dr. ed’s investment insightsthanksgiving day parade. this could be a problem for managing the...

OUTSIDE THE BOX Dr. Ed’s Investment Insights

OAK ASSOCIATES, ltd.

Dr. Ed Yardeni Chief Investment

Strategist

November 22, 2004 THANKSGIVING Thanksgiving is the time of the year when many of us remark how quickly the year has passed by. For most stock investors, the sooner this year ends the better, as long as next year is a better year for the market. I think it will be. Furthermore, 2004 isn’t over just yet. My year-end target is still 1200 for the S&P 500. My target for next year is 1300. We all have plenty to give thanks for, and I am optimistic that the list should include better returns for stock investors through the end of next year. Turkeys. Of course, Thanksgiving is a bad day for turkeys. On the other hand, according to The Stock Trader’s Almanac 2005, “For 35 years, the combination of the Wednesday before Thanksgiving and the Friday after had a great track record, except for two occasions….The best strategy seems to be going long into weakness Tuesday or Wednesday and staying in through the following Monday or exiting on strength.” On Friday, November 19, a few days before Thanksgiving, there was plenty of weakness in the stock market as fears about the outlook for inflation were raised by a jump in the price of oil and weakness in the U.S. dollar. Fed Chairman Alan Greenspan contributed to the dollar sell-off when he warned that the U.S. current account deficit is a big problem:

The question now confronting us is how large a current account deficit in the United States can be financed before resistance to acquiring new claims against U.S. residents leads to adjustment. Even considering heavy purchases by central banks of U.S. Treasury and agency issues, we see only limited indications that the large U.S. current account deficit is meeting financing resistance. Yet, net claims against residents of the United States cannot continue to increase forever in international portfolios at their recent pace. Net debt service cost, though currently still modest, would eventually become burdensome. At some point, diversification considerations will slow and possibly limit the desire of investors to add dollar claims to their portfolios. Resistance to financing, however, is likely to emerge well before debt servicing becomes an issue, or before the economic return on assets invested in the United States or in dollars more generally starts to erode. Even if returns hold steady, a continued buildup of dollar assets increases concentration risk. Net cross-border claims against U.S. residents now amount to about one-fourth of annual U.S. GDP. A continued financing even of today's current account deficits as a percentage of GDP doubtless will, at some future point, increase shares of dollar claims in investor portfolios to levels that imply an unacceptable amount of concentration risk.

This situation suggests that international investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing of the U.S. current account deficit and rendering it increasingly less tenable. If a net importing country finds financing for its net deficit too expensive, that country will, of necessity, import less.1

The balance of payments always balances. The trade deficit will always be offset by private and official (i.e., foreign central bank) capital inflows. Mr. Greenspan worries that this balancing act may soon require interest rates to rise enough to attract foreign investors. In last Friday’s speech, he didn’t mention that a weaker dollar might also boost inflation by pushing up import prices, thus forcing the Fed to raise the federal funds rate. However, stock market traders understood the consequences and sent stock prices lower that day. Together They Gather. Pessimists can give thanks to the Fed Chairman for siding with them on the issue of the twin deficits (Figures 1). He believes that the best way to reduce the current account is to narrow the federal budget deficit: “Reducing the federal budget deficit (or preferably moving it to surplus) appears to be the most effective action that could be taken to augment domestic saving.” He also favors policies that might induce more personal savings. Unlike the dollar doomsayers, Mr. Greenspan is not convinced that this must all end badly: “But should such initiatives fall short, the marked increase in the economic flexibility of the American economy that has developed in recent years suggests that market forces should over time restore, without crises, a sustainable U.S. balance of payments.” The Fed Chairman also worries about the rapidly deteriorating international investment position of the United States. By the end of this year, foreigners will own at least $3 trillion more in U.S. assets than Americans will own abroad (Figure 2). He is concerned that the stream of debt servicing and repatriated profits flowing overseas could become a river, worsening the structural balance-of-payments problem. Chinese Menu. The Calamity Crowd also expects that the Chinese authorities will soon have no choice but to stop pegging their exchange rate to ours and let their currency appreciate relative to the dollar. I agree. When the renminbi depreciates along with the dollar, import prices will rise in China. China imports lots of food and energy commodities, which have much greater weights in China’s CPI than in ours. American economists frequently focus on the core CPI, excluding food and energy. In China, food and energy prices are the CPI. Over the past 12 months through October, China’s CPI was up 4.3%. A year ago, the inflation rate was 1.8% in China. By comparison, the CPI in the United States rose 3.2% over the past 12 months through October. Excluding food and energy, it was up only 2.0%.

