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October 02, 2008

The "Other" Consumer Confidence Survey

The "Other" Consumer Confidence Report...What the heck are they thinking now? You know who we mean, the foreign investment community. Who else? Hopefully without wildly belaboring the point, we remain convinced that the US is ultimately going to face a funding issue down the road. Maybe not a funding issue in terms of being able to borrow funds, but rather the issue is the cost at which funds will ultimately be made available to the US. This is exactly what we addressed when we penned the Fun With Funding discussion last month. Put yourself in the shoes of the foreign investment community. Many moons ago, you started recycling trade related dollars back into US financial assets. In essence, you were able to facilitate a little mercantilist economics. By buying US financial assets (primarily bonds) you effectively helped keep US interest rates low and enabled the relatively blinded by asset inflation US consumer borrowing and spending (on your export products). As commodity prices rose, the BRIC nations and OPEC got into the dollar recycling game in a big way. If you remember the Fun with Funding article, one of the tables in the discussion showed us that since May of 2006, 100% of foreign purchases of US Treasuries were undertaken by Brazil, Russia, India, China and OPEC. Japan was a net seller over the period. Quite the happy circumstance...while it lasted.

But over the past seven months, the foreign community has been treated to the visual of three of the five largest US investment banks disappearing. One literally disintegrating in the night. They also watched as the largest two US residential mortgage-financing intermediaries entered Club Fed, never to be seen again in public. Let's face it, the foreign community knows Lehman had been around for 158 years. The firm had lived through a domestic civil war and a financial/economic depression. And what eventually took it down? Granite countertops, stainless steel appliances and travertine flooring. Quite the sorry commentary. You get the point. We suggest that one of the most important consumer confidence surveys of the moment is the monthly tally of foreign purchases of US financial assets. The foreign investment community has had a front row seat in the US credit cycle drama playing out amongst Wall Street and the Fed/Treasury/Administration. They, along with almighty Bill Gross, expressed their extreme concern over Fannie and Freddie solvency, instigating relatively immediate action. They, along with almighty Bill Gross (to the tune of $750 million) would have been hurt badly had AIG gone nose first into the tarmac without even attempting to pull the nose up before crash landing. We know in part what the foreign community has been saying, but what are they thinking at this point? To us, one of the most important questions as we move forward.

Although we know we have covered this in the past, we believe it's critical to keep an eye on foreign capital flows into US financial markets. We ALL know how important foreign capital has become to the US economic and financial system continuing to function properly. And we all know that since early this year, foreign sovereign wealth funds have gone on a buyers strike in terms of providing US companies capital amidst the ever evolving US credit crisis. No more Saudi princes riding to the rescue? C'mon, where's their sense of humor? Let's have a quick look at the longer-term rhythm of foreign flows of capital into US financial markets. Why? Because the character of that flow is changing meaningfully as we speak. You know these numbers unfortunately come to us with a lag. As of now, data is current through July. Since that time, Lehman has passed away and Fannie and Freddie senior and sub debt securities have been rescued. AIG has been thrown a lifeline and Merrill has crawled under the skirt of BofA. We know the foreign community was indeed getting a bit skittish about the government agencies over the summer, and that skittishness is reflected in these numbers. But what's most important to us is the rhythm of longer-term trends in the twelve month moving averages you see in each chart. In short order, let's have a look.

Clearly into the credit crisis phase of the current cycle beginning last summer, Treasuries have been the asset class of choice for the foreign community. It's a natural. Institutionally the world has been conditioned to run to the supposed safe haven security that is perceived to be UST's. As we're sure you saw, 90-day T-bill yields kissed .2% in trading a few weeks back in what was clearly a panic run into the short end of the Treasury market. The safe haven asset? In spades at that yield. We can understand foreign and domestic investor behavior here, but as we have said many a time in the past, we believe there will indeed come a day when this may no longer be the case. Although one day does not a trend make, gold's one-day price fireworks show a few weeks ago was indeed the noticeable event. We heard rumors of a large AIG short in the metal being covered, but who really knows at this point. Although we're guessing, if gold zooms higher from here, we'd take it as a sign the markets have lost considerable faith in the Fed and Treasury. By extension, could marginal loss of faith in the credit that is US Treasuries be far behind if this line of thinking is even near correct? Nope. No wonder there is such establishment resistance to gold as a monetary symbol.

