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November 03, 2006

Supporting The Trade

Supporting The Trade...It's been some time since we have brought up the US trade deficit. Why? Because there simply is not much to say at this point regarding the magnitude of the numbers that we believe will have any type of immediate or meaningful impact on US financial markets, outside of helping to support them, that is. We'll get to this in just a minute and have a look at some current data. As you know full well by now, each announcement of record monthly US trade deficits barely elicits a yawn on the Street these days. Most Street seers explain away and summarily dismiss current record trends as being related to oil, but that's not the case in its entirety. As per the most recent August trade figures, the average price of a barrel of crude hit a record $66.12, but this is surely set to come down in the months ahead. Although many tended to focus on this in yet again dismissing any type of negative connotation in the broader message of the report, what seemed to be lost in the shuffle was the fact that the volume of month over month crude imports jumped 6.8%. And that's not an annualized number. Month over month, the per barrel price of crude was only up less than 2%. It's volume that largely drove the crude portion of the increase in the monthly trade deficit, not price. So looking ahead, it's much more than an even money bet that the price of crude in the trade number will fall, but what about volume? Before getting too excited about a drop in the deficit to come based on energy prices, let's see what happens on the volume of crude imports front. That's the real issue long term.

It just so happens that in August, our singular country trade deficit with China increased 12.2%, again non-annualized. Since China accounts for 31+% of the total US trade deficit, this is not inconsequential by any means. The nominal dollar increase in the US trade deficit with China alone was greater than the month over month increase in the deficit due to oil volume and price increases together. But as we mentioned, this set of circumstances only elicits yawns from the Street these days. The cries of the negative financial repercussions to ultimately come due to the magnitude of the US trade deficit have long been silenced. Someday this will matter, no question about it. But we're not there yet. We know the world is awash in dollars, but at least for now that accumulation simply continues. As we've mentioned many a time, it's tough to call for reconciliation in the symbiotic nature of the US trade deficit relationship with major foreign economies as it involves a certain amount of pain for all involved. Pain no one wants to be the first accept. For those convinced the US trade deficit was the sword of Damocles in 2001, just how do you feel now?

By the looks of the trajectory of this chart above, we'd have to guess that conservatively the US trade deficit will surpass the $1 trillion annual mark sometime in the next 18-24 months. And lastly, an update of a chart we have not shown you for some time. It's the very simple nominal dollar spread between US imports and exports. Does this really need any explanation? We didn't think so.

So just why hasn't the US trade deficit borne any evil fruit so often predicted by the bearish contingent over the last half decade at least? Very simply, the foreign community has been more than willing to offset this imbalance by lending their savings to the US and by recycling trade deficit dollars right back into US financial markets. A recycling effort that has in fact surpassed the nominal trade deficit numbers in aggregate for many moons now. It just so happens that August purchasing of US financial assets by the foreign community was the largest number on record. Never before have we seen the foreign community collectively purchase $116.8 billion in US financial assets in any one month. NEVER. For a little bit of perspective, the following chart shows us the twelve month moving average of purchases of US financial assets by the foreign community relative to the twelve month moving average of the trade deficit since 1995. Is August's massive purchasing in excess of the US trade deficit something new? Not at all. In fact, it's a foreign family tradition. Any questions as to why the record US trade deficit meets with voracious yawns on the Street these days? We didn't think so. Unsustainable long term? Sure. But for now it is what it is. The game continues.

Isn't this essentially vendor financing? In a sense, sure it is. But the larger issue for us ties right back into the US credit cycle. These days, it seems like everything ties back into the credit cycle, right? It's simply a fact that growth in total US credit market debt has essentially been unimpeded during the entirety of the prior Fed monetary tightening cycle. Well, so too has growth in the US trade deficit been literally unrestrained. If the following two data points are not mirror images, then what are they?

It's clear to us that expansion in total US debt over time, especially at the household level, has allowed US consumers to continue buying ever-greater quantities of foreign goods and services. But in the same breath, and hopefully without stretching for some type of a viewpoint here, we also see growth in US credit market debt as being perhaps the ultimate margin loan in terms of being a support mechanism to US financial asset prices via the global financial recycling of trade deficit related dollars back into US financial assets themselves. Dollars whose origination can be found in US credit market debt growth. The chart above in conjunction with the chart below sure suggest to us that the larger the US credit cycle grows, the larger grows the US trade deficit, and the larger grows the ongoing acquisition of US financial assets by the foreign community. The entire feedback loop, if you will simply seems self obvious. As you can see, below we're looking at the historical purchase of US financial assets by the foreign community (the rolling twelve month moving average is probably the most important data point) on top of the same trade deficit data seen above. Once again, a mirror reflection, no?

So as we step back and try to connect the macro dots, it seems the logic loop is one of the US credit cycle helping in good part to drive the US trade deficit (exporting of dollars), which is in very good part driving the ongoing accumulation of US financial assets by the foreign community (recycling of trade related dollars). This feedback loop is essentially putting an ongoing bid under US financial asset markets. All one needs to do is look at the top portion of the above chart to see this in action. Without sounding melodramatic, this circumstance should not be taken lightly when assessing US financial market prospects at any point it time. Here's a little perspective for you. On a YTD basis through early October, US equity mutual fund inflows to both US centric funds and ETF's totaled $32 billion. Inflows to foreign focused funds totaled $125 billion. And inflows to bond funds totaled $45 billion. Collectively that's roughly $202 billion. As of August month end (latest available data), foreign purchases of US financial assets totaled $672 billion. Get the picture as to just how important the US credit cycle, trade deficit and foreign purchases of US financial assets feedback loop has become? It makes US mutual fund inflows simply pale in comparison in terms of importance. Again, hopefully without stretching or distorting the logic, can we say that the continued growth in the US credit cycle is essentially a very big margin loan in terms of helping to support US financial asset prices via the US trade deficit feedback loop described? We believe as per all of the data presented that this indeed is a very fair characterization of what is occurring and shows us just how important ongoing credit expansion has become to indirectly supporting US financial asset prices. We're very sorry to repeat this for probably the millionth time now, but we are convinced the greater US economy and financial markets are not running on and being responsive to a classic business cycle at all, but rather to a credit cycle of generational proportion. As goes the US credit cycle so goes the US economy and financial markets? If that's not the case, then what is?

