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July 06, 2003

The Ultimate Balancing Act?

Strangers Bearing Gifts From Afar...Every quarter in the subscriber portion of the site we try to take a little peek at total money flows supporting Treasury securities, government agency paper, US corporate paper and US common stocks. In its Flow of Funds report, the Fed is kind enough to treat us to this data. Although there are certainly a fair number of revisions each quarter, we believe watching these numbers is important in trying to get a sense of capital flow trends as they pertain to US financial asset prices. Moreover, a birds eye view of these numbers allows us to see just who has been responsible for strength in purchasing each asset class at the margin. What we hope to do each quarter is get ourselves thinking about the possibilities for why recent patterns of asset purchases have taken place and what potential for change may lie ahead.

Particularly important in this data over the past half decade has been the growing purchases of US financial assets by the foreign community. At least in absolute dollar terms, the following chart of net foreign capital flows into US financial assets simply stands as testimony.

As we have written about in prior discussions, there is no mystery as to why this has happened. Suffice it to say that the existing US trade imbalance has put a lot of paper dollars in the hands of the foreign community. Moreover, with a global economy fairly dangerously dependent on the US consumer, inflows of foreign capital to US financial markets over the recent past has helped keep domestic financing costs low (higher domestic bond prices and lower yields) and the dollar relatively strong against foreign currencies (at least up until the last eighteen months or so). As we have mentioned a number of times, foreign countries are in effect doing a bit of vendor financing when it comes to the US trade imbalance and the global recycling of trade related dollars (global savings) back into US financial assets. At least for the moment, it seems pretty hard to identify just who does not have a vested interest in continuing this great recycling operation.

Again, many a foreign economy is extremely dependent on the US consumer import market. Quid pro quo, of course, being the reinvestment of trade dollars back into US financial assets in support of further US consumption. The US monetary authorities love the help they receive in enhancing domestic liquidity prospects via the enticement of cheap financing costs in part driven by foreign purchases of US fixed income assets. The Administration simply points to the data and characterizes the trade imbalance as proof in the pudding that the US is a great place in which to invest, hence their rather benign reaction to a weakening of the dollar relative to foreign currencies. We all know that this significant imbalance is simply that - a significant imbalance. How and when it is ultimately reconciled remains open to question. The fact that it will be reconciled is much less open to question.

Let's have a quick look at each financial asset class and just who has been doing the buying over the last few years:

US Treasury Market

According to the folks at the Fed, the largest buyers by far of US Treasury paper over the last two years has been the foreign community. As of the close of the first quarter, foreigners owned close to 33% of total US Treasury securities. As you will see in the chart below, this is up substantially from the middle part of the last decade. As a quick tangent, it's somewhat ironic that certain members of the foreign community were at odds with US involvement in Iraq while simultaneously they weren't at all at odds with the financing of that activity, now were they?

As you can see in the table below, over the last two years, no one was even close to the foreign community in terms of Treasury purchases. In absolute dollar terms, foreigners purchased four times more Treasury securities than all other classes of buyers combined.

Government Agency Market

To suggest that the foreign community has been a meaningful supporter of the balance sheet expansion of the federal government agency entities over the recent past is an understatement. As you can see in the following chart, foreign ownership of US government agency paper has been steadily increasing as a percentage of total agency paper outstanding over each and every year of the last eight (at least).

It just so happens that this is the one segment of the US financial asset spectrum where the foreign community has not been the top gun purchaser of assets over the last two years, but darn close. Agencies purchasing the paper of other agencies has topped the scales. We know that current controversy surrounds Freddie Mac. But given the fact that the FHLB (Federal Home Loan Bank) has purchased gobs of Freddie paper over the last "x" years, if Freddie has a problem, then so does the Home Loan Bank. And the crossholdings of GSE paper don't stop there. In a sense, the GSE's are involved in their own little debt instrument version of keiretsu.

