The Current Account Guessing Game

Apogee Research’s Andrew Kashdan wonders…now that all those foreign investors who so generously financed the U.S. spending spree have little to show for it – what next?

Murray Rothbard, the noted Austrian school economist, once said that "more nonsense has been written about balance of payments than about virtually any other aspect of economics." At the risk of adding another layer of gibberish to the mix, we turn our attention to the eventual "end game" for the U.S. current account deficit. Not that we’re foolish enough to try forecasting exactly how and when it will end. No, we just want to ponder the big picture.

Recall, if you can, the balmy days of the 1990s in which a virtuous circle of rising asset prices incited rising foreign investment and U.S. spending, which led to ever- higher asset prices. Well, it was that bulge in foreign investment and U.S. spending, much of it on imports, that produced the huge U.S. current account deficit. But now that investors have marked down at least some of those assets to fair value (or closer to it), it seems to us that the rest of the circle will probably reverse itself as well. It’s all part of the stomach-churning hangover from the go-go years.

The possibly confusing aspect of this part of the cycle concerns the narrowing of the deficit – that is, a rise in exports relative to imports. What is usually seen as a "favorable" trend may not be, depending on how it comes about.

The problem confronting the world today stems from the fact that the U.S. bubble’s sheer size made it the engine of the global economy. On the one hand, the U.S. consumer’s insatiable hunger for imported goods was propping up foreign economies, while on the other, foreign investors’ insatiable hunger for U.S. assets was attracting investment funds. But now, post-bubble, all those foreign investors who generously financed the U.S. spending spree have little to show for it. So, it’s not that the rest of the world is unwilling to carry the burden of importing (as if consumption were an act of altruism), but rather that they are unable.

If the rest of the world is not buying U.S. goods at current prices, then presumably prices have to drop. But as FODR (Friend of The Daily Reckoning) John Mauldin explains, "rather than lower their prices in terms of their local currency, [businesses] urge their governments to lower the price of the currency." That description certainly applies to U.S. exporters. They have long complained about the strong dollar, and since the party ended, they’ve been getting more attention. That brings us to an important point: when market forces are potentially aligned with political forces, that is precisely the time the Fed prefers to act (and so, too, the U.S. Treasury, which is in charge of manipulating the currency markets, should it come to that).

Bottom line: With low inflation providing a margin of safety for monetary expansion, a weaker dollar seems inevitable. If there were ever a consensus for revving up the money supply, this is it!

In surveying the U.S. economy last week, The Economist observed that "debt cannot rise faster than household income forever. Eventually households will be forced to save more and spend less." (By using "forever" and "eventually," the statement becomes a truism and bypasses the annoying question of "when?".) The same inevitability applies to the international balance-of-trade situation, as the IMF acknowledges in its recent World Economic Outlook. Referring to deficit countries (read: the U.S.), it says that "current gaps between the growth in real domestic demand and real output cannot be sustained indefinitely."

In other words, U.S. consumers are living beyond their means. "The underlying issue," the IMF goes on, "is whether the eventual rotation in real demand growth away from these countries to continental Europe and east Asia will occur in a smooth manner or not." It doesn’t quite say it, but the IMF seems less than confident that the transition will be a smooth one.

What sometimes gets lost in the focus on the quarterly flows of imports and exports is a country’s net foreign asset position, which is the result of cumulative current account imbalances. Take Japan and the U.S., for instance. The IMF says that based on its forecasts, by 2007 Japanese net assets, measured as a percentage of GDP, will rise by about one-third to 40% of GDP, and U.S. net liabilities will double… also to about 40% of GDP. The numbers would be unprecedented, the IMF adds, and would occur when even existing levels are hard to justify in the face of fundamentals such as government debt, GDP per capita and demographics.

The implication is that large external adjustments are needed to stabilize the ratios. There are few historical precedents of countries running large current account deficits over a sustained period. Nevertheless, the IMF concludes, not surprisingly, that the adjustments generally occur in deficit countries through a combination of slower output growth and depreciation in the real exchange rate. Because volumes of exports and imports respond sluggishly to exchange rate depreciation – i.e., the J-curve effect – it takes a year or more before the current account is actually adjusted. To our surprise, the IMF’s advice for policy makers sounds pretty sensible: "medium-term fiscal consolidation" by the deficit countries, presumably meaning less government spending, which it says diminishes the likelihood of a too rapid current account adjustment; and reforms by the surplus countries to increase flexibility and competition.

