-->Fair-Weather Flows
The Daily Reckoning
Paris, France
Wednesday, 29 January 2003
--------------------
*** No panic yet...another rate cut?
*** Stocks, dollar - up a bit. Foolish maidens at Pension
Guaranty...Curious twist to modern capitalism: companies
will end up working for retired workers, not for
shareholders...
*** Fiddle dee dee...world unemployment...funds have first
outflow in 14 years...War!...and worse!
No panic yet. But consumers are less confident than at any
time in the last 9 years. And rumors are circulating that
the Fed is considering yet another rate cute to try to
boost consumers' spirits.
The Fed has cut rates a dozen times. And yet, it still
doesn't seem to have found that magic number that turns
excess indebtedness into a virtue. It will try again...what
else can it do? If rates don't go down, the economists at
the Fed must think, the whole world economy might.
The whole world is getting worried; it counts on the
American consumer like a liquor store depends on
alcoholics. There are better customers, maybe, but none
more reliable.
More borrowing and spending may not do the consumer much
good, but exporting nations love it. China, for example,
welcomes Americans' weakness for consumption like the day's
first customer.
Americans increased spending in each of the last three
years. But each year, U.S. business profits fell, even
while businesses were cutting back expenses sharply. Where
did the money go? We need hardly ask the question, dear
reader, for you already know the answer: it went to boost
overseas economies.
Fed governor Ben Bernanke notes that the U.S."can produce
as many dollars as it wishes at essentially no cost". But
the cost is higher than Bernanke imagines. Nothing destroys
a man faster than free money. The poor fellow thinks he has
found paradise. He stops working and takes up dissipation
full-time. Before you know it, he's as worthless as a
congressman.
But who knows? Americans must cut back someday. Maybe this
is the day - even if the Fed dangles another 25-point rate
cut in front of them.
Over to you, Eric, for the latest Wall Street news:
-----------
Eric Fry, reporting from Wall Street...
- The stock market finally regained its footing, at least
for a day. The Dow climbed 99 points to 8,089, while the
Nasdaq added 1.3% to 1,342. The U.S. dollar also managed to
regain its footing - at least for a day - by rising about
half a percent to $1.082 per euro.
- But consumer confidence continues to stumble. The
Conference Board's confidence index dropped to a nine-year
low in January - a victim of the sliding stock market and
sliding job market. The index fell to 79 from 80.7 in
December, which means that this gauge of consumer
confidence has dropped in seven out of the last eight
months. Clearly, the consumer is not feeling very chipper
these days.
- We're not surprised that the consumer is finally becoming
more cautious; we're just surprised that it took him so
long. We were cautious - and occasionally terrified - even
when stocks were going up every day. Now that the stock
market and the economy are slumping in tandem, what
financial phenomenon could possibly inspire confidence? And
remember, if consumers don't consume, corporate earnings
don't rise...and neither does the stock market...
- What's this? The Pension Benefit Guaranty Corp. (PBGC) is
running low on funds? Didn't this very same federal agency,
which safeguards the nation's pension plans, assure the
public last month that all was well? Yes, as a matter of
fact, it did.
- In the December 12, 2002 issue of the Washington Times
"Insight" magazine, PBGC spokesman, Jeffrey Speicher, said,
"The PBGC is able to meet its commitment to pay benefits
for the foreseeable future. We have been running a surplus,
but, even if that should go away, we have the wherewithal
to meet our commitments that we were set up to
pay."...Hmmm...we might define"wherewithal" a little
differently that Mr. Speicher.
- Responding to Speicher's assertion, your co-editor was
quoted by"Insight" as saying,"While the PBGC has about a
$4.8 billion surplus [currently], it had a $9 billion
surplus two years ago. So this ample surplus...has been cut
in half in the last two years, despite the fact that the
wave of problems hasn't yet hit. The number of pensioners
receiving benefits from them is about 270,000, but they
expect that to go to 400,000 by year's end. It isn't hard
to imagine what this means. If you boost the number of
recipients by 50 percent, and at the old number you eroded
half of the surplus in two years, how long would the
alleged surplus last?"
-"Not long," is the unfortunate answer. Already, the
PBGC's surplus has disappeared and plummeted into deficit,
which means that the PBGC has somewhat less"wherewithal"
than it used to.
-"The federal agency that insures the pensions of 44
million Americans has been pounded by a succession of big
corporate bankruptcies and has burned through its entire $8
billion surplus in one year," the New York Times reports.
