The Last Shall Be First

To be American is to be a "rich" American…at least that’s how most foreigners see us.

In fact, we believe it ourselves. We have been called "rich Americans" for so many decades that we have come to assume this state of affairs as a kind of birthright. But the world we have known may be changing…and if so, the financial world that global investors have known may also be changing.

We Americans are so used to being the "haves" of the world that we have allowed our privileged status to color the way we regard the "have-nots." In our inimitably imperial style, for example, we refer to the world’s "lesser" economies as "emerging" markets. We are on top and THEY – whoever they are – are on the bottom. This is the financial world order to which we are accustomed.

But this familiar and comfortable world order is changing before our eyes. So rapidly – and convincingly – are many of the world’s emerging economies transforming themselves into paragons of capitalism that the American economy seems to be SUB-merging by comparison. In short, the poor are becoming richer, while the rich are becoming poorer.

For the last couple of years, Moody’s and S&P have been issuing credit upgrades to developing countries faster than tech companies issue stock options to their executives.

"Moody’s Investors Service has announced 50 sovereign upgrades since the beginning of 2002 and only 17 downgrades over that span," the Wall Street Journal reports, "a sharp reversal from 1998, when it carried out 22 downgrades and just two upgrades amid the financial crisis and Russian debt default."

As a result of the upgrade binge, almost 45% of the weighting on the 31-country EMBI Global Index had achieved an investment-grade rating by the end of January, up from 4.1% a decade ago and 16% five years ago.

Many former economic basket cases, like Brazil and Russia, are developing an economic physique that shames the U.S.Russia’s GDP jumped 6% last year, its sixth-straight year of GDP growth in excess of 4%. Meanwhile, its government has produced five straight budget surpluses.

Brazilian GDP growth is also humming along at nearly 6% annualized, while its national finances are improving rapidly. The government’s budget is still operating in the red to the tune of about 2.5% of GDP, but looks likely to move into surplus by 2006.

Meanwhile, America’s national finances are going from bad to worse. The U.S. trade deficit soared to a record $617.7 billion last year, and the budget shortfall stood at $412.3 billion. And over in the private sector, consumers are racking up record-high debts.

Is it any coincidence, therefore, that ALL U.S. financial assets have been under-performing their emerging market counterparts over the last few years? The dollar is falling; U.S. stocks are trailing behind most emerging market indices and Treasury securities are losing their premium pricing relative to emerging market bonds.

As the chart above clearly shows, the "spread" (or difference between the yields) between the average yield of emerging market debt securities and the yield of U.S. Treasurys has contracted dramatically over the last 10 years. In 1995, for example, bond investors demanded a yield from emerging market debt that was nearly double the yield of comparable Treasury notes. Today, the spread between the two has narrowed to a record low of less than 300 basis points. The narrowing of credit spreads may be a function of growing confidence in foreign borrowers or eroding confidence in U.S. national finances…or both.

"A country that is now aspiring to an ‘Ownership Society’ will not find happiness in – and I’ll use hyperbole here for emphasis – a ‘Sharecropper’s Society,’" Warren Buffett laments in his annual letter to Berkshire Hathaway shareholders. "But that’s precisely where our trade policies, supported by Republicans and Democrats alike, are taking us."

Buffett’s well-founded concerns inspired him to place a titanic $20-billion bet against the dollar last year.

Of the $3.5 billion in pretax gains on investments Berkshire Hathaway realized in 2004, well over half came from betting against the dollar. Berkshire chalked up about $2 billion from various sorts of foreign currency hedges and investments.

"There are deep-rooted structural problems that will cause America to continue to run a huge current-account deficit unless trade policies either change materially or the dollar declines to a degree that could prove unsettling to financial markets," Mr. Buffett warned in his annual report.

If Buffett’s pessimism proves correct, we sharecroppers will find ourselves becoming increasingly indebted to our foreign "landlords," while holding a currency whose value steadily decreases.

What’s more, if we Americans are becoming sharecroppers, the world’s financial order must change in ways that we will not enjoy. A sharecropper’s economy could not possibly represent the global standard for the currency markets, or the bond markets or the stock markets. Our role must diminish.

If the perennial basket cases can no longer be counted on to disappoint, can the perennial powers be counted on to lead the way to prosperity? Or to rephrase the question, why not invest in the future rather than the past. All else being equal we rather own the stocks and bonds and currencies of rapidly growing, surplus-producing countries rather than grudgingly growing, deficit-producing countries.

Despite Buffett’s bearish position on the dollar, he maintains, "[The U.S.] economy is far and away the
strongest in the world and will continue to be. In no way does our thinking about currencies rest on doubts about America."

We do not believe him…and we’d rather follow Buffett’s walk than his talk.


Did You Notice…?
By Eric J. Fry

What may look like a "housing bubble" to the residents of Peoria or Pasadena, may look like a bargain to the residents of Paris.

The nation’s skyrocketing home prices seem fairly daunting – and vulnerable – when viewed in terms of U.S. dollars. But when viewed in euro terms, U.S. real estate seems a veritable bargain. As the chart below shows quite clearly, average U.S. home prices haven’t budged since 1998…when priced in euros.

This reality may be an irrelevant influence in most of the nation’s regional housing markets. But Europeans and other euro-toting foreigners have already become a significant influence in selected real estate markets on the East Coast. The nouveau riche from Latin America, China, Russia and elsewhere are also dipping toes in the U.S. housing market.

We should not be surprised, therefore, if real estate becomes America’s next booming "export" industry.

The Housing Bull That Debt Built


And the Markets…



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