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February 02, 2003

At Your Service

The Weight Of Trade...Although the ever struggling consensus missed the actual number by about 10% to the downside, it certainly wasn't that big a surprise that the November trade deficit hit yet another record number. As you know, by now the financial markets barely give this statistic a second glance. Ho-hum. It's simply another in place imbalance that continues to widen over time. In looking ahead, based on recent Port of Long Beach activity, we fully expect the upcoming December trade report to hit yet another record reading in spite of the fact that November was a pretty substantial gap to the downside. On a year over year rate of change basis, the number of empty containers departing the Port of Long Beach for strange and exotic global ports of call was the largest seen in the 15 year history of Long Beach container stat records.

And it's also really no surprise that the US trade gap is being driven by greater and greater import activity from Asian goods manufacturing sources. Almost one quarter of the entire November increase in the aggregate trade figure was the result of a sharp increase in the singular deficit with China. Quite telling is the fact that the trade gaps with Western Europe, Canada and Mexico narrowed for the month. It's no secret that China is increasingly becoming the destination location of choice for the global manufacturing community in terms of new and replacement capacity build out. Although certainly not in whole, the answer to America's lack of macro capital spending strength can in part be explained by looking at what is happening in China. Simply stated, global fixed investment is moving to the East. It's all part of the evolution of the global economy. Nothing more and nothing less.

What is a bit of a twist in terms of trade for this cycle can be seen in the following chart:

We began the above chart with data from the early 1970's as this is really the initial period in recent US economic history where the trade deficit was noticeable statistically (especially relative to domestic GDP). As you can see in the chart, during some point in every recession over the period shown US import and export activity was in balance. Until this recession, that is. The US trade deficit was in balance in 1974, the early 1980's, and came close enough in the early 1990's to call it even. At the moment, at least in dollar terms, the US trade deficit has widened to the greatest extent ever seen. Unlike prior recessionary periods, during our most recent academic recession our import activity dropped, but export activity likewise experienced a synchronous decline. For now, the message is relatively clear. The efforts to globalize trade over the past few decades have succeeded wonderfully in aligning global economic movement as almost never before.

Given that we have been unable to close the trade gap during this period of recent domestic economic softness, does this experience suggest that we are facing an uncontrollable trade deficit quagmire ahead? Have we passed the point of no return economically in terms of our ability to reconcile this deficit without some type of corresponding watershed domestic economic dislocation? Our goods related trade deficit now leaves the US with a total current account deficit approaching 5% of GDP. A demarcation line of historical importance where currencies usually sit up and take notice of the imbalance.

Although the US is clearly currently favoring the foreign community as a source for manufactured goods, this trend isn't exactly new. In fact it has been evolving for decades. The history of industrial production is crystal clear on the subject:

As is literally plain as day in the above chart, over the last 60 years industrial production has been less and less meaningful as a contributor to the cyclical swings in macro US GDP. The highs and lows in terms of rate of change in industrial production have become increasingly muted as the decades have passed. Over this same period we have witnessed the rise and subsequent softening of activity in differing global centers of manufacturing strength with each passing cycle. Japan, Mexico and South America have all had their turn at bat in what has been the "shifting" of global manufacturing intensity seen over time. And now it's China as the growing center of importance for manufacturing intensive goods production. Coincident with the recent industrial production cycle in the US is the fact that manufacturing employment stateside rests at its lowest level in four decades.

At Your Service...As the US in particular has continued to export its manufacturing base over the past half century, the services portion of the economy in the US has taken on increasingly greater meaning to total domestic GDP growth over time. Hidden inside of the overall trade deficit figure is the fact that the US enjoys a services related trade surplus and has for some time. Admittedly, this services export surplus condition in terms of absolute dollars is clearly exceeded by the value of the goods import deficit balance. Our dollar based exports of services are about one-quarter of the value of our dollar based imports of goods.

In our minds, the immediate reconciliation of the absolute dollar trade deficit may not be as meaningful to near term prospects for our economy as will be the ability of the US to move further out on the economic value added curve relative to the entire global economy. With each passing decade as the US has watched significant portions of its manufacturing base be exported, advances in services and technology have allowed the domestic economy to push forward. The broad tech driven expansion of the 1990's was a clear example of the US economy moving outward on this global value added curve. It was immaterial to total GDP that we had lost manufacturing of commodity consumer electronics such as TV's and VCR's when we began designing, producing, and selling higher margined routers, switches, and servers, etc. during the last decade. The unknown at this point for both the domestic economy and financial markets is when and if this next value added shift will occur.

In the meantime, it's a darn good bet that the next significant near term trade related issue the US will face is the increasing transfer of our services economy abroad. Especially high end (wage) IT related services. Although we are only now beginning to see this issue addressed quite sporadically in the mainstream, like goods manufacturing, subtle shifts in the service economy have been slowly taking place for decades. We'd suggest that the domestic tech boom of the last decade that spawned advancement in global telecommunications, information processing and internet based service applications will accelerate the potential for transfer of high end service functions to lower cost and well educated global centers such as India, China and Eastern Europe. Already we have recently witnessed the export of increasing amounts of data processing, call center, IT, software and hardware design, as well as architectural design work to these areas. As you may know, our home base is the San Francisco Bay Area. A number of our contacts in the Silicon Valley have told us that they have not witnessed conditions like we now experience in the Valley in three decades at least. They are referring to both business conditions and the increasing global outsourcing of the engineering function. In our book, this will be the next big trade related hot button. Especially as it ultimately translates into US employment and wage statistics in the not too distant future.

