October 4, 2004
Paying the Fiddler
An old proverb goes “He that dances should always pay the fiddler.” That may be true, but for at least the past few years, an ever-growing stack of IOUs has been enough.
In discussing the risks to the financial markets and the U.S. economy, I've been careful – particularly over the past 18 months – to distinguish between fundamental risks and short-term outcomes. In March 2003 we observed enough improvement in stock market action to recognize that investors had adopted a robust preference to take risk, while valuations, though higher than at the start of any prior bull market in history, were at least more reasonable than they had been for years. By September 2003, valuations had once again reached unusual levels by any historical norm, and by April of this year, market action was showing increasingly tenuous behavior, which continues today. For a few weeks in the summer, that action was indistinguishable from a negative condition, but has improved enough to simply call it tenuous.
Normally, we don't see abrupt market plunges born of overvalued markets until market internals deteriorate somewhat more than they have here. Investment advisory bullishness is again relatively high, insider selling is accelerating again, complacency is high as measured by the CBOE volatility index, and we continue to observe a variety of what I would call “initial divergences” in market action. Still, we don't have enough evidence to take a fully defensive position here. So again, I have to emphasize that great fundamental risks don't translate into immediate short-term risks.
That said, I like to think our shareholders are averse to having a cigar party in a house full of dynamite, regardless of the fact that nobody has dropped a match. Not that we're absent – you just won't find us in the middle of the room doing the Mambo with lampshades on our heads. We're the ones close to the exits, smoking Cuban stogies through full body armor, watching for sparks.
Valuations, China, balance sheets, oil and the dollar
Despite geopolitical tensions and a lackluster job market, there's no question that Americans have been dancing to an as-yet-unpaid fiddler. Valuations in the stock market remain near 20 times peak earnings – the same multiple observed at the 1929, 1972 and 1987 extremes, and significantly exceeded only at the bubble peak of 2000. Worse, earnings remain unusually elevated compared with other fundamentals such as revenues, book values and dividends, so current valuation multiples based on other fundamentals are even more extreme from a historical perspective.
The debt we owe to the fiddler has many aspects. Aside from valuations, which largely ensure that long-term returns on stocks will be unsatisfactory (regardless of whatever speculative returns we might observe in the short-term), the level of U.S. domestic debt, relative to GDP, has surpassed its prior 1929 peak. Cash-out mortgage refinancing has kept consumer spending strong – and though consumer spending has never turned negative on a year-over-year basis, the growth rate in the coming years is likely to fall short of overall GDP growth (another way of saying that savings rates will invariably be forced higher in the years ahead). On the domestic investment side, all of the growth in U.S. gross domestic investment since 1996 has been financed by massive and continuous inflows of foreign capital, evident in a current account deficit of a size normally only seen in banana republics. On the fiscal side, government spending (in all of its unproductive forms) has continued to grow strongly, while tax revenues in 2004 are projected to be only 16.2% of GDP. That's the lowest share of GDP since the 1960's (before the explosive growth of government spending which contributed to the rapid inflation of the 1970's).
In short, the key characteristics of the U.S. economy feature unusually rich valuations in financial assets, and unusual dependence on leverage and debt at every level – consumer, business, government and international.
How is all of this financed? Simple. Well over a billion dollars a day flows into the U.S. in the form of foreign savings. Foreign investors now own more than half of the existing float in U.S. Treasury securities. Much of this, as I've emphasized repeatedly (and will until the importance becomes generally recognized) is the result of foreign central bank buying in order to support the value of the U.S. dollar, primarily by China and Japan.
Last week, the IMF repeated calls for China to revalue the currency peg between the Chinese yuan and the U.S. dollar. The peg is currently 8.28 yuan to the dollar. In order to significantly affect the current account deficit, that peg would have to be moved to something near 6 yuan per dollar. At a dinner on Friday, prior to the G7 meeting, China's central bank governor indicated no willingness by China to change its current peg. Though China issued a joint statement with the U.S. that it supports a flexible exchange rate “as rapidly as possible,” no plans or timetable were provided, and governor Zhou remarked to reporters afterward “It is impossible to change it.”
The problem is this: China is growing fast enough for strains to develop in its ability to provide sufficient output at current prices. As a result, Chinese inflation has hit a 7-year high of 5.3%. Now, since U.S. inflation is only about 2%, one might argue that the “fundamental” value of the yuan is dropping at about 3.3% annually against the dollar. But at that rate, it would take about 10 years for the yuan to move to an appropriate value. Meanwhile, China has its 1-year interest rate pegged at about 5.3% as well, which offsets any negative pressure on the currency versus the U.S. dollar, at least at current U.S. interest rates.