"Though it can continue to make its current payments, the
agency is expected to disclose a deficit of $1 billion to
$2 billion at the end of this month. Its soundness is
likely to deteriorate further in the coming months."
[Editor's note: to read the Insight article in its
entirety, click here:
http://www.insightmag.com/main.cfm?include=detail&storyid=331611]
- Since the PBGC's deficit calculation rests upon various
assumptions about future income and liabilities,"deficit"
does not exactly mean bankruptcy (Of course, neither does
it exactly mean solvency). The PBGC, like the federal
government itself, can, and does, operate for years in
deficit.
- Nevertheless, the PBGC's Icarus-like descent from surplus
to deficit highlights the many vulnerabilities of our post-
bubble economy. Like the"foolish maidens" of the New
Testament parable, the PBGC did not"fill its lamp with
oil" when it had the chance. The PBGC did not raise
sufficient insurance premiums during the fat-income, bubble
years to adequately safeguard pensions during the lean
years in which we now find ourselves. As a consequence, the
PBGC may soon be forced to raise insurance premiums, which
would amount to yet one more assault on corporate
profitability.
-"Some 35,000 insured pension plans participate in the
PBGC," Insight magazine explains,"paying a flat $19 per
employee per year, plus additional variable rates paid by
the underfunded plans." Obviously, $19 per employee per
year will not begin to cover the looming liabilities.
-"Some possible palliatives for the PBGC's current
situation," says Reuters,"would involve charging
businesses higher premiums." Of course, what is the PBGC's
palliative is corporate America's poison. But U.S.
companies have far greater pension-plan worries than the
size of the insurance premiums they pay to the PBGC.
- As Apogee Research has been highlighting for months, the
$323 billion plain-vanilla pension shortfall amassed by the
S&P 500 companies is only half the story...literally.
"Other post-employment benefits," or OPEBs, which includes
things like medical care for retirees, has become a
whopping $317 billion liability for the S&P 500 companies,
according to CFO Magazine.
- The S&P's $323 billion pension liability, coupled with
its $317 billion OPEB liability, totes to a cool $640
billion liability - or more than two years worth of the
entire S&P 500's net income! That money has to come from
somewhere. Net-net, we would repeat what Apogee Research
first observed last October 25th:"Companies could end up
working for their retirees instead of their shareholders."
- Forecast that, Abby!
------------
Back in Paris...
*** The International Labor Organization says there are
more unemployed people around the globe than ever before -
180 million of them. In Argentina, for example,
unemployment is up to 22% of the labor force. The number of
people who either have no jobs or earn less than $1 per day
has risen to 730 million, says the ILO. Gosh, what will
happen when Americans stop buying?
*** In 2002, equity mutual funds had their first year of
net outflows in 14 years. $5.5 billion went out of stock
funds in December.
*** Every conversation seems to turn to war...
"War, war, war... If I hear the word war one more time I
shall leave the room and never talk to any of you the rest
of the evening..."
Scarlet O'Hara didn't like it when men's attention turned
from her to other subjects. But men are so much more at
ease in front of an enemy army than they are in front of a
beautiful woman. The stakes are so much lower.
And so they turn to war for safety.
***"I just can't believe the way you Americans are so
eager to go to war against Iraq," Sylvie began last night's
French lesson."You know, I give lessons at the American
embassy, too. I don't like to talk politics with my
students, but the subject came up with a woman there. We
were reading a newspaper article which asked,"should the
inspections continue?" She didn't think for a moment. 'No
way,' said she. 'The inspectors should get out of there
right away so we can get on with the war.' I mean...Isn't
this very strange? Sometimes people have to go to war.
Sometimes they have no choice. But this woman wanted
war....I never would have imagined it possible."
"But, Scarlet...I mean Sylvie..." your editor began his
explanation."French military history is nothing but a
series of debacles ever since Waterloo. The war with
Prussia in 1870...WWI...WWII...each one was a disaster.
Even Algeria was a disaster. And every war 'hero' in France
- Napoéon...Pétain...DeGaulle - is loathed by at least
half the population. No wonder the French would rather make
cheese than make war.
"Americans," he continued,"have an entirely different
history. It is so much simpler. Each time we faced an enemy
we won...with modest casualties (excepting the War Between
the States) and got richer doing it. Besides, the guys who
fought in WWII, and remember how awful a war can be, are
either retired or dead...."
The Daily Reckoning PRESENTS: The dollar has dropped nearly
30% since its peak against the euro. Apogee Research's
Andrew Kashdan takes a look at the"twin deficits" growing
in the U.S. and concludes:"the correction is just
beginning"...