What we suggest bears serious monitoring ahead is the following chart. Quite simply it is the year over year rate of change in US exports of "services" over the last four decades:

Much as the chart of industrial production change tells the story of a less manufacturing intensive US economy over time, so too does the above chart reveal that the export market for US services is becoming less and less robust on a rate of change basis with each passing cycle. As you can see, the recent negative year over year experience in this indicator was the first significant negative dip in four decades. Moreover, since 1981, every cyclical year over year peak in this reading shows us a consistently lower peak growth rate. The classic declining tops line, if you will. Could the US really become a net importer of "services" say over the next five to ten years? As always, anything can happen, but the in place rate of change trend is moving disturbingly in that direction with each passing cycle. We may not have to wait five to ten years.

Also well worth monitoring, and in almost mirror image to the chart above, is the history of domestic US services employment over the last four decades. Once again, the declining tops line tells the story:

At the moment, maybe the most important question domestic investors face is whether the US economy can move out on the fabled global value added curve at a rate of change greater than the rate at which it is now beginning to export relatively high wage portions of its service based economy. For now, the domestic US economy finds itself in a post-bubble aftermath environment. Availability of R&D and venture related capital has shrunk incredibly relative to what was considered normal just a few years ago. In like manner, other significant economies such as Japan and Germany are at best lethargic, and at worst sliding back towards outright recession as we speak. Together, the US, Japan and German economies simply dwarf the remaining economies of the planet and are clearly acting as a current drag. At latest count, the largest six economies in nominal terms are as follows:

Emerging economies and markets such as China, India, Eastern Europe and Russia simply do not have the nominal girth necessary to act as a significant growth catalyst for the broader macro global economy over a short period of time, despite the fact that they will be direct beneficiaries of this global outsourcing of services functions (not strictly a US phenomenon). The simple comparison of nominal country by country economic weight suggests that a continuing slow growth global environment will necessarily mean further large economy corporate focus on costs as a means to hold up and possible enhance earnings performance. And certainly the 800 pound gorilla in the cost structure of labor is wages and salaries. This is where the repositioning of global services battle will be fought. As you can see, in weighing a potential global services outsourcing decision for a domestic corporation, within the context of the current economic environment, the decision largely begins and ends with the following table:

For years we have watched companies such as Wal-Mart squeeze their suppliers on price. And then squeeze again. This has pushed their suppliers to continuously rationalize cost of production over time, necessarily involving orienting more and more manufacturing to offshore locations. Just how much of the current trade deficit is directly related to Wal-Mart? Will we now witness the tech and some broader services industries go through the same conceptual exercise? It's a darn good bet. In a slow growth environment, it's simply a matter of survival. There is no question that certain services can never be outsourced to the global community, but those that can are almost by nature what have been the higher wage domestic service industries of the recent past few decades. Largely IT related. It is quite telling to note that in the most recent downturn, year over year rate of change in a tech centric city such as San Jose literally fell off a cliff. A world of differential from the tech downturn of the late 1980's/early 1990's.

What we fully expect to be the changing nature of the domestic service industry in the US in the years ahead is going to present investors with both challenges and opportunities.

Although we expect the outsourcing of portions of the domestic white-collar service industries to be a phenomenon that plays out over time, two themes come to mind when addressing this issue. The first is what we expect to be the continuing moderation in domestic consumer spending. Outsourcing of high wage service jobs will pressure domestic personal income in the aggregate. Combined with other significant consumer related issues such as household leverage, personal savings, etc., the changing nature of the services landscape will add to the changing complexion of domestic consumption patterns ahead. Employment concerns will move up the political agenda sharply. The rate at which domestic services are outsourced ahead will directly impact the near term ability of the US economy to grow given its highly dependent consumer orientation.

Secondly, and more importantly, looking abroad for investment opportunities may once again become a very important exercise for domestic investors. Investors who for good reason need not have looked any further than the US over the past 20 years. We're not saying global investing has lost current importance, but rather the synchronous nature of directional change we have witnessed in global markets over the recent past may once again become less synchronous, as certainly was the case a number of decades ago. We can remember sitting in the St. Regis Hotel in Manhattan maybe 15 years ago listening to futurist Alvin Toffler speak to the fact that technology would recast global standards of living in the decades to come. The recasting of those standards has begun, both for better and for worse, dependent of course on the country in which one makes a living. It just may be that the best growth investment opportunities of the next few decades lie outside of the large, developed economies and financial markets.

The January Defect...As goes January, so goes the remainder of the year? Well, maybe. We'll just have to see what the market has to say about that as we move ahead. There are a ton of statistics and studies regarding the "meaning" of January to potential market movement in the remaining months of any one year. Studies of all years. All years ending in an odd number. All third years of a Presidential cycle. And so on. Although we try to always be open to any point of view, there is one set of January data that we have our eye on at the moment. It's this one:

January domestic equity fund flows are certainly no dramatic change in trend of the last half year. But relative to prior year singular January experiences its a big switch. In the most recent ICI (investment Company Institute) data, it can be seen that domestic equity mutual funds ended 2002 with 4.4% of their assets in cash. Just maybe, the chart above and the data on cash availability in aggregate equity funds are the most important January indicators, do you think?

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.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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