The other significant non-foreign buyer of government agency paper over the last few years has been the US commercial banking system. And it's no wonder. As you know, government agency paper offers yields greater than like maturity Treasuries while being accompanied by the assumed perception of safety. Given that bank lending to corporations has literally nose dived over the last three years, now at absolute dollar levels not seen since 1998, putting capital to work in alternatives such as government agency paper is no surprise at all. But ultimately, banks will be fair weather friends to vehicles such as agency paper. Here are the numbers for the last eight quarters:

Corporate Debt

Simply put, foreign buyers of US corporate paper have dominated the space over the last few years. And much like the experience with government agency paper, they have become progressively larger owners of total US corporate paper outstanding since the middle part of the last decade. For now, the foreign community owns approximately 21% of total US corporate debt. Where the US commercial banking system has had increasingly less to do with financing corporate debt over the last three years, the capital markets have filled the void. And the foreign community has been a big buyer.

It's certainly clear that the scramble for yield is really global in nature these days. Foreign investors in US corporate paper have lived through the Enron's, Worldcom's, KMart's, UAL's, a record number of bond rating agency downgrades, etc. and have barely even blinked. Foreign purchases of US corporate debt in 1Q was near top quarterly absolute dollar purchase levels of the last few years. But as you will see in the table below, the scramble for yield is not confined to the foreign community. Much like their Japanese brethren a decade back, insurance companies are seeking out higher rates of return with relative vigor. Although still meaningful, they were not dominant players in terms of the purchasing of UST's and government agency debt, preferring yet higher yielding corporate debt securities to increase yield in their investment portfolios over the last few years. Lastly, households and mutual funds have increasingly been notable buyers of corporate debt during the last eight quarters. Not surprising given the record inflow to bond mutual funds in the US over the last three years.

We've lead off this view of capital flows with fixed income securities for a reason. The tables you see above are in good part reflective of not just investment activity, but of the expansion in the US credit cycle over the last few years. Financed, of course, by the fine participants you see above. Record foreign inflows into US fixed income securities has been accompanied by record domestic bond mutual fund purchases and significant increases in bank and insurance company buying over the last eight quarters. All of these buyers moving increasingly in the same direction. Overlay the activities of the leveraged speculating community (hedge funds, etc.) in this country and it's easy to understand why credit quality has really taken a back seat to yield and sheer momentum driven price performance in recent years.

If we had to single out one reason as to why our economy has slowly trudged forward over the last few years despite the once in a generation bursting of a financial asset bubble, that reason is broader system wide cost of capital. Cost of residential mortgage financing. Cost of consumer credit. The cost of Federal debt. And cost of corporate capital, especially in what have been the very accommodative capital markets of the last half year or so. And in virtually ranked order, here are the folks we need to thank for their capital lending generosity. Their generosity in parting with their own precious capital for stated coupon rates of return that in many cases are as low as anything seen in three to four decades.

In terms of US fixed income instrument yields that ultimately set the cost of capital in this country, just what would our economy look like today had it not been for strangers bearing gifts from afar over the last two to three years (let alone the last decade)? But this does point up a question about "tomorrow". As we mentioned, the confluence of US fixed income buyers, domestic and foreign, acting in similar manner has helped create the following multi-decade round trip.

But what happens as the secular bull market in US fixed income vehicles ultimately comes to a conclusion? As you can see from the graphs and tables above, a lot of folks are lined up on the same side of the trade right here. Recently encouraged by the Fed's jawboning campaign on deflation and implied promises to buy longer term debt securities if need be. But at least over the last few weeks, global debt markets have been sending signals that change may be in the wind.

To us, the global bond markets are suggesting one of two things. They are potentially trying to tell us that the global campaign to reinflate is either beginning to head in the right direction, or that global credit risk is building in a very unacceptable manner given that liquidity is literally being force fed into the system, regardless of sound credit risk characteristics among a good number of borrowers. After all, how else could a company like a Yahoo finance convertible debt on a zero coupon basis? If either of these two thoughts regading reinflation or credit risk are correct, this one way directional buying of US fixed income assets may have seen its best days (although we're sure the Fed has yet to attempt to have the last word in terms of unconventional monetary warfare). Although we have long described the ultimate balancing act as characterizing the US trade imbalance, maybe the more important balancing act to come relates to whether foreign buyers of US fixed income assets will continue their push forward in supporting US debt markets to theoretically further the cause of their export industries, in spite of what may turn out to be a secular conclusion to the US bond and interest rate bull market.

