Balance of Payments
I have written a couple of times recently about
the amount of political distortions that dominate the subject of
America's trade deficit. One final comment in the general form of a
summation, and I promise I will not bore you with the subject any
further. What have I learned about the trade deficit since I started
writing on the subject?
First of all, I have arrived at the conclusion that 98% of the noise about the subject is politics. Now when I hear some talk about the twin deficits or American profligacy, I look to see where the author is coming from. It is mostly either some politician trying to get elected to something; or some businessman or labor leader whose ox has been gored by foreign competition, and is looking to the government to bail his ass out.
There is no question that the dollar was, and probably still is overvalued. But the reason for this has nothing to do with American consumers desire to own an infinite number of flat panel TV screens. The dollar is over valued not because of our desire to buy, but because of rest of the world's desire to sell to us.
The trade deficit exists because of the power of the American consumer, and while it is likely that currency markets will remain volatile, and may even perhaps get violently more so in the near term, the underlying factors that are the cause of this overvaluation of the dollar are not likely to change in our lifetime.
What do I have to support these conclusions? One
thing is the current market for US treasury securities. Last month
there were two big auctions of treasury securities. The demand at
the auctions was so strong that interest rates went down about 25
basis points. So who is buying all these bonds, and why? The rumor
is that 40% to 50% of the bonds sold where purchased by the Bank of
Japan. Why does the Japanese Central Bank need all this low-yield
American paper?
Japan has been going through a twelve-year
economic contraction and has recently experienced the beginnings of
a recovery. The American economy is getting stronger and we are
starting to buy a lot of stuff from Japan. US dollars are flowing
into Japan and as the dollars flow in, a lot of them end up in
Japan's central bank, the BOJ. The BOJ can sell those dollars or the
can hold them. The problem is, if the bank dumps the dollars, it
drives the price of the dollar down relative to yen. The last thing
that Japan needs right now is a weak dollar. A weak dollar makes
Japanese goods more expensive for the American consumer. With the
American economy the only large economy showing much life right now,
if the Americans stop buying, the Japanese economy goes back in the
toilet and existing Japanese politicians will be looking for a new
line of work.
But it is not just the Japanese, In the last
three months of 2003, foreign central bank holdings of U.S.
government securities grew by 37.4%. Two weeks ago the Russian
Central Bank announced that it was buying dollars. The dollar has
declined 12% in the last year relative to the Ruble and Vladimir
Putin thinks it important that Americans should not have to face a
cost increase for their Stolichnaya Vodka (thanks Vlad).
The Power of the American Consumer
The U. S has a trade deficit because the dollar
has been overvalued for a long time. It has been over valued because
foreign central banks like it that way. When they get dollars, and
to the extent that they can, they hold on to them (use them to buy
US treasury securities). The foreign central banks like it that way
because the local politicians like it that way. Everyone wants to
sell to the American market. If you have a product and you aspire to
world-class status for that product, you have to be able to sell
successfully in our market place. Without a share of the American
market it is difficult to generate enough revenue to achieve the
economies of scale that you need to compete in the international
market place.
Assuming that some or all of this is true, what
does it mean, and what are the consequences? Well I would not expect
that the long-term trend will change much. It is likely that the
dollar will stay weak or even decline further, but because foreign
companies are still going to want to sell their products to our
market. The dollar is not likely to decline to the point that our
current account deficit will disappear. The dollar is likely to
remain overvalued because the rest of the world would prefer that it
does.
The short term may be more interesting. The
imbalances have become so glaring that it has attracted a lot of
currency speculators, and history tells us that once the speculators
start to smell blood, central banks can get crushed.
In the unlikely event that the dollar were to
suddenly fall to the level where its trade deficit would be
eliminated, the pain would be much greater over-seas than it would
be here. In the US prices would increase for imported goods, but
this negative would be off-set for us by increased profitability for
companies that export and a rapid increase in employment in the
manufacturing sector. On the other hand, countries that sell goods to
us have benefited from the strong dollar because it makes their
products cheaper, and a sharp drop in the dollar, if maintained for
a long period, would see rising unemployment in industries that rely
heavily on the American market. Profitability of companies that sell
to us would fall and if the decline was sustained, it could lead to
debt defaults and bankruptcies.
As for the stock market, I personally will stay
away from large financial institutions like J.P. Morgan Chase, BOA,
or Citibank because of the off-chance that currency traders might
set off a small nuclear accident in the derivatives market. But I
was going to stay away from those stocks anyway (derivatives-related
to real estate mortgages are probably a much bigger threat). On the
positive side, it is probably time to start looking for companies
that will benefit from rising commodity prices and lessoned foreign
competition.
"Skating on Thin Ice"
Last year, despite his view that the market was
overvalued Jeremy Grantham correctly predicted that the market would rally.
He is looking for another up year this year, but after that he sees
a return of the bear. If you do not want to read the whole thing
here are the highlights:
"As a new devotee of the presidential cycle, I
think we can count on a high probability of a relatively stable
stock market year. The value of the market, which on a 1-year basis
never matters as much as sensible investors would like, simply does
not matter at all in year three, but in year four, it has an almost
normal effect and obviously at 25 times normal profit margins, this
is a very overpriced market. However, the stimulus program was
profound and the economy has responded and this momentum is an
obvious positive."
In other words presidential politics trump value
when it comes to guessing at the direction of the market in the
third and fourth year of our presidential election cycle.
"On average, value stocks (or low growth) also
have their best year in year four; perhaps just making up for year
three's overdoing it with growth stocks. My conclusion is that the
economy, profits, and the market are likely to do quite well or
better in the first half, and less well in the second half, as the
stimulus runs out and the over pricing of the market is felt."
2005 and 2006 are likely to be the time when the problems caused by too much pre-election financial ease and the resultant asset bubbles will likely turn the stock market into a black hole.
"The outlook for 2004 is not bad, but the market
is very overpriced and all predictors look bad for next year and the
year after.
"The purist's investment position is clear: the
market is overpriced and investors should duck! The problem with
this strategy, as we have all painfully learned over and over again,
is that an overpriced market can really run, and this overpriced
market has quite a lot going for it in the near term...
"I am confident—but far from certain—that the
long-term problems already discussed, which will affect every
country, lie out beyond the next 6 months and probably this year."
The thing that bothers me is that I almost completely agree with this view and when the people running big money agree with me, I start to get nervous.
In the second part of this article Grantham
discusses factors the effect the direction of the market on a
short-term (one year) basis and finds three strong predictive
indicators:
- The Presidential Cycle
- The January Effect
- Value (Price to 10-year trailing earnings)
While this may sound superficial, the article is
an interesting read, and Grantham is no slouch. 2003 saw his company
GMO increase its assets under management from $23 billion to $54
billion.
The Value of "Value"
An interesting aside to his study is that
"Value" analysis is a lot weaker predictor of one year performance
than it used to be.
"The decline in predictive power in the last 30
years is disturbing to worshipers of mean reversion." (Value
investors)
"What is going on here? Is value, surprisingly,
being used so much that it is losing its power... This raises an
important, but not too surprising issue: to win on value, you must
be prepared for increasing noise and greater pain and time on
average before you win."
Buffett has been successful for a number of reasons, but for most of his career he has been an outlier doing things differently than the Wall Street herds. In the last ten years he has become much more widely known and his teachings much more popular with investors big and small. What impact this will have on the new and future practitioners of value investing is at this point an open question.