For now, foreign flows into Treasuries, as seen above, are not a major issue point of concern, but we watch intently as we move ahead. As a quick refresher, we believe the important data point in the chart above is the twelve month moving average of purchases. We're well below record highs seen years ago, but in no way are we looking at a supposed collapse for now. One note that we'll refer back to as we conclude this discussion is that into the last US recession, the foreign community was a seller of Treasuries in aggregate. Although the credit crisis environment in the US has taken center stage attention for now, the fallout influence of the credit crisis on the real economy, and the real world recession it will ultimately engender, is the next act to anticipate in the current drama playing out before our eyes. Will we see a repeat performance of foreign liquidation of UST's in the US recession to come? If so, it could not come at a worse time. We watch and wait.

Before moving forward, one last few of life for perspective on the importance of the foreign community to the US Treasury market. Below is a look at the character make up of Treasury holders as of the conclusion of 2Q 2008.

As we suggested in the "Fun With Funding" discussion last month, the US government balance sheet will expand meaningfully ahead. Key question being, will the pie chart we see above change in character as this balance sheet expansion occurs? Will households become big UST buyers? How about domestic banks that currently own the smallest slice of the pie? For now, although it's clearly loose commentary cast in the heat of the moment, the "reaction" of major sections of the foreign community (Asian, European and Middle Eastern) to the proposed bailout package in the US has been well south of a resounding thumbs up. But, as always, it's not what they say, but rather what they do ahead that will be important to US funding outcomes. Let's move on to the foreign influence in the government agency market.

The fact is that the sale by the foreign community of US government agencies in July was a record. The chart below is relatively dramatic in revealing this circumstance. Certainly some of the proceeds of these sales found their way back into Treasuries. We know the foreign community was indeed "asking questions" prior to the "conservatorship" of Fannie and Freddie, despite the implicit moral hazard guarantee that had been in place for literally years. So it's a one off in July, we believe. But despite the one month July sale-a-thon in agency paper by the foreign sector, the longer-term trend embodied in the 12 month MA has already been telling us for some time that the foreign community is growing weary of continuing to acquire agency paper. If the July activity in agency sales isn't a ding in the side of the greater confidence ship on the part of the foreign investment contingent, we just don't know what would be characterized as such. Who knows, now that agency paper is essentially government paper with a yield premium, foreign community percpetions may change ahead. We've seen buying in recent anecdotal data. But we're not holding our breath. As the chart clearly shows us, the foreign community indeed was a key provocateur in funding the macro US mortgage market from the mid-1990's through to late 2006. Will they be so obliging to do so again given what has happened to supposed quality mortgage paper in the current cycle? We'll see.

The real and very meaningful walking away, or confidence destruction, seen in actions by the foreign community in terms of purchasing US financial assets has occurred in the corporate bond market. Without question, what you see below speaks to academic risk reduction and a very much heightened sense of currently pricing in investment risk, if you will. The drop in foreign acquisition of US corporate bonds is striking, if nothing else.

As a quick tangent, we take what we see above very seriously. Corporate bond spreads have widened very meaningfully over the last year. Whether it's corporate Aaa versus 10 year Treasury yields, Baa credits using the same spread, or high yield corporate spreads, it is clear that meaningful change has occurred in macro credit market perceptions and pricing. In our minds, there is no way the US economy is about to reaccelerate until corporate bond spreads contract. This is a distinct and definitive message of history. And as is more than apparent in the chart, the foreign community has been nothing short of integral in keeping US corporate bond yield spreads tight throughout the entire prior economic cycle via their very meaningful purchasing activity. The twelve-month moving average of foreign purchases of US corporate bonds is just about back to the trough of the prior cycle seen early this decade as we speak. This strikes directly at the heart of the real economy being able to fund itself as we look ahead.

The last asset class under examination is equities. Foreign investment history has been that peak exposure usually occurs at major price peaks and trough exposure at major price troughs. You know, buying high and selling low. So what else is new in terms of human behavior? Not much. Since last summer, the foreign community has lost it's taste for US equities, as has the US public. Funny that way. Stick a 30% off sign in a retail store and it attracts buyers immediately. Stick a 30% off sign on Wall Street and everyone avoids the place like the plague. Human nature never changes, does it? We simply need to be aware of our own faults in terms of emotional human decision making and try to "rewire" our actions and reactions.