Could the US financial markets tolerate a slowdown in foreign purchases of US debt instruments? Would that complicate the best laid plans of the Fed? Now that the Fed has largely used up its conventional monetary weaponry against a slowing economy, would they possibly be forced to move toward unconventional means of accommodation, such as pegging longer term yields, if the foreign community choose to take a few steps back from their as of late US financial asset purchasing leadership role? It just so happens that in April (post the 1Q Fed Flow of Funds data), foreign buying of US Treasuries dropped significantly relative to what had been happening year-to-date. Of course this is only one month's data.

We may be getting close to the time when the Fed may either have to put up or shut up. The warning shot in the bond market of the last few weeks just may be the market's way of suggesting to the Fed that they get on with supposed unconventional action as opposed to continued promises, threats and jawboning. And if a scenario like this comes to pass, monitoring foreign flows of capital may be more critical than ever since potential change at the margin in the buying habits of the single largest buyer of US debt instruments over the last few years would be more than meaningful. Unconventional Fed monetary warfare would necessarily mean a big expansion in the monetary aggregates (M3, M2, MZM, etc.). In essence, this type of activity would be an open and outright "dilution" of the dollar, especially in the eyes of foreign holders of dollar denominated assets. Would foreign money continue to be lavished so generously upon the US fixed income markets if a scenario like this were to occur? It may be well worth pondering because if the economy does not experience the fables second half recovery, election concerns on the part of the Administration may mean that the Fed is allowed leeway to move on to Plan B in relatively short order - the unconventional weaponry espoused by Greenspan, Bernanke, et al.

Alternatively, if some type of recovery does transpire, the talk of deflation will have proven to be an illusion. Either way, we have a lot of long bond players potentially looking to be less long in simultaneous fashion. As per the 1Q Flow of Funds data, the foreign community just may be leading the pack of big US debt holders pondering asset allocation, in spite of the fact that US trade related dollars continue to swell their holdings of foreign reserves. Remember, we're not suggesting that foreigners will sell their dollar denominated financial assets en masse. That's probably not realistic under any scenario except an outright panic. It's the potential slowing of foreign purchases of US fixed income assets that carries the most weight with us. Especially because it would probably occur within the context of the leveraged speculating community being forced into a bit of liquidation.

Common Stocks

Finally, here's a little look at purchases of US common stocks by sector over the last two years. It is clear that despite the foreign community having cumulatively been the largest buyer of US common stocks over the last eight quarters, the peak in quarterly buying by the foreign community happened a good number of quarters back. Purchases of US equities by the foreign community has been incredibly subdued over the last four quarters. And, in the scramble in terms of hoped for rate of return, insurance companies have been one of the most significant buyers at the margin recently.

For now, the foreign community owns a little over 11% of the total US equity market.

Since the bear in equities began in March of 2000, the foreign community has literally been the largest buyers of domestic equities. Again, we have to believe that the incredible amount of trade related dollars being pushed into global economies made this possible. Much like the secular implications embedded in the fifty year chart of the ten year US Treasury yield we showed above, foreign support of the US equity market has been occurring against the backdrop of the following historical context. (The chart uses data provided by Bob Shiller, of "Irrational Exuberance" fame.)

It seems a bit odd to us that in the day to day cacophony of news, data, facts and rumors spewing forth from Wall Street that there isn't more appreciation for the fact that the foreign community has played a huge role in shaping US financial markets and prices of the last two to three years, let alone the last decade. We suggest that watching the action of foreign capital ahead may be one of the more important exercises in macro investment analysis given their asset purchasing leadership position of the recent past. Clearly, foreign support of US financial markets has indirectly been a support of their own export manufacturing industries. But is the time approaching when the foreign community may be forced to choose between the value of their significant investments in US financial assets and their implicit support of the current status quo imbalance that characterizes global trade? In our eyes, and importantly for US financial markets, it may be the ultimate decision making balancing act yet to come.

Market Observations
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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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