As the U.S. ramps up government spending while Japan and Europe make little headway on economic reform, the global economy has obviously seen better days. "[O]ne key aspect of the legacy of unbalanced global growth," says Stephen Roach, is "America’s gaping current-account deficit… So, too, is an overvalued U.S. dollar." Accordingly, Roach’s team at Morgan Stanley has just reduced its estimate for global growth to 3.1% in 2003, a full 0.5 percentage point lower than the 30-year trend, and the risks are on the downside. Roach thinks global policy coordination is sorely needed.

But regardless of what the bureaucrats decide to do, we know that Mr. Market will go his own way, ultimately fixing the mess the bubble has left behind. Trouble is, it might hurt a little (or a lot).

Andrew Kashdan,
for The Daily Reckoning
October 3, 2002

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Apogee Research

Mr. Bear! That sly fellow…just when you think you’ve got him figured out, he does something unexpected.

Yesterday, for example, we were pretty sure we’d see at least another bullish day on Wall Street. The Dow is far below its moving average. Prices have been falling day after day, month after month. It was time for Mr. Bear to let up.

Not out of a sense of mercy, of course. Au contraire, with malice aforethought! Investors were getting edgy, panicky…it looked like they would soon pack up their picnics, jump in their cars, roll up the windows, lock the doors, and rush out of the stock market. If they had done that, prices would crash and the bear market would be over.

But this is no ordinary bear. This is Ursa Major…the kind of animal you see once in a lifetime. Instead of backing off…the great bear came out again yesterday, reared up on his hind legs and ripped into stock prices.

We stand back – well out of range – in awe and wonder. We have the feeling we are witness to something remarkable. The greatest bull market in history is now being followed by the greatest bear market. And the biggest boom seems likely to be followed by the biggest bust too.

In the economy as in the stock market, people who still have their wits about them should be making a getaway. Consumers, already carrying the heaviest debt loads ever, should be taking off their knapsacks and chucking out unneeded items. When you are running from a bear, you want to be as light on your feet as you can be.

Instead, yesterday brought news that the poor hopeless schmucks were standing in line to get bigger mortgages; there were a record number of mortgage requests last week. Refinancings at lower mortgage rates typically help cash flow even while they make the balance sheet worse. Consumers end up with a bigger mortgage, but lower monthly payments. But recently, a hint of desperation has crept into the refinancing statistics. "They’re refi-ing to get another $40 a month in their check," reports Michael A. J. Farrell of Annaly Mortgage Management. "Why is that? We think it leads back to economic weakness."

How can we help these people, dear reader? Or investors who rush to join every rally in the stock market? We don’t know…

Eric’s report…


Eric Fry from the city of New York…

– As West Coast surfers would say, "That Mr. Market dude is bummin’ my high."

– "Yeah," would come the reply, "He’s a real buzz-kill."

– Every time investors start to get a little excited about owning stocks again – like during Tuesday’s 346-point Dow rally, for example – along comes another big sell off to "bum their high." Yesterday, the Dow dropped a buzz-killing 183 points to 7,756, while the Nasdaq Composite was also pretty much of a downer – dropping more than 2% to 1,187.

– The gold market provided a minor rush by gaining 60 cents to $322.80…

– Let’s try not to shed any tears for Cisco Systems. The shares of this once-and-former leading light of the dot-com era dipped below $10 yesterday. That’s right, the same Cisco Systems that once boasted a spectacular $575 billion dollar market capitalization became just another single- digit stock. But let’s not look on the forlorn, broken-down Cisco that we see before us today. Instead let’s remember the more youthful and confident Cisco of the late 1990s – the company that inspired us all to hope big hopes and to dream big dreams.

– Remember how Cisco filled us all with giddy euphoria? Let’s not forget how Cisco inspired us all – an entire nation of gullible investors – to squander trillions of dollars buying overpriced and over-hyped tech stocks.

– And let’s remember the Cisco of an earlier, happier time, when the ever-soaring Nasdaq Composite moved us all to feel much, much richer – if only for long enough to amass sizeable debts that will weigh on us for the rest of our lives.

– Ah…Those were the days!

– Cisco shares managed to inch back above $10 by the end of trading, but the psychological damage had been done: Cisco shares changed hands at "nine and change."

