US Federal Reserve Bank Chairman Alan
Greenspan is confused - why are long-term interest
rates so low? Is what he calls "too low" a risk
premium courtesy of his successful policies?
Inflation runs at an 18-year high. Will gold climb
further, and the dollar resume its decline?
Let us start with Greenspan's "conundrum".
Many flat out say the market has it all wrong and
will come to its senses, suggesting that long-term
interest rates will rise dramatically. Maybe.
Market prices reflect the average of all
participants' expectations. If your opinion
diverges from the average, then you may choose to
invest accordingly in anticipation that the market
will converge on your scenario. Of course, in the
future, market prices will not reflect the facts
then, but expectations at that point; be aware of
the old saying that markets may stay irrational
longer than you can stay solvent. While we often
disagree with what the average is thinking, it is
a good starting point in any analysis. If you know your
opponent's strategy, it is
much easier to win than if you are convinced of
yourself and blindly execute your own strategy
without reference to your environment.
Similarly, if Greenspan tells us he
doesn't understand the yield curve (the
relationship between longer and shorter dated
securities), we should be worried. He might just
push the economy in the wrong direction if he
doesn't know where it is heading.
Enough
modesty - let us attempt to explain what so few
have been able to. Some say low long-term rates
suggest we have no inflationary pressures. Joe
Battipaglia, an eternal bull who tells us to "look
at the facts", dismisses arguments that inflation
is in the pipeline and that the soaring price of
gold is a reflection of jewelry demand picking up
in Asia and China. With due respect to
Battipaglia, this is nonsense. The gold price, in
our view, clearly signals that we have
inflationary pressures and a flight to hard money;
the expected increase in jewelry demand cannot
fully explain its rise.
But why are
long-term interest rates so low then? Is it the
foreign purchases of US debt? They are a factor in
holding long rates down, but let us keep in mind
that foreign governments tend to purchase mostly
shorter-dated maturities. What about corporate
America as a buyer of longer-dated debt
securities? While the US consumer is heavily in
debt, corporate America has amassed enormous
amounts of cash after cleaning up its balance
sheets - many US corporations are now adding to
the demand rather than supply in the fixed-income
markets as they manage their cash.
We
believe there is another story behind the low
rates of longer securities that is all too
obvious: the US economy is slowing down. But there
is a difference: after all, we had GDP growing at
3.3% in the 2nd quarter - not exactly a sign of a
stalling economy. One can argue that GDP is
overstated because of inflation, and that an
economy that must offer "employee discounts" to
sell cars is in trouble. We would like to take it
a step further. We had one airline after another
declare bankruptcy; now the world's largest
automotive supplier, Delphi, has declared
bankruptcy. General Motors and Ford are likely
bankruptcy candidates. What is happening is that
corporations cannot pass costs on to consumers.
Greenspan has been arguing that prices have to
rise at some point because of costs being passed
on. Stagflation advocates have said that wage
pressure will build. What is different from the
1970s is that we now have Asia at our doorstep
flooding us with cheap goods. The analysis cannot
stop there. We believe that companies that cannot
adapt will simply disappear (or be kept alive with
subsidies or protectionism). If you are a European
exporter and cannot pass on your higher costs and
lower margins due to a strong euro, you might just
vanish.
The Greenspan conundrum,
unplugged, means: Our low long-term interest rates
suggest that we are going to lose entire
industries in the looming economic downturn.
Industries that cannot adapt quickly enough to our
global economy will be wiped out; cutting expenses
is important for them, but will not be enough, as
no developed country can compete with the cost of
labor in Asia. Instead these companies must focus
on superior value. Some European firms have long
embraced a luxury brand model; but that may not be
enough if these firms do not control their
distribution channels. As an example, Safeway
dictates what the cost of a six-pack of beer is.
If you can't meet that price, there will be others
that will.
There are a number of reasons
why it is so much more difficult to pass on higher
costs these days. Much of it has to do with Asia
over-producing goods as a result of their
subsidized exchange rates. Asia believes that it
must generate economic growth at all cost to
provide jobs and political stability. The result
is a surge in world commodity prices (we had high
commodity prices before the hurricanes) and low
consumer goods prices. In addition, take a US
consumer that is heavily in debt, and you end up
with very little pricing power. Corporate America
is squeezed by both high raw material prices and a
lack of pricing power, resulting in accelerated
outsourcing. US policy makers have added to this
vicious cycle with low taxes and low interest
rates. What US policy has done is to accelerate a
cycle to the point where the transition is too
fast for old economy companies to keep up.
The US economy is a diversified economy
with great success stories; one of the more recent
ones is the rise of Google. Google is all that
"old economy" is not: flexible and capable of
thriving in this environment. Highly accommodating
monetary and fiscal policies have helped pick up
the slack of ailing industries. This is not the
place to discuss whether an economy can survive
long-term if it entirely dismantles its
manufacturing base and exclusively focuses on
services. What we do know, though, is that the
accommodating policies have created inflationary
pressures in just about all sectors of the economy
where we cannot import goods from Asia. And while
we are at it, we also created a phenomenal housing
bubble that has allowed the US consumer to
increase spending (by taking out home equity loans
and refinancing) while real hourly wages have been
on the decline.