FAIR-WEATHER FLOWS
by Andrew Kashdan
Several years ago, Alan Greenspan defended the Federal
Reserve's economic forecasts, observing that"the fact that
they have been wrong for 14 straight quarters does not mean
they will be wrong in the 15th quarter." The comment was
not only funny, it was true...and the same might be said
about trying to forecast the path of the dollar and trends
in international finance. Nevertheless, what follows is an
analysis of how the U.S. has been able to finance its
current account deficit to date, and why it may be more
difficult in the months and years to come.
To start, we should head off any possible misconception
about how the U.S. dollar might get its comeuppance. It's
not as if a large group of foreign investors will wake up
one morning and decide not to invest in the United States
of America anymore. Financial flows do not turn around so
quickly - barring a major crisis, that is. What can change,
however, is the price paid for U.S. assets at the margin.
At the macro level, the easiest adjustment is through the
currency exchange rate, which in this case is the value of
the dollar.
Today, the structure of international money flows suggests
further downside risk for the dollar. This is a flavor-of-
the-month assertion, to be sure, but we hope to shed some
light on the underlying data that support it.
Despite warnings to the contrary (including our own), the
growing current account deficit failed to incite dollar
weakness in years past. However, we long doubted that this
relationship - largely a bubble phenomenon - could hold,
and now it has started to break down. That is not to say
that there should be an inverse relationship between the
dollar and the current account deficit. At any particular
deficit level, the foreign exchange market will balance
inflows and outflows. But the expanding size of the deficit
makes it harder to clear the market at a particular
exchange rate, and the cumulative build-up of liabilities
only adds to the difficulties.
In the four quarters ended September 2002,the current
account deficit was $462 billion. To finance this Everest
of debt, foreign investors purchased $418 billion in U.S.
assets. The difference was made up by foreign central
banks' increasing their reserves of dollar-denominated
assets by an estimated $66 billion. (The numbers do not sum
due to statistical discrepancies in the reported data and
our own small rounding error. But the discrepancy does not
eliminate the major trends we are highlighting.)
At first glance, the foreign central banks' actions in
recent quarters might suggest that there is, in a sense, a
shortfall in available financing. We wouldn't go quite that
far. Flows from central banks are as good as any other form
of deficit financing in any particular period. But if we
consider the nature of these flows, along with the fact
that the U.S. is reliant on an historically high level of
foreign investment to finance its deficit, we might
conclude that the ability of the United States to attract
such financing is diminishing.
The $66 billion of increased reserves at foreign central
banks is the"swing factor" that is helping to offset the
U.S. current account deficit. From the U.S. point of view,
this is the"balance-of-payments deficit", or the payments
gap that remains after accounting for non-official foreign
purchases of U.S. assets. It is this gap that official
reserve transactions must cover.
To be sure, there is good reason for foreign central
bankers to increase their dollar holdings. For one thing,
by buying dollars, foreign banks help to weaken their own
currencies, which, in turn, helps their export industries.
The decision to try to prop up the export industry is
usually an easy political call, because the trade-offs
involved - notably, higher prices for consumers - can be
blamed on other factors.
There is no historical relationship in the post-gold-
standard era between balance-of-payments deficits and a
weak dollar. So the recent increase in the deficit is not,
in itself, a smoking gun in terms of financing problems.
But by the same token, there aren't many examples in
financial history of a major debtor country running a
deficit the size of America's under a fiat currency regime.
So the potential for a significant dollar correction can't
be ruled out, either.
Central banks around the world are not likely to dump their
dollar holdings. But we do think that, at the margin, the
U.S. will find it more difficult to obtain financing from
both private and official sources. Despite the potential
reasons for acquiring dollar assets, we would presume that,
other things being equal, central banks would prefer not to
hold depreciating assets. As history shows, there is a
limit to foreign central banks' willingness to finance
America's"deficit without tears," as a French official
once called it.
But the real"hot money" comes from private sources. In one
sense, it would be better if the U.S. current account were
financed completely by private,"non-official" purchases
rather than by official ones. It would at least serve as an
implicit vote of confidence in U.S. productivity (and even
if the vote were a wrong one, it would be subject to market
discipline). However, it would also mean that current
account financing was subject to the whims of self-
interested investors. It would be better still if the
deficit were financed by direct investment or privately-
floated securities, rather than by government obligations.