1 Remarks by Federal Reserve Chairman Alan Greenspan at the European Banking Congress 2004, in Frankfurt, Germany, on November 19, 2004. The transcript is available online at http://www.federalreserve.gov/boarddocs/speeches/2004/20041119/default.htm.

OAK ASSOCIATES, ltd. / November 22, 2004 / Outside The Box www.oakassociates.com

http://www.federalreserve.gov/boarddocs/speeches/2004/20041119/default.htm

If the Chinese let their currency appreciate, that would help to moderate inflation in China. On the other hand, it could boost inflation in the United States by raising the prices of imports from China. According to the Calamity Crowd, this might push U.S. bond yields higher, especially since the Chinese central bank would be cutting its purchases of U.S. Treasuries. Even worse, as soon as the Chinese revalue, “hot” money—which has poured into China betting on this event—might spill right out after the anticipated event. This could burst the China Bubble, in the opinion of the most extreme naysayers. In other words, the Chinese have only two unpalatable choices on their menu. They can continue to peg, which would drive up inflation and interest rates if the dollar continues to plunge. Or they can let their currency appreciate, which might trigger a banking crisis. Mr. Greenspan discussed these options in a speech at the end of last year:

No one truly knows whether easing or ending of capital controls would ease pressure on the currency without central bank intervention and, in the process, also eliminate inflows from speculation on a revaluation. Many in China, however, fear that an immediate ending of controls could induce capital outflows large enough to destabilize the nation’s fragile banking system. Others believe that decontrol, but at a gradual pace, could conceivably temper such concerns.2

Feast Versus Famine. So what do I think? I think the pessimists need a vacation. They’ve worked too hard this year. They need a break. We can certainly use a break from them. The solution they offer to solve the twin deficit problem is a starvation diet. I am all for starving the federal government by putting a lid on public spending. I am not for raising taxes until government revenues match government spending. That would slow consumer spending on everything, including imported goods, thus narrowing the trade deficit. A recession would certainly fix the trade deficit. It would also cause the federal deficit to widen again because higher taxes on falling incomes would most likely depress government revenues. This is exactly what happened over the past few years. It was the large tax cuts of 2003 in combination with easy monetary conditions that revived the U.S. economy in 2003 and 2004 (Figures 3 and 4). Now, over the past several months, tax revenues are starting to rise and the federal deficit is narrowing (Figures 5 and 6). In other words, prosperity is a much better fix for the federal deficit problem than is a recession. As Thanksgiving approaches, let’s choose feast rather than famine. Prosperity won’t make the federal deficit go away, but it should help to narrow it in 2005. There remains a structural spending problem, which requires caps on spending growth,

2 Remarks by Federal Reserve Chairman Alan Greenspan before the World Affairs Council of Greater Dallas, in Dallas, Texas, on December 11, 2003. The transcript is available online at http://www.federalreserve.gov/boarddocs/speeches/2003/20031211/default.htm.