We do not see a conflict in
low long-term rates and high gold prices - at
least not for now (depending on Federal Reserve
actions down the road, long-term rates can easily
rise substantially). What about inflation and
economic growth going forward? The Fed has been
steadily raising rates. Bill Seidman, respected
for his role in handling the Savings & Loan
(S&L) crisis in the 1980s and now chief
commentator on CNBC, says Federal Funds rates
would need to move to 5.5% just to have a neutral
impact on economic growth. We agree: even with the
many small increases in rates, we still have an
accommodating monetary policy, one that fosters
growth and inflation. At the same time, the
economy is clearly slowing down. Because consumer
debt is at record levels and consumer spending
comprises an ever larger share of the US economy,
the economy is ever more sensitive to changes in
interest rates. The federal government is also
more interest-rate sensitive: not only has the
absolute debt increased dramatically, but since
the former treasury secretary, Robert E Rubin,
abolished the 30-year bond, the duration of
federal debt has significantly decreased. In plain
English: the government has joined the large
portion of irresponsible consumers by refinancing
its debt with the equivalent of adjustable rate
mortgages.
Corporate America has
reasonable-looking balance sheets, but we cannot
rely on them to bail this economy out. The reason
Corporate America has not invested much of its
cash is because it sees the shakiness of the
American consumer and is reluctant to invest.
Policies in the US and Asia have led to such a
rapid acceleration in the pace of change that much
of the developed world cannot keep up. We hear a
lot about the US economy being less
energy-dependent than in the 1970s. That's only
partially true. We consume a lot more than we did
in the 1970s. Nowadays, many of the goods are
produced abroad, but it still takes energy to
produce them. For now, foreign producers have
absorbed the high energy cost through lower
margins. We still need to transport these goods
within the US, which is causing us plenty of pain
with high energy prices. In Asia, companies also
get squeezed more and more. While China is a
cheap-labor country, it is not a low-cost country.
We believe Asia will continue its path as
long as it can afford it. We also believe that we
cannot assume Asian countries will react
rationally when US consumption slows. It is
unclear whether Asian countries will try to
devalue their currencies even further in a
desperate attempt to continue to sell to the
United States, even at a loss. Governments in Asia
may be more interested in political stability -
presumably achieved through economic stability -
rather than internal transformation. Some argue
that Asia would be better off if the region
deployed its massive labor force to focus on
internal growth rather than feeding the US
consumer. While that may be the case long-term,
political leaders are afraid of the transition: if
its largest customer, the US, were to diminish in
importance, the void would pop some of the bubbles
that years of over-expansion have caused within
Asia.
What does this all mean for the
dollar? We believe the dollar continues to be at
serious risk as the balance of payments between
the United States and the rest of the world is
unsustainable and further escalating. Currently,
foreigners have to purchase more than $2 billion
worth of US denominated assets each day just to
keep the dollar from falling. Until a year ago,
many of these purchases were direct purchases of
US government securities. Over the past year, a
shift to direct investments has taken place; the
highest profile move was China's failed attempt to
purchase US oil firm Unocal. As China is rebuffed
from securing its future resource needs in the US,
it has moved to purchase resources in other
regions in the world. Not only is China
diversifying away from US dollar assets, more and
more governments openly talk about moves to
diversify their dollar holdings. As countries look
for alternatives to the US dollar as a reserve
currency, gold and the euro are gaining a higher
profile. We also believe countries will intensify
dealing in the local currencies of their trading
partners. For example, as China wants to diversify
its export market, it may acquire more euros to
subsidize its sales to the region; conversely, as
China is going to get ever-more resource hungry,
it will engage in more trade with resource rich
countries, notably Australia and Canada.
If US consumption drops, there might be a
drop in the trade deficit. A lower trade deficit
will require fewer purchases by foreigners of US
dollars. However, a drop in the trade deficit may
not be enough to support the dollar. The United
States next year will pay more to foreigners in
interest charges on its own debt than it receives
in interest. With US debt growing rapidly,
interest rates rising and much of US debt in
short-term securities, this will have a negative
impact on the balance of payments. Also, if - as
we suspect - US consumption slows just as the
housing market enters a more-serious decline,
foreigners may be less willing to invest in US
assets. We do not believe the fundamental pressure
on the dollar will go away unless and until
policies are put in place to foster savings and
investment rather than consumption. In the short
term, an already negative US savings rate may
decline further as this winter's higher heating
costs will surprise many. This will be offset in
the medium term by an inability to extract further
equity from refinancing; US credit card companies
are also about to double the minimum payment
required on outstanding balances, which may
provide short-term relief to the reported savings
rate. For now, consumers continue to believe that
their real earnings will grow and have refused to
cope with reality.
In the meantime, expect
inflationary pressures to continue to build, just
at a time when the US economy is slowing.
