3rd Quarter 2006: Structural Imbalances in a Global World

Third Quarter 2006
Market Commentary

Structural Imbalances in a Global World

In our prior quarterly commentaries, we have often written about the dangers presented by our growing trade deficits. These trade deficits, now running at $700 billion plus, which when added to our budget deficit, ($300 billion plus), accounts for an approximate $1 trillion outlay. In turn, a substantial percentage of this is draining capital (i.e. savings) from our shares to other parts of the world. The consequences of this are many and varied, and has both proponents and antagonists.

In this issue, we decided to give a mid-year appraisal of what we see as the structural imbalances of these deficits, particularly as it relates to its financing, and to where all this may lead, given the fact that it has now become an international problem.

Proponents argue that these deficits are mere stumbling blocks on the way to achieving a global economy, which in turn, they say, leads to a more peaceful world. Idealists point out that it is less likely for nations to go to war if they are trading partners, and that the greater the inter-action among nations, the more peaceful the world becomes.

Antagonists argue that it is financially irresponsible to jeopardize the savings of our country in order to achieve a result of dubious benefits.

Indeed, we have pointed out that raw economic statistics indicate that hundreds of billions of dollars have left America, only to wind up in banks and governments of foreign countries, and especially (in recent years) China. We have tried to connect the dots, showing that the increase of U.S. home equity loans for non-real estate purposes approximately equals the increase in the holdings of U.S. government securities by other nations, with China being the largest recent beneficiary.

We have further concluded that, from a macro viewpoint, much of this increasing personal debt against one's home, has been masked by the significant increase in home equities enjoyed around the country. Debt however, is permanent until paid; equity value is a function of demand and supply, and can fluctuate just like any other market.

In our past commentaries we have also noted that much of the increase in (residential) real estate has occurred as a result of interest rates being kept artificially low during the Greenspan (mid 2002 - mid 2004) era.

During this period, and indeed, into 2005, close to 40% of new home mortgage originations were written as adjustable rate mortgages (ARM's); and in many parts of the country, a significant percentage of ARM's were written as interest-only adjustable rate mortgages (especially in California).

Now, after 17 successive interest rate hikes by the Federal Reserve, interest rates are no longer artificially low, and those people who were stretching their finances to buy larger homes, or leverage real estate holdings, are having to cope with increasingly higher monthly payments to maintain ownership of their property.

So why, one might ask, is the Federal Reserves doing this? Their mandate is not to target prices of different asset groups; (although one could argue they did just that with stock prices in 2000-2002).

This time around, however, we believe, that while (residential) real estate is probably going to slow as a consequence of federal policy, the Federal Reserve is looking at larger and (from their viewpoint) more critical variables.

Those variables are the structural imbalances, which occur from trying to finance all our deficits. This is where the proponents of global trade - under the way in which we conduct it, fall short - they fail to take into account the fact that no one wants the value of their money to go down. Since such value is measured in dollars, what we're dealing with is an attempt by the Federal Reserve to maintain the dollar's value - while at the same time - maintaining enough liquidity to maintain a healthy economy here at home.


The process of doing this is unfolding as we speak; and one could argue that its largely a trial and error process. Greenspan has been quoted as wanting to raise interest rates, until "it feels about right". Bernanke, the new federal chairman, is quoted as referring to his job as "driving a car by looking in the rear view mirror".

It's not that these officials don't know what they're doing; it's just the fact that there are now a lot of moving parts, and relevant factors are interacting simultaneously in ways we haven't previously experienced.

For one thing, there is now almost universal conversion and transparencies among currencies, with daily fluctuations occurring just as in other financial markets, such as stocks and bonds.

So, whereas we look at such factors as a) sales, b) earnings, c) debt ratios, d) growth, and e) price when evaluating companies; so too do international banks, governments, hedge funds, and currency speculators look at similar factors of a country and its government. They look at a) GDP, gross domestic product; (GDP in this case is equal to sales of a company), b) surplus and or deficits in a countries internal budget (equal to profit or loss), c) debt ratios of a country relative to GDP, d) projections of a countries growth versus its ability to finance that growth, and e) the price (or exchange rate vis-à-vis other currencies).

While these are obviously not meant to be exclusive factors, it gives one a starting point to perhaps better understand the volatile world we have entered.

Let us expand on items a) through e) as it pertains to the U.S. The first, (a) has the U.S. maintaining its lead as the strongest economy on earth. Our GDP growth has averaged close to 4% per year for the past three years. This blows away economic growth in Europe, but trails Asia. China has been growing at 10% per year for the past three years, albeit on a smaller economic base.

Indeed, if you take 4% of a $12 trillion economy it comes to almost $500 billion. That incremental growth - on an annual basis, is essentially equal to 60% of Canada's GDP, between 25% and 30% of Great Britain, and close to 20% of Germany.

