Monday, October 10, 2005

More gloom and doom...

I'll briefly quote one of the Marketwatch stories mentioned below:

Investors who can overcome their myopia stand to gain huge amounts over the very long term.

These and related thoughts went through my mind when I read the most recent issue of Fosback's Fund Forecaster, edited by Norman Fosback. In it, Fosback explored developments that may not have any noticeable impact on the markets over the next week, month, or even the next year - but which could very well have a huge impact over the next several decades...

The picture that emerges is, in Fosback's words, "not pretty": Foreign opinion of the U.S. has already begun to fall markedly, and will likely continue falling. Though the downward pressure of this on U.S. investment markets will not be felt overnight, over the next several decades its impact will be profound...

In a nutshell, Fosback argues that the U.S. experience in Iraq and Katrina has eroded the world's belief in U.S. invincibility and competence. What's happening in Iraq is revealing to the world "our inadequacy of imposing a political vision on those to whom that vision is alien. Now, in the New Orleans aftermath, the world has witnessed firsthand America's extraordinary ineptitude in dealing with a purely internal, and preventable, crisis."

As a result, according to Fosback, the "American leadership mystique has been shattered." To put this another way, "the U.S. 'model' is no longer viewed by billions around the globe as the world's one best hope."

Which brings me to the venerable Stephen Roach, and his sunny outlook for today:

Hindsight is always a great luxury. This would certainly have been the year for global investors to have avoided dollar-denominated assets. While the dollar itself has held up surprisingly well, US stocks and bonds have not. Year to date, the S&P 500 is down 1.3% versus a 9.5% increase for the All-Country World ex US Index (in US dollars). Returns in Japan, Europe, and most emerging markets have been terrific. Despite all the euphoria over sustained upside earnings surprises in the US, equity returns have been hammered by a wrenching compression of multiples. US sovereign bonds have also underperformed most of their global counterparts; year-to-date returns of 1.7% on 10-year Treasuries have fallen far short of above 9% returns for German bunds and emerging market debt. Only Japanese government bonds have lagged those in the US -- hardly surprising in light of the nascent recovery in the Japanese economy.

The single most important question for global asset allocation is whether this year’s under-performance of dollar-based assets is just an anomaly, or the beginning of a multiyear trend. For what it’s worth, I suspect it’s the latter. The metrics I continue to use suggest that there has been only scant progress on the road to global rebalancing. The disparity between the world’s current account surpluses and deficits continues to widen, likely to hit a record of nearly 5% of world GDP in 2006. America’s massive external deficit of 6.4% of GDP in the first half of 2005 -- on track to account for 70% of all the world’s deficits this year -- seems set to go from bad to worse over the next year, as the US saving shortfall is exacerbated by energy-related pressures on households and Katrina-related pressures on the Federal government. And the US consumption share remains at a record 71% of GDP, well in excess of shares in Europe (58%), Japan (55%), and China (42%). The world may have woken up to the imperatives of rebalancing. So far, however, there is very little to show in the morning after.

The good news is that the laggards of the world are on the mend. Restructuring and reforms are leading the way in the surplus-saving economies of Japan and Europe. Yet it is very different in America. Suffering its greatest shortfall of domestic saving in modern history -- a net national saving rate that has averaged just 1.5% of GDP since early 2002 -- the US lacks the internal wherewithal to support investment in public goods such as infrastructure, homeland security, and a safety net for the underclass (see my 9 September 2005 dispatch, “The Shoestring Economy”). When saving-short America needs funding, it turns to the rest of the world to provide the capital. Global lenders have been delighted to so -- and, so far, have offered the flows at extremely generous financing terms insofar as the dollar and real interest rates are concerned...

America has long stood alone in embracing the “creative destruction” of corporate restructuring. The US penchant for shredding social contracts and forcing bad companies out of business is widely viewed as a unique aspect of “flexibility” that other nations were reluctant to embrace. America was the unquestioned front-runner in the global restructuring sweepstakes.

That was then. Today, the restructuring playing field has many more players than was the case in the 1980s and 1990s. That’s certainly been the case in Japan over the past several years and now appears to be so in Germany. The balance between headcount reductions and job creation is key in discerning the macro impacts of ongoing micro shifts in corporate performance. The first phase of restructuring is usually dominated by plant closings, outsourcing, and net job destruction -- a distinct negative for personal income generation and consumption. In the second phase, the balance shifts toward renewal, expansion, and net job creation -- conditions that foster a healing of consumer confidence and income generation, which eventually sets the stage for a pickup in private consumption. After a decade of restructuring, Japan may well be on the cusp of entering the healing phase. In Germany, corporate restructuring remains in the painful first phase -- although the gap between job reductions and creation has been narrowing this year. That’s usually a good leading indicator of a shift to the healing phase.

The point is that the US no longer has the restructuring story to itself -- a distinct shift from the climate of the past 20 years. Moreover, Delphi’s bankruptcy underscores the heavy lifting that still lies ahead for Corporate America and the US workforce. That, in turn, draws into question the relative restructuring premium that has benefited dollar-denominated assets over this period. Moreover, there is good reason to believe that the US model will now have to face some new and important challenges of its own -- not just the pension time bomb symbolized by Delphi but also the downside of another asset bubble, shifting political winds, new leadership at the Fed, and the inevitable current account adjustment. This spells unrelenting pressure on US-centric global growth and asset allocation.

There's probably still lots of money to be made overseas, but I tend to agree with the above 2 gentlemen; unless Americans figure out "Phase 3," there doesn't seem much point to keep money invested in the US, unless you know exactly where it's going and why.

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