– What is nearly as remarkable as Cisco’s colossal 87% collapse from its peak of $80.06 in March of 2000, is the fact that the company still boasts a market cap of $73 billion.

– As the once-titanic market cap of Cisco Systems breaks apart and sinks into the sea, so do the aspirations of countless hedge fund managers, particularly those who forgot to hedge.

– There is no direct connection, perhaps, between Cisco’s sinking share price and the death of numerous hedge funds, but both are victims of the post-bubble bear market.

– One of my well-placed contacts in the hedge fund industry tells me that hundreds of managers will be calling it quits at the end of the year. These well-heeled unfortunates have lost so much money for their clients that their hedge funds have become woefully uneconomic propositions.

– Most of the stories I’ve heard have been remarkably interchangeable. They go something like this: "Acme Hedge Fund" opens for business in 1994 with $1 million. Throughout the 1990s, the fund enjoys considerable success by simply riding the bull market ever higher. All the while, the funds do very little actual hedging. (Short- selling was self-evidently stupid, most managers believed). Assets under management at Acme Fund gradually increase to $75 million by March of 2000. Then, all hell breaks loose. But Acme doesn’t do too badly at first. Stocks are so obviously overpriced in 2000 that even diehard bulls think it appropriate to short a stock or two, just in case the stock market stops going up for a while. After the dust settles, Acme finds itself with a loss of 15% in 2000. Acme loses another 15% in 2001 – the results might have been much worse, but the post-9/11 rally saves the day. Enter 2002, everyone "knows" two things for certain: 1) the economy will recover by June and; 2) the stock market cannot possibly fall for a third straight year…Ergo, time to buy!

– We all know what happens next. The economy doesn’t recover in any meaningful way and stocks collapse. Our not- so-imaginary Acme Fund is now down another 18% through the first nine months of 2002, bringing its cumulative losses since the end of 1999 to 41%. And that’s very bad news for a hedge fund manager.

– Now, the fund must gain 70% just to get back to break- even, and therefore, back to the level at which the manager receives 20% of the profits. Until he has made back the accumulated losses, he receives no share of the profits. Making 70% might take a while, and many of Acme Fund’s clients don’t feel like sticking around. Many of them withdraw what’s left of their money so that they can re- invest in the "much-safer" real estate market.

– Acme Fund’s assets under management have dwindled to $18 million…which means it’s time to close up shop and freshen up the resume…And that can really bum your high.


Back in Paris…

*** What a central bank does best is inflate the currency. But there comes a time when even the best of them cannot overcome the deflating effects of a major bear market and economic downturn.

When that happens, people with big mortgages come to grief. Deflation raises the value of money…and, naturally, claims on money streams – such as bonds and mortgages. It the rentiers’ delight, as it increases the value of every coupon he cashes in. But, on the other end, the debtor finds himself doubly damned. His liabilities increase. And the real interest rate he pays goes up. Even if the nominal rate is only 5%…when the CPI is also dropping by 5%, the real rate of interest is 10%.

That is a big part of Japan’s problem now…and it could become America’s soon.

*** Paris is beautiful…but gray as a white alley cat. Here at the Daily Reckoning headquarters, this is our favorite time of year. The leaves have turned yellow and flicker in the light breeze, and the dying light of autumn casts a candle glow over the city like the viewing room of a mortuary.

But how we admire the city! So beautiful, so sophisticated, so coy and witty. What a great day to wink at a homely girl or ask a broker for financial advice. Not that we would want to follow up on either. But it is a good day for light-hearted mischief…

*** "What was wrong with that man in front of us," Edward, 8-years-old, asked as we got in our car.

"He is very sick," replied his mother.

"What’s the matter with him?" came the follow-up.

"He has cancer…"

In the pew in front of us on Sunday, the couple held hands. Marie-Claude gripped her husband’s hand to steady him, for he could barely stand. But he pulled himself up at the critical moments and faced his friends and his God.

The poor man will probably not make it until Christmas. In the last 6 months his hair has turned white and his skin has turned yellow. There was the scent of death in the air.

"Why doesn’t he go to the doctor?" the questioner continued.

"There’s nothing the doctors can do."

"Will I get cancer?"

"No, it usually attacks old people."

"How old is he?"

"He must be in his ’60s."

"How old is Dad?"

"Not that old."

"Why do people die?"

We had no good answer.

But everything does. Exeunt Omnes. The best you can do is to do it with grace and dignity.

The Daily Reckoning