http://www.federalreserve.gov/boarddocs/speeches/2003/20031211/default.htm

especially for entitlement programs like Social Security. Spending growth is bound to drop as benefits are scaled back over the next few years. Social Security should be an insurance program to help the unfortunate, not the fortunate. As Jim Oelschlager, my colleague and the Sage of Akron, says: “From those who have received much, much is expected.” What about the current account deficit? It is our gift to the rest of the world. If we didn’t cut taxes, if we didn’t stimulate our economy, then the global economy would still be in a recession. The simple fact is that Americans “do” prosperity better than other leading industrial economies. We share our prosperity by buying so many goods and services from foreigners. They prosper as we prosper. As they become wealthier, they need to invest their wealth in high-quality, liquid capital markets. Naturally, they invest in the United States. Some view this as a huge “imbalance” that needs to be corrected. I see a balance, though I agree that it might not be sustainable forever. Like the Fed Chairman, I believe adjustments will happen gradually rather than calamitously. The best solution for the U.S. current account deficit is more prosperity and more spending in places like Europe, Asia, Latin America, the Middle East, and Africa. The prospects for this scenario are very bright in Asia and Latin America, not as bright in Europe, and dim in most of Africa. Higher oil prices are boosting prosperity in the Middle East. Floating In The Parade. The weather forecast is that it could be windy during Macy’s Thanksgiving Day Parade. This could be a problem for managing the balloons. The floats, however, will move forward despite the weather. The dollar has been floating steadily downwards since early 2002. The Fed’s measure of the trade-weighted dollar is down 29% from its peak in late 2001 through November 19, 2004.3 In other words, the dollar has already plunged considerably without unleashing the global financial crisis predicted by several doomsayers. The press reports that the euro is at a record high of $1.30. That’s true, but we can also create a synthetic euro prior to January 1, 1999, when it replaced the national currencies of Europe. This measure peaked around $1.35 in 1995 and $1.50 in 1992. I don’t recall any currency crises at either times (Figure 7). I wouldn’t be surprised to see the euro retest and hold the $1.50 level in 2005. This would be another confirmation that my “1990s Replay Scenario” remains a useful script for investors to follow.

3 This index includes Switzerland, Germany, Japan, France, the United Kingdom, Canada, Italy, the Netherlands, Belgium/Luxemburg, Sweden, Spain, Ireland, Austria, Finland, Portugal, and Australia. Notice that China, India, Mexico, Brazil, and the oil exporters of the Middle East are not included in the index.


A Hearty Appetite For U.S. Securities. It is true that the decline in the dollar would have been more precipitous but for huge foreign central bank purchases of U.S. Treasuries. Over the past 12 months through September, the U.S. federal budget deficit and the U.S. merchandise trade deficits were $412.3 billion and $606 billion, respectively. Foreign official dollar reserves held in U.S. Treasuries rose $259 billion over this period, thus financing 63% and 43% of the budget and trade gaps, respectively. Treasury securities purchased by all foreigners, including both private and official accounts, financed nearly all the U.S. budget deficit over the past 12 months (Figure 8). As a result: 1) Foreign official assets in the U.S. rose to a record $1.3 trillion in October (Figure 9). 2) Foreigners own 45% of the U.S. federal debt held by the public. Foreign central

banks are holding nearly a quarter of this debt (Figure 10). Over the past three months through September, there has been a noticeable slowing in foreign purchases of U.S. Treasuries, especially among Asian investors. This caused some foreign exchange market observers to sound the alarm. The situation is less alarming if we observe that over this same period, foreign demand for U.S. corporate bonds rose to a record high of $396 billion, at an annual rate (Figure 12). The fact is that we should be thankful that foreign investors continue to have a huge appetite for U.S. securities. They bought $838 billion of them over the past 12 months through September (Figure 12). Plenty Of Liquidity On The Table. There is a very strong inverse correlation between the yearly percent change in the trade-weighted dollar and the yearly percent change in foreign official dollar reserves (Figure 13). This makes sense, and it is a major transmission mechanism that links the economies of the world. It explains today’s global synchronized boom. To revive the U.S. economy from the recession of 2000-2002, U.S. policymakers provided very stimulative monetary and fiscal policies. As the economy recovered, the current account deficit swelled because Americans purchased more goods and services from foreigners than they purchased from us. The downward pressure on the dollar started to build in early 2002 and was somewhat reduced by aggressive foreign central bank purchases of the dollar. Foreign official dollar reserves are up 29% over the past 52 weeks through November 11 (Figure 13). This significant increase in global liquidity explains how America’s stimulative policies caused the present global synchronized boom. This boom is very visible in industrial commodity prices and in the U.S. PPI for crude goods and for Intermediate Goods (Figure 14).


