebalancing does not have to have a disruptive endgame. Fed Chairman Alan Greenspan used the occasion of the fifth anniversary of NASDAQ 5000 to argue for just such a benign scenario (see his 10 March 2005 remarks, "Globalization," presented to the Council on Foreign Relations in New York). While such a constructive stance is to be expected from any central banker, Greenspan has been in a league of his own in arguing for gentle post-bubble adjustments over the past seven years.
"But there are no guarantees as to the severity of the endgame. Irrespective of mutual interest in the benign resolution of global imbalances, experience tells us the greater and longer the build-up of imbalances, the higher the chance of a more serious correction. In the event of a rougher endgame, the dollar would undoubtedly fall a good deal further, while longer-term U.S. real interest rates would finally start to rise toward more normal historical levels."
A few weeks ago, I introduced you to a paper by Nouriel Roubini and Brad Setser, "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-06" February 2005, on http://www.stern.nyu.edu/globalmacro/. In it they speculate that the implicit agreement between Asian nations to take dollars and fund the U.S. trade deficit may in fact be coming to an end in about two years.
Maybe it will not even be that short of a time before it begins to unravel. Since they wrote their paper and I began this series about one month ago, we have had first Korea, then China and now Japan suggest that it may be time for them to diversify their dollar holdings in their individual central banks.
Et Tu, Japan?
"Prime Minister Koizumi of Japan said his country 'in general' needed to consider diversifying its foreign currency reserves, the world's largest. 'I think it's necessary to diversify the investment destinations' of foreign reserves, Koizumi said. 'At the same time, we have to make a judgment in general, considering what's profitable and what's stable.' This is a big step for Japan, as they have generally always talked about their reserves as a monetary policy tool, rather than a financial investment. With $820 billion now at stake it is clear that the government is concerned about their returns, and the returns of dollar assets to a global investor have recently been ugly. If Japan is going to start moving $820 billion dollars around, it is inevitable that others will try to get ahead of them." (Bridgewater)
Immediately, Japanese Ministry of Finance officials began to either outright deny Koizumi's statement or suggest that the press did not understand the clear intentions of his words. But understand this, if the dollar were to drop 15% against other Asian currencies, while Japan fought to maintain their dollar yen ratio above Y100 to the dollar, Japan would lose over $100 billion in purchasing power. That is not small potatoes. Koizumi recognizes this and also recognizes the serious strain that their government deficits and huge debts have on their economy. Koizumi was clearly stating that losing $100 billion is not going to be politically acceptable.
As I said a few weeks ago, the dollar is going to become the Old Maid. It is going to start being passed around from country to country in an effort to lessen the impact of a falling dollar in the local economy.
There are many who speculate that foreign nations will begin to sell the dollar. I suppose that is possible, but that is really not something that I'm terribly worried about. The chief concern is not that they sell the dollar, but simply that they stop buying. Let me illustrate.
The nominal U.S. trade deficit widened to $58.3 billion in January from December's downward revised $55.7 billion deficit. A price-related drop in oil imports helped the deficit, but this will likely reverse with the February data. The trade deficit with China widened by $1 billion to $15.2 billion, in part possibly due to a jump in apparel imports following the expiration of quotas. (www.dismal.com)
This year the trade deficit will be well over $700 billion, up almost $100 billion from last year. Our government is running a deficit of some $400 billion. If we were running a balanced budget, we would be able to take that money, and more or less apply it towards the trade deficit. However, since we have a low savings rate and a huge government deficit, it is necessary that we look outside the United States for someone to fund our trade deficit. In essence, we are expecting the Asians to pony up $100 billion more than they did last year.
What happens if they don't? Interest rates will have to begin to rise in order to attract more money. It is simple as that. Interestingly, we watched rates rise in the past few weeks. The interest rate on the 10-year bond has risen to over 4.5%, after being in the 4% range for a very long time. This has also sent mortgages back to one-year highs, and the stocks of home construction companies tumbling.
