07/05/2001 Breaking the Speed Limit *

Global financial markets took a decided turn for the worst this week, with severe stress enveloping emerging markets from Latin America, to South Africa, to Eastern Europe. With a major crisis in Argentina seemingly coming to a head, related tumult in Brazil, Chile and throughout the region, and ongoing crisis in Turkey, there are myriad specific problems hampering the markets. The Brazilian real dropped 5% this week, the Polish zloty 4%, and the Turkish lira 3%. Derivative markets are now signaling a major devaluation in Argentina. Even the market for the Hungarian forint, a previously strong currency, this week faltered in illiquidity. This does increasingly have all the signs of a major systemic issue for the global financial system. The first casualties, as is typically the case, are the emerging markets. When the emerging market dislocation runs its course, we will then see how the marketplace deals with a fundamentally vulnerable U.S. dollar.

It was a dismal week for global equity markets. Stocks in Argentina were hit for 8%, with Brazil sinking 5%. Technology stocks were hammered globally, with Asian and European markets performing poorly. Japan’s Nikkei dropped 5% to 12,306, its lowest level since March. Here at home, the Dow dropped 2% and the S&P500 declined 3%. The Transports lost 3%, with the Morgan Stanley Cyclical and Morgan Stanley Consumer indices both declining 1%. Safe haven buying fueled the Utilities to a 2% advance. The broader market was quite weak, with the small-cap Russell 2000 sinking 6% and the S&P400 Mid-Cap index dropping 3%. The technology sector was pummeled, with the NASDAQ100, the Morgan Stanley High Tech, the Semiconductor, and The Street.com Internet indices all slammed for about 9%. The NASDAQ Telecommunications index sank 7%, while the Biotechs dropped 8%. Financial stocks were under pressure as well, with the S&P Bank index declining 2% and the Securities Broker/Dealer index sinking 5%. Despite a $5 dollar decline in gold, the gold stocks generally held their own.

Global financial turbulence worked to the advantage of the U.S. credit market, with short-dated Treasuries performing strongly. For the week, 2-year and 5-year Treasury yields declined 10 basis points to 4.13%, and 4.85%, respectively. A steepening yield curve saw the key 10-year decline only 4 basis points to 5.37%, while long-bond yields dipped 2 basis points to 5.74%. Mortgage-back yields generally declined 7 basis points and agency yields 5 basis points. The 10-year dollar swap spread narrowed 3 to 87. U.S. spreads were generally little changed, while emerging market spreads widened significantly. Despite today’s rally, Argentina bonds have been under heavy selling pressure. Short-term interest rates jumped from 18% to 22.5% in Brazil, as higher rates were seen as necessary to support its faltering currency.

For this holiday-shortened week, we will take a smorgasbord approach to data indicative of a highly imbalanced U.S. economy, with increasingly fragile financial systems at home and abroad, and try not to yell "fire" too loudly. Until proven otherwise, we’ll go with the assumption that "things are happening," and work diligently to monitor "hot spots" and stay on top of unfolding developments. From Moody’s: "around $55.9 billion of new dollar-denominated bonds were sold last month, compared to the $76.1 billion of May. June monthly totals are still a bit shy of average $64 billion sold per month in the first five months of the year but tower over the $31 billion average monthly sale of last year." We will be monitoring new issuance data carefully going forward for indications of faltering liquidity.

According to Bloomberg, first half municipal bond sales totaled $133.5 billion, a 39% increase from last year. And while two-thirds of this volume was related to refundings, financings for new public projects jumped 16%. Tuesday, the Commerce Department reported construction spending at an annualized rate of $882 billion during May, up 8.3% y-o-y, with y-t-d spending running 7% above last year. Expenditures on public projects increased 25% year over year, with public housing up 50%, education 31%, roads 22%, "conservation" 50%, sewer systems 22%, and water supply 33%. From Bloomberg: "Builders are doing well in part because of federal aid. The Transportation Equity Act for the 21st Century, enacted in June 1998, provides as much as $218 billion for road, transit and airport projects beginning in fiscal year 1998 through the end of fiscal year 2003, according to the Federal Highway Administration. That compares with $155 billion in the previous six-year plan." According to the chief economist of the American Road and Transportation Builders, $19.1 billion of new highway and bridge contracts were awarded last month, up 8% y-o-y.