We should give thanks for the global boom. Prosperity isn’t a zero-sum game. It is something that can be and should be enjoyed by all. We should give thanks that the weak dollar and the flood of global liquidity have averted deflation, without putting much upward inflation pressure at the front end of the PPI, i.e., for finished goods (Figures 14 and 15). I thank you, my readers, for your interest in my thoughts on the economy and financial markets. I wish you and your family all the best during the holiday season and the coming New Year. The years go by so fast.

* * * The opinions expressed herein are those of Oak Associates, ltd. and are subject to change without notice.


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TWIN DEFICITS(billion dollars, 12-month sum)

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Source: U.S. Department of Commerce, Bureau of the Census, and the Treasury Department.

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Figure 1.

U.S. trade deficit rises to record high as cost of oil imports soars. U.S. federal budget deficit is starting to narrow.

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U.S. PUBLIC DEBT VS. NET INTERNATIONAL INVESTMENT POSITION(trillion dollars)

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2004e

Source: U.S. Bureau of Economic Analysis, Federal Reserve Board’s Flow of Funds Accounts.

yardeni.com

Figure 2.

U.S. Public Debt held by the public soared to $4.3 trillion in October. Government’s (bogus) IOUs to itself (mostly Social Security Trust Fund) rose to $3.1 trillion. Foreigners own $3 trillion more in U.S. than Americans own abroad.

- Twin Deficits -

/ November 22, 2004 / Outside The Box

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Source: U.S. Treasury Department.

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Figure 3.

U.S. federal budget deficit is starting to narrow as outlays growth slows while tax receipts are picking up along with the economy.

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U.S. FEDERAL BUDGET BALANCE(billion dollars, 12-month sum)

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Figure 4.Figure 4.

- U.S. Federal Budget -


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PERSONAL INCOME: TRANSFER PAYMENTS VS. PERSONAL TAXES(billion dollars, saar)

Transfer Payments*

Personal Tax and Nontax Payments

* Mostly social benefits provided by both federal and state & local governments, including old-age, survivors, and,disability insurance as well as hospital insurance and Medicaid.Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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Figure 5.

Almost all of the U.S. federal budget deficit can be attributed to the big gap between transfer payments received by individuals from the government and personal taxes paid.

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U.S. FEDERAL BUDGET DEFICIT & PERSONAL INCOME(billion dollars, 12-month average)

U.S. Federal Budget Deficit

Personal Income: Transfer PaymentsLess Personal Taxes

Source: U.S. Department of Commerce, Bureau of Economic Analysis, and the U.S. Treasury Department.

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Figure 6.Figure 6.

- U.S. Federal Budget -


Figure 7.

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TRADE-WEIGHTED DOLLAR*(1973=100)

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U.S. DOLLAR / EURO**(inverted scale)

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JAPANESE YEN / U.S. DOLLAR

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11/22GOLD PRICE (dollars per ounce)

* Includes Switzerland, Germany, Japan, France, United Kingdom, Canada, Italy, the Netherlands, Belgium/Luxembourg, Sweden, Spain, Ireland, Austria, Finland, Portugal, and Australia.** On January 1, 1999, the euro was introduced. On that date, the exchange rates of the participating currencies were irrevocably set. Data prior to 1999 are derived from European currencies. Source: Board of Governors of the Federal Reserve System, Morgan Stanley Capital International, and Reuters America Inc.

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- U.S. Dollar & Gold -


Figure 8.

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FOREIGN PURCHASES OF U.S. TREASURIES(billion dollars)

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U.S. FEDERAL BUDGET DEFICIT & FOREIGN OFFICIAL CAPITAL INFLOWS(billion dollars)

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* Held in custody for foreign official and international accounts at the Federal Reserve.Source: Bureau of Economic Analysis, Board of Governors of the Federal Reserve System, and U.S. Department of the Treasury, Office of International Affairs.

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- Foreign Purchases of U.S. Treasuries -


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FOREIGN OFFICIAL ASSETS IN U.S.*(billion dollars)

U.S. Treasuries*

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* Data from 1952 to 1996 are foreign official assets held at the Fed in U.S. Treasuries. From 1997 to the present,data are marketable U.S. Treasury securities held by the Fed for foreign and international accounts.