Finally, add the fact that global oil producers are operating at nearly full capacity, largely due to the addition to global demand from China and India. That's what's keeping oil prices near $50 a barrel, and has kept long-term oil futures prices high as well (normally, long-term futures don't move up with short-term oil prices, since price spikes are expected to be temporary – the current situation indicates expectations that oil prices will remain high for a much longer period). When you consider that oil is a global commodity, an appreciation of the yuan and a sharp depreciation of the U.S. dollar would effectively increase the U.S. dollar price of oil while making it cheaper to China. It's a given that a more expensive yuan would reduce U.S. import growth from China and increase inflationary pressures here due to higher import costs. That would also reduce measured U.S. productivity growth - an argument that I outlined last year in The U.S. Productivity Miracle (Made in China).
A recipe for stagflation
Let's put all of that together. The U.S. securities markets are overvalued, largely because of expectations of strong productivity growth and benign inflation – both the happy consequence of a strong trade-weighted dollar, falling import prices, and an ever-expanding current account deficit. At this point, the U.S. has become massively dependent on foreign capital inflows.
China, meanwhile, is experiencing increasing strains, yet is unwilling to increase interest rates or revalue the yuan (in a monetary sense, these are the same thing, as higher domestic interest rates would place upward pressure on the Chinese currency). As Stephen Roach of Morgan Stanley puts it “The combination of currency and interest rate pegs puts an overheated Chinese economy on an increasingly unstable path, in my view. It runs the growing risk of accelerating inflation, a massive investment overheating and rapidly emerging property bubble.” I would add that holding down the value of the yuan is also very expensive to China, given its increasing consumption of imported oil.
Though it's certainly possible that we could continue on the current trajectory for a few more quarters, ultimately we are going to observe a revaluation of the yuan and very possibly a U.S. dollar crisis. The longer China waits, the more disruptive this event will be.
A number of probable consequences come to mind. First, lacking a reason to continue its enormous purchases of U.S. Treasury securities, we're likely to see a substantial decline in foreign savings inflows from China, which would most probably trigger a slump in U.S. gross domestic investment. A reduction in cheaply available credit is also likely to cause something of a credit shortage, which would increase the default rate of domestic borrowers with marginal balance sheets. The prices of imports and oil (as measured in U.S. dollars) would both increase, as a revalued yuan would be equivalent to a reduction in the yuan price of oil, increasing the demand for oil by China.
Though the likely effect would be higher U.S. inflation, particularly given the rapid expansion of unproductive government spending in recent years, higher debt defaults might lower monetary velocity and keep inflation in check (not that that would be a “good” outcome in any meaningful sense). It's also true that sufficient economic weakness would keep oil prices in check by reducing global demand, but that's not a particularly good outcome either. In any event, if China substantially slows its accumulation of U.S. Treasuries, softness in the economy would not necessarily translate into lower interest rates. The end result is simple to describe – a stagnant economy, most probably with an inflationary bias unless credit defaults or substantial economic weakness emerge.
Is there a way to avoid these results – to enjoy strong and sustained economic growth despite excessive reliance on foreign capital, with a strong and sustained bull market in stocks despite high valuations? In my view, not really. The timing isn't clear, and I continue to distinguish fundamental risks from short-term outcomes, but the consequences of overvaluation, debt, deficits, and over-reliance on foreign capital inflows can hardly be avoided. Valuations are already rich, and debts have already been taken on. Speculation, debt, lack of fiscal discipline and irresponsible spending all have a way of catching up. It's fun while it lasts.
We don't position our investments based on a forecast that these consequences will happen soon. But we do have to allow for them, and continue to attend to developments as they emerge.
As of last week, the Market Climate in stocks was characterized by unfavorable valuations and tenuously favorable market action. The Strategic Growth Fund remains fully invested in a broadly diversified portfolio of individual stocks, with an offsetting hedge in the S&P 100 and Russell 2000 indices, and a small call option position sufficient to provide the Fund with as much as 35% exposure to market fluctuations in the event of a strong near-term market advance.
Probably the most notable event in the Fund last week was the sharp decline in Merck on Thursday, which represented about 1.77% of the Fund's value as of Wednesday's close. Of course, Merck also represented about 1.75% of the S&P 100 at that time, so much of the decline in the stock was recovered by the offsetting index hedge, and the Fund was unchanged on the day.
In bonds, the Market Climate was characterized by unfavorable valuations and modestly favorable market action. Valuations in bonds tend to take precedence over market action, so the rally early last week provided an opportunity to reduce the duration of the Strategic Total Return Fund to just under 2 years (meaning that a 100 basis point move in interest rates could be expected to impact the value of the Fund by about 2% on the basis of bond price fluctuations). The Fund currently has about 15% of assets in precious metals shares. With our portfolio duration fairly low, that precious metals position can be expected account for the bulk of day-to-day fluctuations in Fund value here.
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