Is there any evidence that foreign central banks might not be stepping up to the plate? There in fact may be. Dennis Gartman gives us the following comment:
"In this regard we are a bit dismayed by the results of yesterday's 10 year note auction. The bid/coverage and other aspects of the auction were fine, but we did find it a bit disconcerting that the so-called 'Indirect Bidders,' amongst which are the world's foreign central banks, bought only 11% of the total $9 billion at auction. This is down from last month's 29% foreign 'take.' It does, however, compared passably with the last 're-opened' auction went 10% to the 'indirect bidders.' In an untroubled time, this might have been passed off lightly; in the current rather troubled time for the U.S. dollar it cannot be."
I repeat, all that has to happen for the dollar to begin a serious bear market against Asian currencies is for Asian countries simply to stop or to limit their buying. This will also have the effect of driving the dollar down against almost every other currency including the euro. When this happens, we'll be at the beginning of the heavy lifting of rebalancing global trade and currency valuations. This heavy lifting is going to strain more than a few backs. It will take more than a few Advil to deal with the pain.
The process means that interest rates will go up, which will slow the economy and hit the housing markets. Prices of goods from foreign nations will go up, thus creating inflation pressures and limit the ability of the Fed to fight rate increases or to stimulate the economy. I really don't see how the end result can be anything other than a recession. It will catch most economists off guard, as do most recessions.
Is there a recession that we can somehow see in the future? Paul Kasriel, the director of research of Northern Trust suggests that there is a linkage between the dollar holding of foreign central banks and the future economic growth of the U.S. economy. Rather than summarizing this report, I'm going to print it in its entirety, because I think it's important.
An "Unofficial" Leading Indicator Is Flashing Yellow
"The Conference Board's index of Leading Economic Indicators has been trending lower since midyear 2004. Now, an 'unofficial' leading indicator also is starting to signal caution about the future strength of the U.S. economy. This unofficial leading indicator is the sum of the monetary reserves created by the Fed, largely its purchases of U.S. Treasury/agency securities, and the U.S. Treasury/agency securities purchased by foreign official entities, predominantly foreign central banks. In effect, this sum is a proxy for global central bank holdings of U.S Treasury and agency securities. How do central banks, ours and the rest of the world's, get the wherewithal to purchase U.S. Treasury and agency securities? By figuratively printing their national currencies - dollars in the case of the Fed; yen in the case of the Bank of Japan. The Bank of Japan prints the yen to buy dollars. It then uses these dollars to buy U.S. securities.
"[Paul then shows a chart which]shows the year-over-year percent change in this proxy, advanced four quarters, versus the four-quarter moving average of the ISM manufacturing composite index. The correlation coefficient between the two series is 0.63 out of a possible 1.00. So, there is a relatively high correlation between the growth in global central bank holdings of U.S. Treasury/agency securities today and the level of the ISM manufacturing index four quarters from today. When global central banks are adding to their holdings of U.S. securities at a more rapid pace, four quarters later, the pace of U.S. manufacturing activity - and for that matter, the growth in U.S. economic activity in general, tends to pick up.
"What might explain this positive leading relationship between the growth in global central bank holdings of U.S. securities and the growth in the U.S. economy? As alluded to above, central banks purchase securities by creating credit out of thin air - much like a counterfeiter operates. If you or I, presumably not counterfeiters, purchase a security, we either have to cut back on our current spending on other things or sell some other asset we already own. If the latter, and assuming the purchaser of our asset is not a central bank or(?) a counterfeiter, then he has to cut back on his current spending.
"But when a central bank/counterfeiter purchases a security, no one else need cut back on his current spending. In the four quarters ended Q3:2004, the Fed created an additional net $47.9 billion of monetary reserves and foreign central banks purchased a net $323.1 billion of U.S. Treasury and agency securities. The sum of their activities totaled $371 billion. During this same period, the U.S. federal government spent $412 billion more than it took in from taxes and other revenues. Had it not been for the Fed and foreign central banks stepping into the breach, we non-counterfeiters would have had to cut our spending so that the U.S. federal government could continue its spending.