Direct investment is not so easily repatriated. Also,
government bonds are far less likely to finance something
that is productive in the economic sense. James Grant,
writing recently in Grant's Interest Rate Observer, noted
that,"in recent years, foreign dollar holders have shied
away from direct investment in this country, favoring
instead Treasury securities and federal agency obligations.
They have switched their focus from investing in American
enterprise to funding the housing market and the U.S.
government."
Measured on a rolling four-quarter basis, foreigners'
purchases of U.S. assets have declined from over $1
trillion in early 2001 to $647 billion in the latest four
quarters. A subcategory, foreign direct investment, has
withered from over $300 billion in 2001 to $46 billion in
the latest four quarters. Part of the reason this
contraction hasn't made the U.S. funding problem even more
severe is the increase in foreign official reserves noted
above, coupled with the repatriation of overseas assets by
U.S. investors.
Should either trend reverse, the dollar would have to fall,
unless an offsetting increase were to appear somewhere
else.
Most readers of the Daily Reckoning have some idea of the
size of the current account deficit. Rarely mentioned,
however, is the cumulative impact of all these deficits. At
the end of 2001, the net result was that foreigners owned
$2.3 trillion more in U.S. assets than U.S. investors owned
abroad, which produced a negative net asset position for us
Americans, equivalent to more than 20% of U.S. GDP.
The trend may seem alarming, although we might exaggerate
its importance. As author and economic commentator Andrew
Smithers pointed out recently on Breakingviews.com,"In a
world of massive disequilibria, the threat that foreigners
will, on current trends, own 12% of the U.S. capital stock
by the next decade is hardly worth half a pint in a gloom
merchants' saloon bar." Perhaps. Yet it seems to us that
foreigners might become increasingly concerned about the
risk of currency depreciation as debts continue to rise.
The increase in liabilities also has a direct impact on
investment income. Martin Wolf noted in a recent column in
the Financial Times that, despite the negative net asset
position of the U.S. in 2001, the country ran a small
surplus in investment income - it received more in income
than it paid out. The U.S. earned an average of 4.1% on its
assets in 2001, while paying out 2.9% on its liabilities.
This favorable difference is nothing new for the U.S., and
Wolf concludes that"foreigners are stupid investors".
Maybe so, but perhaps they are no"stupider" than their
U.S. counterparts.
Delving into this phenomenon, we calculated the returns,
based on income payments and receipts, going back to
1982,the earliest available estimates for this particular
measure. The U.S. advantage has occurred every year since
then, but both U.S. and foreign returns have been in a
fairly steady decline. America's consistent relative
advantage is clearly the result of its perceived safety
vis-Ã -vis non-U.S. financial markets, hence the lower
returns. Because the U.S. net asset position continues to
deteriorate, however, the absolute amount of the investment
income surplus has been in an uneven, downtrend.
In other words, the sheer weight of liabilities, along with
the declining income returns, is countering the apparent
advantage of U.S. investors. Importantly, the peak surplus
of $36 billion registered in 1983 covered nearly all of the
annual deficit for that year. By stark contrast, 2001's
$14-billion surplus covered about 3% of the U.S. current
account deficit over the last 12 months. Since there is
little reason to expect the U.S. net asset position to
improve in the near future (and even if it did, it would
take a while for the turnaround to have an impact), here is
yet another source of financing that appears to be drying
up.
Another problem for the U.S. current account is the return
of fiscal deficits. As the fiscal deficit expands, the
current account deficit will likely follow suit, thus
putting even more pressure on the dollar by increasing the
severity of the financing problem. If the U.S. private
sector moves toward financial balance, a fiscal deficit
necessitates a current account deficit, because the
government needs to borrow from foreign investors. Stephen
L. Jen of Morgan Stanley predicts that the"twin deficits"
problem will become so severe in the coming two years that
"it will overwhelm other factors that may be USD-positive."
Of course, it is difficult to predict to what degree the
size of the deficit will impact the dollar, and to what
degree a weaker dollar will narrow the deficit. Either way,
though, unless net exports happen to increase substantially
without any help from a weaker currency, a dollar
correction seems like a logical consequence.
Regards,
Andrew Kashdan,
for The Daily Reckoning
P.S. The dollar's perpetual decline against real goods will
continue; it has lost more than 94% of its purchasing power
since the founding of the Federal Reserve in 1913. When it
comes to exchange rates, however, the feeble alternatives
among the world 's currencies - none of them backed by more
than a friendly face - will guarantee that a dollar
correction will only go so far.
Be that as it may, I believe the correction is just
beginning.
|