The second item, (b) relates to earnings. On a national level, this relates to our federal budget surplus and or deficit; and on this count, the U.S. while improving, has been consistently weak. On the one hand, one could argue that this year's deficit, c) projected now at approximately $350 billion, is a low percentage of GDP, relative to the European nations. On the other hand, it's a huge number, and does not bode well for maintaining the stability we are trying to achieve. On this point, there's not a lot of room for error.

Insofar as (d) growth, is concerned, we think our previous comments on homeowners liquidity - or lack thereof - may stunt the growth of the U.S., depending on where we end up on interest rates.

The current situation is problematic insofar as the consumer is 2/3 of the economy, and the consumers' largest asset is his/her home. Assuming that the average homeowner has a mortgage against his/her property, and following the pattern of a material and significant number of homeowners refinancing their property through ARM's, we feel that this data point alone will lead to a slowdown, but not a recession. Further interest rate hikes will exacerbate this problem.

In all fairness, we should step back and expand on item (b), our national profit as viewed by focusing on the federal budget. Economists would add two other factors that can either offset or worsen these numbers. One is corporate profit, which, in the aggregate, will offset budget deficits. We did not include them, however, as U.S. corporations are not on the hook to pay government liabilities. In fact, as we have previously written, Corporate America compounds these structural problems by keeping profits from U.S. products manufactured overseas in foreign banks. They do this because Congress passed a law allowing them to do so, without paying U.S. taxes on those products.

Moreover, within the framework outlined above, U.S. corporations as measured by the S&P 500, have just completed 12 successive quarters of double-digit earnings growth, and are the strongest sector of the economy.

Whereas consumers are 2/3 of the economy, the corporate sector represents the other 1/3 of the economy, and it is doing quite well. That's a major reason why we favor large U.S. based but globally operated companies for investment.

The remaining factor in item (b), profit and loss, are households. Much of the relevant finances of households are contained within our previous comments on residential real estate. Apart form that, however, personal non-real estate debt has also been piling up at an alarming rate. Shown below is a chart graphically illustrating the imbalances described above.


Perhaps the most telling and startling data point on the chart above is the top line - foreign lending.

In other words, we are only in a surplus position with U.S. business, and the difference between its profits and the combined deficit (losses) of government and households are being made up by foreign lending. Translated, that means China, India and other countries which have trade surpluses with us are keeping everything going by taking the dollars deposited abroad and re-investing them into treasury securities issued by our government. This has helped to keep interest rates low, but it's not a long-term solution.
In our view these imbalances cannot continue indefinitely and the longer they last, the bigger and more painful the adjustment will be. The government and, above all the household sector, are in huge deficit. In 1982, the household sector ran a surplus of 5.5 % of GDP. Now it runs an unprecedented deficit of close to 7 % of GDP. Unfortunately, the counterpart of the huge capital inflow is not increased investment but increased consumption and falling national savings.

Where we're going with this is that, at present, the financing of our economic growth is coming from those countries who increasingly are providing the labor for the products we buy; and we believe its giving those countries undue leverage over U.S. policies. While the U.S. has lots of ways not to allow others to influence such policies, whatever they might be; we think that its quite probable we will reach on inflection point where others might use this leverage against the will of our people and our elected representatives.

This brings us to item (e), price. The price refers to how many pound sterling, yuan, euros, yen and roubles we can buy with our savings. As long as other countries need our consumption to keep their economies going, the dollar will remain relatively stable, and little change will occur in our daily way of life.

Nonetheless, with China leading the way, there has been a global accumulation of $2,340 billion in additional foreign currency reserves since the beginning of 2000, much of this in U.S. dollars. So as long as the dollar remains stable, with unemployment remaining low; home values generally remaining high, and consumer confidence positive, these foreign dollar holdings may not present a problem.

But, as we stated earlier, this cannot go on forever, and we suspect that the real reason the Federal Reserve is pushing interest rates up is to placate these foreign lenders to continue holding dollars.

The real question is - how long will this Federal Reserve tightening continue? Most observers have predicted that the end is just around the corner. However, they (economists, brokers) have been saying that for the past year and a half, and they've been wrong for a year and a half.

Indeed, along with the most recent federal tightening last Thursday (June 29) to 5 ¼ %, Ben Bernanke, Fed Chairman, made remarks that led investors to interpret his statements for future guidance as being neutral. This, in turn, led to an impressive 2-day rally. Still, futures trading for interest rates indicate that rates may go up again in August at the next Fed open market meeting, and there is anything but a consensus on this point.

We would be remiss in not including oil and its impact on all this. Recall that in our last commentary, we walked through the supply-demand factors pertaining to oil, and came out with the conclusion that oil prices will remain high, and that our sources of supply are being increasingly compromised by the political viewpoints and actions of our increasing number of our suppliers.