"What is happening now to the growth in global central bank holdings of U.S. securities? It is trending lower. After peaking at 18.5% year-over-year growth in Q3:2004, growth in central bank holdings of U.S. securities sharply decelerated to 12.0% in the fourth quarter of last year. And what is the likely course of this series? [Paul's next chart] shows that there is a negative relationship between the level of the fed funds rate and the growth in global central bank holdings of U.S. securities. The way the Fed gets the funds rate to rise is to slow down the growth in its supply of monetary reserves. As the fed funds rate rises above the U.S. inflation rate, the dollar starts to rise, lessening foreign central bank's motivation to buy dollars and recycle them into U.S. securities.
"In sum, growth in global central bank holdings of U.S. Treasury and agency securities is a leading indicator of U.S. economic growth. A rising fed funds rate is negatively correlated with the growth in global central bank holdings of U.S. securities. Growth in global central bank holdings of U.S. securities is decelerating. The Fed is expected to continue hiking the funds rate. All of this suggests a slowdown in U.S. economic growth is in the cards. (Paul L. Kasriel, Director of Economic Research http://www.ntrs.com/library/econ_research/weekly/.)
The Trade Deficit End-Game
The whole process of global rebalancing is thankfully going to take a great deal of time. But it looks like we may be at the early stages of the Asian countries allowing the dollar to begin to fall. This will bear watching. Every interest- rate increase in the longer part of the yield curve will need to be carefully monitored. Hedge funds are going to be looking at the dollar holdings and new dollar investments of Asian central banks with increased intensity. Indeed, Asian central bank will be looking at their brethren to make sure that one country isn't getting a "jump" on any other country in the rush to "diversify out of the dollar." U.S. debt auctions will come under increased scrutiny. Can anyone say increased volatility, gentle reader?
In my opinion, over the long term the dollar has nowhere to go but down, although over the short term the dollar could give us a head fake and strengthen. Interest rates, at least until we are in a recession, will be heading higher. Please understand this is not the end of the world. Life will go on and eventually we will work through this process, just like we worked through stagflation in the 70s. It was not exactly the easiest of times, but the 80s and 90s turned out just fine, thank you very much. The American economy is quite resilient and can deal with bubbles and imbalances and still improve over the decades. There will be plenty of opportunities for the astute investor to protect and grow his portfolio, not to mention increasing his purchasing power. As I've been writing for many years, investing like it is the 90s is not going to be a successful strategy for quite some time.
It should go without saying, the above scenario will not be a good one for the broad stock market or for bond funds. It's just another reason why I believe we will be in a Muddle Through Economy for quite some time.
A New Bull's Investing Book Club And Spring Break
Last year, I told readers of my book, Bull's-Eye Investing, that I would do something special for them. We have finally figured out what we can do. My associate (and daughter), Tiffani, will be organizing three one hour question- and-answer sessions over the next year. If you've bought the book, you'll be eligible to listen in. We will send you a phone number and a time. You send me your questions and I will attempt to answer as many of them as possible.
If you have already bought the book, simply reply to this e-mail and put "book club" in the subject line. We lead you to the list and notify you of the first session. If you have not bought the book but would like to be added to the list, you can go to www.amazon.com/bullseye and buy the book, and then drop us a note. We trust you. If you would like more information on the book, you can go to www.absolutereturns.net.
If you replied earlier to our requests to let us know if you have bought the book, we have your name already.
It's Spring Break time for some of my kids, but not for all of them. Some congressman should enter a bill to require that all schools have their Spring Break at the same time. For those of us with multiple kids (in my case 7) in multiple colleges and schools, it would be more than convenient to have them all at home at once.
This would be something they could do without running up the budget. Tax receipts rose 10% in February from over a year ago. Think that helped cut the deficit? Think again. Spending rose 14%. Note to Karl Rove: you can't balance the budget by not holding down spending below receipts. Time for W to use all those vetoes he's been saving. 14% growth in federal spending when the economy grew less than 6% (nominal) is ridiculous. Cut the pork and all the new programs or we are going to be looking at the repeal of the Bush tax cuts. And it would have the salutary effect of making the balancing of the trade deficit less of a problem.
Sigh. One can always hope.
Your wishing for a little fiscal restraint analyst,
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