As you can see in looking at the absolute dollar numbers, foreign purchases of US equities in terms of dollars is very small. It's the fixed income markets where the big foreign money is invested. And to us, this is very meaningful in that, as we have said, the big issue looking ahead is how the US government and greater economy funds itself. Who provides the funds and at what cost? Critical questions.

Final chart, we promise. Total foreign flows of capital into US financial markets over the last two-plus decades. There have been very few instances of monthly net selling by the foreign community of US financial assets. July just happened to be one of those months. Not good for a greater economy that we believe faces intermediate term funding "challenges", to be tactful. But as we've said looking at individual asset classes, this is not a one-month one-off experience. The declining trend in foreign purchasing of US financial assets has been happening for a year now, completely coinciding with the deteriorating credit market fundamentals in the US. The chart is clear on this statement. Does this show us what the foreign community is thinking? How could it be otherwise?

As a quick comment on historical perspective, we know the nominal dollar decline in the twelve month moving average of foreign purchases total US financial assets is meaningful. As of July, the 12 month MA has declined close to $50 B from June of 2007. In percentage terms it's a 46% decline. In the wake of the Asian currency crisis, we saw a 51% top to bottom drop in this 12 month MA. So is the world coming to an end here and are we in uncharted waters? Not yet. What we believe is most meaningful right now is the powerful issue of change at the margin. At the exact time macro US funding needs are increasing, one of the largest buyers/holders of US financial assets is changing their behavior at the margin. This is what we need to stay on top of, monitor monthly, and anticipate financial market and real economic outcomes based on this change.

There you have it, a very important foreign financial consumer confidence survey if we've ever seen one. Maybe one of the most important confidence surveys we can think of at the moment for a US financial sector and general economy increasingly in need of capital. In summation, we believe the foreign community faces the following decision points over the near term. As has been the case for many a moon now, foreign investment in US financial assets must contend with interest rate risk and currency exchange rate risk. Nothing new to see here. But what is changing is the very important need of the US government to expand its balance sheet very meaningfully. You already know our thoughts on this. Third, the US and really the globe is heading into a consumer led recession that at this point, as we see it, is unavoidable. Key questions for now being duration and depth. Will BRIC country and OPEC capital reserves (the key foreign buyers of UST's over the last two years) be needed on their respective home fronts to help shore up/stimulate their own economies? If so, that's competition for a US government in need of increased funding. Lastly, there is a new monkey wrench that has been recently thrown into the total equation. The foreign community has been treated to the new wrinkle that US authorities are now willing to "change the rules" without any prior notice. Again, at the margin this creates investment uncertainty. How are foreign entities to feel comfort in providing capital to the US financial sector when equity and preferred asset values can be essentially wiped out on a Sunday afternoon? It's no wonder the global sovereign wealth funds have been on a buyers strike.

As a quick counterpoint to what we see as enhanced risk to foreign capital committing to US assets at the moment, be sure to keep your eye on many of the major European financial institutions. In terms of the raw numbers, leverage ratios for many of Europe's largest financial behemoths make former US investment bank outfits look like choirboys and girls. IF the European financial sector encounters meaningful credit issues ahead, as have their financial sector brethren in the US, we could indeed see Treasuries continue to be the safety trade of choice. A confusing time with a lot of moving parts globally as really global credit cycle reconciliation plays out? You better believe it.

Point blank, the US cannot afford to lose the confidence of the foreign investment and central banking communities in US financial asset markets. Now more than at any other time in recent memory, the US financial sector and real economy need access to relatively inexpensive foreign capital. We would just remind you of one truism we have repeated in these pages for years. Liquidity/Capital is a coward. There's always too much around when it's least needed and it's never there when needed most. One has to look no further than the US residential mortgage markets to be reminded of the importance of this comment. But unfortunately and quite inconvenient for US financial and real asset markets is the fact that as humans, we're "wired" incorrectly. In times of stress the fight or flight mechanism takes over. You can blame the cave men and women for that one. Hey, they don't have any capital, do they? Just checking.

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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