** Data from 2000 onward include federal agency securities.Source: Board of Governors of the Federal Reserve System.

yardeni.com

Figure 9.

Foreign official assets in the U.S. (i.e., mostly the dollar reserves of foreign central banks) rose to record high of $1.3 trillion in October.

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Q2U.S. FEDERAL DEBT HELD BY FOREIGN INVESTORS(as a percent of total federal debt held by the public)

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ForeignCentral Banks*

* Data from 1952 to 1996 are foreign official assets held at the Fed in U.S. Treasuries. From 1997 to the present,data are marketable U.S. Treasury securities held by the Fed for foreign and international accounts.Source: Federal Reserve Board, Flow of Funds Accounts.

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Figure 10.

Foreigners own nearly 45% of U.S. federal debt held by the public with foreign central banks holding nearly a quarter of this debt.

- Foreign Official Assets In U.S. -


Figure 11.

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NET SECURITIES PURCHASED BY FOREIGNERS FROM U.S. RESIDENTS(billion dollars)

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SepAsia____

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___________Rest of World

Source: U.S. Department of the Treasury, Office of International Affairs.

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- U.S. Capital Inflows: Treasuries -


Figure 12.

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NET SECURITIES PURCHASED BY FOREIGNERS FROM U.S. RESIDENTS(billion dollars)

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_______________________U.S. Corporate Stocks: Total

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Sep_____________________________U.S. Treasury Bonds & Notes: Total

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Source: U.S. Department of the Treasury, Office of International Affairs.

- U.S. Capital Inflows: Total -


Figure 13.

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FOREIGN OFFICIAL DOLLAR RESERVES & THE DOLLAR(yearly percent change)

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Yen/US $

* U.S. marketable securities held in custody for foreign official and international accounts at the Federal Reserve. Monthly data from 1952 to 1987 include only U.S. Treasury securities. Weekly data from 1988 to present include U.S. Treasury and federal agency securities.

** On January 1, 1999, the euro was introduced. On that date, the exchange rates of the participating currencies were irrevocably set. Data prior to 1999 are derived from European currencies.

Source: International Monetary Fund International Financial Statistics and Board of Governors of the Federal Reserve System.

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- Foreign Official Dollars & Currencies -


Figure 14.

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FOREIGN OFFICIAL DOLLAR RESERVES & PPI INFLATION(yearly percent change)


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PPI: Intermediate Goods

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PPI: Finished Goods**

* U.S. marketable securities held in custody for foreign official and international accounts at the Federal Reserve. Monthly data from 1952 to 1987 include only U.S. Treasury securities. Weekly data from 1988 to present include U.S. Treasury and federal agency securities.

** Excluding food and energy.Source: U.S. Department of Labor, Bureau of Labor Statistics and Board of Governors of the Federal Reserve System.

yardeni.com

- Foreign Official Dollars & PPI -


Figure 15.

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06-30

-20

-10

0

10

20

30

40

-30

-20

-10

0

10

20

30

40

Oct

Oct

TRADE-WEIGHTED DOLLAR & PPI INFLATION(yearly percent change)


PPI: Crude Goods

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06-4

-2

0

2

4

6

8

10

12

14

16

18

-30

-20

-10

0

10

20

30

40

Oct

Oct


PPI: Intermediate Goods

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06-2

0

2

4

6

8

10

12

14

16

-30

-20

-10

0

10

20

30

40

Oct

Oct


PPI: Finished Goods*

* Excluding food and energy.Source: U.S. Department of Labor, Bureau of Labor Statistics and Board of Governors of the Federal Reserve System.

yardeni.com

- Trade-Weighted Dollar & PPI -


Copyright (C) Dr. Edward Yardeni 2004. All rights reserved. Theinformation contained herein has been obtained from sources believedto be reliable, but is not necessarily complete and its accuracy cannot beguaranteed. Any opinions expressed are subject to change without notice.

Additional Information Available on Request.

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