Believe us, in their collective heart, the Fed really isn't afraid of popping an equity bubble or a residential real estate bubble at all. But they have to be deathly afraid of potentially popping the macro credit bubble, or at worst slowing its ongoing expansion. Stepping back a bit, it's not about the bubble nature of any one asset inflating at any point in time, it's all about the entire credit cycle moving forward at all points in time that's the important issue. The Fed knows this. After all, is it any wonder why we experienced an unprecedented and completely telegraphed seventeen 25 basis point Fed Funds rate increases in the prior monetary tightening cycle? A cycle where expansion in total credit market debt never slowed for even a second? The Fed knew exactly what they were doing. And that was nothing to slow aggregate US credit cycle growth. What we've described above in terms of the credit financed feedback loop bid sitting under US bond and equity markets is but one, albeit very important, manifestation of the greater US credit cycle circumstances. Although it sounds wildly simplistic, we're convinced that the credit cycle is the key to the real US economy and financial markets.

Burning Down The House?...We can remember a scene from an early 1990's Daniel Day Lewis movie whereby Lewis and a group of others were tearing up the floor joists in a home and burning them to keep warm. As we look at the credit cycle/trade deficit feedback loop we described above, is the US ripping up the floor joists of its own economic house and burning them to keep the US economy continually warm? In an analogous sense, we think that's exactly what's happening. Increased borrowing supporting increased short term consumption that ultimately supports the increasing transference of ownership of US financial assets to the foreign sector on a net basis. In fact, the graphical description of this set of circumstances is what you see below. The following is an update of a chart we've shown you in the past. It's net foreign investment in the US inclusive of financial and hard assets. It says that as of 2Q 2006 period end, the foreign community owned close to $6 trillion more of US assets than US interests owned of foreign assets. It directly parallels the growth in the US trade deficit over time. Is the US essentially "trading" ownership of long term financial assets for short term goods consumption? In many senses, yes. For now, the US is tearing up its financial asset ownership floor joists and burning them to maintain economic warmth at all costs.

Do We Have Any More Bids?...As a matter of fact we do. As described above, we're convinced US credit cycle dynamics have helped put a very important bid under US financial asset prices. Although this set of circumstances may be an anomaly and comes about as a result of unprecedented global financial imbalances, for now it is what it is. We simply need to recognize this and incorporate it into our ongoing thinking and decision making, as well as being on the lookout for change in these dynamics moving forward. It just so happens that there is yet another important bid being put under US equity prices in aggregate these days, and that's from the corporate sector itself. Below is a chart that chronicles the long term retirement of equity by the non-farm non-financial US corporate sector. And what's clear is that 2006 to date (annualized through 2Q) equity retirement is the greatest number ever seen. This probably continues for a while ahead as the tsunami of institutional private equity money is put to work and the need to offset stock options dilution continues.

For perspective, we've also incorporated the longer term growth of non-farm and non-financial corporate debt into the above chart. It just so happens that on a cumulative basis over the last three decades, issuance of corporate debt has outstripped the retirement of corporate equity. So in one sense, can we say that all corporate equity retirement of the last three decades was debt financed? Academically it's an argument. And once again it hits to the heart of the long term credit cycle. We know that the bulk of corporate debt issuance was not specifically earmarked for stock buybacks. Clearly corporate leverage has been used for business expansion and investment that ultimately yielded the fruit of higher earnings and cash flow, both of which have supported stock buyback activity. But the real reason we bring this up is to point out yet another "bid" that is sitting under US financial markets of the moment.

To give you one last feel for how important equity shrinkage, if you will, has been to the US equity market in 2006, just have a look at the following chart. We're taking this and the prior three years and looking at corporate equity issuance, corporate equity buybacks/acquisitions, and net equity reduction on a YTD basis for all of the years. You get the picture. Net equity shrinkage in 2006 YTD is running twice the number seen in 2005. And compared to 2003 and 2004, 2006 is simply off the charts. All of the numbers in the graph below are in the billions of dollars.

The primary reason for this discussion is to provide perspective. It's a set of facts that hopefully helps bridge the conceptual gap between the actual fundamentals of the economy and individual stocks (and bonds) we see every day, set against the reality of ongoing changes in financial asset prices. So often we hear questions such as, why didn't the markets go down on bad news? Why doesn't anyone seem to care about the US trade deficit? How come extremes in the credit cycle seem to be completely ignored? How can bonds do well when it's clear that inflation stats do not reflect reality? You know the drill. The above discussion hopefully helps shed a bit of light on the fact that there indeed is a certain, ongoing and meaningful bid under the financial markets that has little to do with daily news or near term fundamentals. This bid is being driven by US credit cycle dynamics and consequences. It is being driven by the corporate need to offset stock options dilution. It is being driven by the plethora of money flooding private equity firms by large institutional investors desperately searching for rate of return. We've said many a time that being aware of the magnitude, weight and direction of money in the aggregate at any point in time is more than half the battle in trying to maintain a level head and flexibility as investors. As you know, this very discussion simply reinforces our ongoing attention and research into the greater US credit cycle, the manifestations of which go far beyond SUV's and residential real estate prices. Far beyond.

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.

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