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September 01, 2005

That's The Way Love Goes

I've Been Throwin' Horse Shoes Over My Left Shoulder ...As you might know, we cover the international capital flow statistics on a pretty darn regular basis. In the spirit and mantra of "thinking globally", we personally consider this little exercise a must. And we really cannot see how that's going to change in the future. A few weeks back the June global capital flow statistics that pertain to the US financial markets and assets were released. Although we always get the numbers with a lag from our wonderful friends at the Treasury department, making them a bit meaningless in terms of day-to-day decision-making worth, it's the longer term trends that we believe are very important. And it just so happens that the June numbers contain a few very notable anomalies. Anomalies that just may be markers of meaningful change in global capital flows. We'll move through this quickly. Again, it's the change in longer-term trends that we're after here and how those changes may influence the US capital and broader financial markets ahead. Those are the important issues.

Anomaly number one is the fact that in June there was actually a drop in UST holdings among the "major" foreign holders of UST's. There was not a drop in aggregate foreign UST holdings, but again a drop among the major foreign holders (we list the specific major foreign holders in a table below). The issue that caught our eye was that we have not experienced this magnitude of a month over month drop in Treasury holdings among the major foreign players since March of 2000. And interesting date to say the least. The second issue, which we will cover in a bit more detail, is the fact that the foreign community purchased a record amount of US corporate debt in June. $52+ billion dollars worth of corporate bond purchases to be exact. That's far from insignificant. What we've seen so far in 2005 is the foreign community losing the love they have so dutifully expressed for US Treasuries over the last three to four years and finding new romance with the US corporate fixed income sector. Moreover, the leading cast of lovers is changing. Europe has emerged as the new US financial asset Don Juan while Asia (largely Japan) has adopted the role of wallflower for the moment. Oh well, that's the way love goes, right? Again, in aggregate, it's not so much that total foreign community enthusiasm for US financial assets is waning, but rather that the cast of buyers is changing more than noticeably. We fully understand the Asian motive behind supporting the US dollar vis-à-vis the purchasing of US financial assets over time, but what is motivating Europe to pick up the eye opening slack created by the Asians? Quite unfortunately, in this discussion we probably have more questions than answers. But, as always, we hope that asking the right questions is more than half the battle in terms of correctly anticipating change in the broader financial markets.

First, let's have a quick look at what our for now former primary bankers in the Asian community have been doing as of late in terms of purchasing US Treasury securities. We've been tracking the top Asian players in the US Treasury market and have been "marking" their activity since November of last year. For 2004, November just happened to have been the peak month for combined Chinese and Japanese holdings of UST's. Here are the numbers:

Over the last seven months (since last November), this group of Asian heavy hitters has collectively purchased all of $20.5 billion in US Treasuries. Given that this is an aggregate seven month purchase number, the annualized like time period equivalent clocks in at $35.1 billion. On a current "run rate" basis, so to speak, this is now where we stand. For a bit of glaring perspective, just compare it to the annual historical calendar numbers you see below. Again, this is the collective calendar based UST purchasing by the total Asian bloc you see in the table above:

In other words, on an annualized run rate basis over the last seven months, the Asian community has virtually disappeared in terms of being meaningful Treasury buyers. This IS a big change. So, just who have been the big buyers who have picked up the slack in terms of foreign purchasing of US Treasuries? Just have a look. (By the way, these are the "major" foreign holders of US Treasuries we referred to above who collectively sold Treasuries in June of a magnitude not seen since 3/00.)

There is no question that the former 800 pound gorilla UST buyer, Japan, is sitting out the current inning. As designated pinch hitter for Asia, China has firmly gripped the bat and stepped up to the plate. Above and beyond that, the UK has no peer in UST buying over the last seven months. And our wonderful friends in the Caribbean Banking Centers (thought to be the hedge funds) have been lending a friendly hand right alongside, but to a meaningfully lesser extent. But with Japan out of the game for now, the long term trailing twelve month buying of Treasuries by the foreign community in aggregate is heading south in rather abrupt fashion as we speak. Over the past twelve months, China has actually purchased more UST securities than has Japan. Maybe only fitting since the US trade deficit with China has been a mushroom cloud.

Very quickly, net foreign buying of US stocks in June literally was a rounding error. It clocked in at $107 million. Hardly worth mentioning. And in government agency land, the twelve month rate of change in foreign buying is continuing to fall from what had been a very high level. It's in the world of US corporate bonds where the foreign community has really been stepping on the accelerator in 2005. Just have a peek at the chart below for a little perspective on June activity relative to historical precedent. Off the charts pretty much describes it.

And what's a bit amazing is that, as you know, from an historical standpoint, yield spreads between US Treasury and domestic corporate debt is pretty darn tight these days. The current yield spread between Moody's Aaa debt and Treasuries is as tight as anything seen since 1997.

And Moody's Baa debt is not much of a bargain either based on the yield spread relative to Treasuries.