So lets add oil into the equation by looking at the next chart. This chart was compiled by Larry Sommers, past chairman of the Counsel of Economic Advisers under Bush 2, and former president of Harvard University.
This tells a story that indicates that we are not only financing our trade deficits thru treasury purchases by China, Japan, and other trading partners, but also by borrowing to purchase our energy need from abroad as well. (See oil exporters - $328 billion). It shows how global imbalances worldwide are now being financed. Note that oil-exporting nations, along with China, Japan, and other Asian nations, are the primary suppliers of liquidity to the world markets; whereas the United States is buying all their products, but are $800 billion in the red.


The sum total of all this becomes somewhat problematic, and our sense is that the Federal Reserve is not going to go away (i.e. - stop raising rates) until they feel the solution to these imbalances are at hand.

That, however, does not preclude the Fed taking a breather in their consistent string of hikes to gauge the effects of what they have already done. This, in fact, is what we consider to be the most likely outcome. We say this because we are of the opinion that the 17 rate hikes already put into place, are already beginning to have a lag effect on economic growth.

Further, while we see Fed activity directed towards protecting the dollar's international value; we must not forget that they also have a mandate to protect the internal purchasing power of the dollar.

So we see the probability that the Fed will tend to seek equilibrium in their policies, or some kind of balance between the two goals of protecting the dollar's international value and maintaining economic growth internally.

Indeed, most economic forecasters are already predicting a slowdown in our growth rate beginning this quarter - extending into 07'. The majority of forecasters, however, still see positive economic growth and most estimates hover around the 3% rate over the next 3-4 quarters. If these GDP growth estimates are correct, and the economy glides along at around the 3% level, we believe the stock market should hold its value and slowly rise, and the bond market should remain fairly steady, with a slight upward bias to rates, and a downward bias to price.
Meanwhile, the economy rolls along at high rate. 1st quarter GDP numbers were just recently revised upward to 5.6 %, a rate, however, that the Fed considers both unsustainable and too high without rekindling inflation.

Nonetheless, much has already been done to bring these policies into balance. The economy will soon feel the effects of 18 months of Fed tightening (there is usually a 12-18 month lag time from actual interest rate hikes, and its effect on the economy).

In fact, the Wall Street Journal's latest survey conducted in mid June also suggests an economy at a crossroads, with growth appearing to slow but inflation accelerating. Inflation is accelerating because the appetite of the exporting countries of the Far East are consuming all the natural resources they can get their hands on; and the impact of this is causing higher prices at home.

Others are beginning to see a similar scenario. To bring this discussion back full circle, lets revisit inflation. For inflation is the wild card, and inflation pressures are what caused the Fed to begin this process two years ago. Shown below is a graph of inflation which has been creeping higher over the past three years.

At the crux of this, however, Bernanke understands that raising rates slows down the economy, but may not do much to temper inflation, at least in the near term. This is because he realizes that the drivers propelling the current inflation are unlikely to end any time soon.

We believe that higher interest rates aren't going to have much of an impact on world oil prices either; given the demand-supply imbalances we described in our last commentary. As we mentioned, oil is a primary factor in causing the increase in inflation, as well as the impact high oil prices have on the cost of energy needed to manufacture and transport everything we build and sell. If our analysis of this is correct, incremental rate hikes from this level will probably not cause the price of oil to drop much, yet, as we mentioned earlier, the economy is at a crossroads, and economic activity will suffer if the Fed goes much farther, even if it strengthens the dollar.

In addition, other primary drivers of inflation - such as wage increases, have been relatively benign; and home values, which, as discussed earlier, are at the very least beginning to level out; and its evident that prior rate increases by the Fed are taking its toll on this sector of the economy.

In conclusion, we think there are structural imbalances which are weighing the market, and creating volatility as the market factors into this equation all of the above elements. Nonetheless, apart from these imbalances, there is positive news to report.

First and foremost, we are entering into earnings season, and all indications are that earnings will remain quite strong. Remember that in the overall scheme of things, the graph presented earlier in this discussion illustrated how strong corporate earnings have been as a source of national income. S&P 500 Corporations are also sitting on over $2 trillion of cash, the largest trove of cash ever in the coffers of corporate America. More over, there is also a large cash buildup in 401-K and pension accounts, plus over $2 trillion in money-market funds. Further, there have been increasing numbers of companies buying back their own stock. This provides a lot of liquidity and buying power, and has led to an increasing number of mergers and buy out activity.

So along with our assessment of Bernanke striving for an equilibrium between protecting the dollar and maintaining economic growth makes as cautiously optimistic that well selected securities should do well in the second half, despite the backdrop of geo political problems which surround us.

Bill Schnieders

Jim Schnieders, CFA

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