Why the heavy buying of corporates by the foreign community? Although we're really searching for many an answer in looking at all of this data ourselves, just maybe relative currency movements can help explain some of the recent activity. It just so happens that as we look over the entire last twelve months for the period ended 6/30/05, Europe was the largest single bloc buyer of Treasuries, US corporate bonds and US common stocks. And to be honest, they were a very close second to Asia in terms of the purchase of US government agency paper. As opposed to Asia having bought US financial assets in essence to attempt to support a sagging US dollar in the past, is the European community now piling into US financial assets to participate in a dollar that has strengthened over the first six months of the year relative to the Euro? In other words, is Europe looking for a return on investment? Asia was attempting to support their export driven economies. Two very different agendas. We're hoping that the answers to some of these questions will be revealed with the release of the July global capital flows data in a few weeks. As you know, the YTD rally in the US dollar recently topped literally on the first day of July. So in July we have a declining dollar and a strengthening Euro. Will the Asian and European community switch places in terms of buying US financial assets in July? We suggest it will be more than interesting to find out. Although currency movements have probably been a big driver in terms of the behavior and character of foreign purchasing of US financial assets YTD, the real question looking ahead is whether the European community has the staying power to continue purchasing US financial assets if the Asian community continues to stay away from the game as they clearly have for a good seven months now. For now, the headline numbers in terms of global capital flows into US financial assets look fine. The numbers are large and more than offset the trade flow imbalances.

The only issue in terms of trying to match global flows of capital with goods trade imbalances is that it's Asia with which we have the massive trade imbalance, not Europe. That suggests recent European buying of US financial assets is investment based as opposed to a mercantilist economic practice. And if that's indeed the case, it would seem reasonable to believe that the Europeans will only stick around for a favorable rate of return and no more, whether the return is investment or currency related, or both. That has NOT been the case with Asian intentions and resulting US financial asset buying practices over the last three to four years. Lastly, among the recent European community of buyers, private sector buying has outweighed that being done by "official institutions" (central banks). Again, another big difference relative to former Asian buying. This really suggests the motivation of the European buying YTD is much different than has been the case with Asia over the last three years. Much different. So although the headlines regarding capital flows to US financial markets look good, it's what's happening beneath the headlines that really counts. And below those headlines are some major shifts occurring YTD relative to our experience of the last three years.

One last comment prior to our leaving this subject. It's often said that America is borrowing the savings of the global economy vis-a-vis the trade deficit and recycling of US dollars back into US financial assets on the part of the foreign community. In other words, it's a good bit of conceptual vendor financing. We've even said it ourselves in the past. In part, there is definitely some truth to these comments. But what is also true is that to a very large extent, the global central banks, largely the Bank of Japan and the People's Bank of China, are creating liquidity (money) with which they are purchasing US financial assets. The following chart is an update of the importance of "foreign official institutions" (central banks) to the buying of US Treasury securities.

One quick question. Without central bank buying of US Treasuries over the last few years, just where would Treasury yields be today? To be honest, we don't mean this question to be bearish or pessimistic. Truth be told, we're almost stunned longer term UST yields have stayed low YTD in the absence of Asian buying since late 2004. In our minds, that may really be the real conundrum of the moment. We have the feeling that at this point, since investors have "learned" over the past few years that spikes in 10 year Treasury rates have been short lived, it's going to take a sustained backup in rates that plateau say at or above 4.75% on the 10 year to bring in the real selling. And, of course, we have no idea if this is going to happen. But based on the current character of global flows of capital we discussed above, we'd suggest that the Treasury market may be at a more heightened level of supply/demand risk today (that ultimately translates into price) than at any time over the past three+ years given that the folks who don't really care about a rate of return (Asia), due to their practice of mercantilist economics, are no longer the significant buyers, and those that perhaps do care a lot (the private European sector) about absolute rate of return have been the marginal buyers of Treasuries so far this year. Implicitly, when it comes to the greater foreign community financing the ongoing US trade and government deficit, the game has changed and it seems so have the risks.

That's The Way Love Goes ...We know that the US has become quite dependent on foreign flows of capital to finance domestic spending, funding of operations in Iraq, we could go on an on. Our trade and fiscal deficits are simply testimony to this fact. And that makes watching for changes in trend of global flows of capital extremely important both now and as we look ahead. We have a very hard time believing that the European community would have any interest in financing the longer term US fiscal and trade deficits via their continued buying of US financial assets under any circumstances, as the Asian community has really been doing for some time now, with the simple exception of the profit motive. Again, are we experiencing significant shifts in foreign flows of capital into US markets so far in 2005? Absolutely. But the real test of meaningful and significant change lies dead ahead when the global capital flow numbers for July, August and beyond become available. So far, movements in the Euro and the US dollar go a long way toward explaining the change we have seen in European and Asian purchasing of US financial assets YTD, as is clear in the chart below. For now, the 50 day moving averages of both the Euro and USD deserve watching.

Admittedly, from a longer term perspective the Euro looks pretty darn oversold relative to the US dollar.

Importantly, as we look ahead, if the dollar weakens from here, will the Asian community revert to their dollar propping ways of the last three to four years? Will mercantilist economic practices once again rear its head? Or is the dramatic change we have experienced in collective Asian purchasing of Treasuries, or really lack thereof, since last November the beginning of a very important shift in global capital flows that have really been vital to the US economy and financial markets up to this point? Although we're clearly jumping the gun in asking these questions at the moment, the answers lie in our near future. And we suggest that the answer to these questions will be quite meaningful for not only US financial asset opportunities and risks moving forward, but also the reality of the US economy. Stay tuned.

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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