Private construction spending was up 4.3% in May from year ago levels, led by an 8% increase in multi-family housing, and a 9.9% increase in home improvement spending. It is notable, however, that private non-residential spending has slowed markedly, with spending only slightly above last year’s level. Spending on new office buildings during May was flat year over year, while industrial projects were down 7%, and hotels/motels sunk 14%. Year-to-date, spending on office construction has been running up 15% and industrial up 8%, while hotel/motels has declined 9%. There is no doubt years of overbuilding and unsustainable bubble-period demand are beginning to come home to roost in commercial real estate markets throughout the country, especially in the major technology centers. From Bloomberg: "In the commercial real estate industry, developers are feeling the pains of the economic slowdown and poor conditions in the computer and Internet industries. San Francisco’s office vacancy rate has risen to its highest level since the 1990-1991 recession as Internet-related, legal and advertising firms cut back on space…Almost 10 percent of the office market is vacant, up from 7.6 percent in the first quarter, according to broker Grubb & Ellis Co. ‘It’s as close to a collapse as one can get,’ said Leland Whitney, managing principal broker of Whitney Cressman Ltd." It is our understanding that published vacancy rates, often not taking into account newly available sublease space, are understating office vacancy rates, and in some cases significantly.

Pardon the detail, but I continue to find the U.S. automobile market both fascinating and illuminating of what I see as continued bubble economy excess. During June, sales came in at a very strong seasonally adjusted annualized pace of 17 million units, 500,000 above estimates and only slightly below last year’s 17.1 million. Analysts have now significantly underestimated sales every month this year, as an expected slowdown failed to materialize. From a top Toyota executive: "The strong, steady pace of consumer spending continues to drive industry sales. In spite of the downturn in other key sectors of the economy, the auto industry could well achieve its third-best sales year ever."

Toyota enjoyed its best June on record, with sales surging 20% from last year. The company concluded its best second quarter on record and best first half. Light truck sales were up 44% year over year. It was also a record June for Lexus, with sales up 18% (up 17% year-to-date). It was a record June for Honda, with sales up 7%. Honda’s luxury Acura division saw sales up 23%, with y-t-d sales up 25%. It was Honda’s best month ever for light truck sales, and the stock was rewarded this week with a record price in Tokyo. June BMW sales were up 32% (y-o-y). Year to date, BMW has recorded sales of 107,257, 21% above last year. From a top BMW executive: "It took almost a full year for BMW to sell 100,000 units in 1996, the first time we accomplished this achievement. Since then, our sales volume has nearly doubled and this year, we’ve hit that mark in less than six months." Volkswagen had its best June since 1973 (up 3%), while Audi (up 35%) and Subaru (up 24%) enjoyed their best June’s. Volvo sales increased 14% and Mazda sales were up 12%. The Korean manufacturers continue to do exceptionally well. It was the best month ever for both Hyundai and Kia, with sales up 36% and 31%, respectively.

Ford sales declined 8%, although it was a record month for Explorer sales. GM sales were down about 3%, with weak car sales offset by a 9% increase in truck sales. DaimlerChrysler sales actually increased over 1%. "Big Three" market share declined to 63.9% from last year’s 66.7%. The Japanese share increased from 24.3% to 25.9%. While total industry car sales were down 3.5% during June, light truck sales were up 4.3%. To put total industry sales data in perspective, it is interesting to note that last month’s 17 million rate compares to an average of 14.67 million units for the three "pre-bubble" years 1995 to 1997. The June sales rate then increased to 16.7 million in ‘98, 17 million in ‘99, and then 17.1 million last year. Bloomberg quoted a sales analyst from Ford: "We still have 4.3 percent unemployment, incomes are growing faster than inflation and manufacturers are tripping over themselves to provide consumers with generous pricing. It’s an unbeatable combination." It certainly appears that way.

This week the Commerce Department reported a 0.3% increase in May Personal Spending, along with a 0.2% increase in Personal Income. Year over year, consumption is running up 5.6%, led by a 6.4% jump in spending on services. Expenditures on Non-Durables are up 4.9%, with a 3.3% increase in spending on Durables. This data becomes more illuminating with a little digging below the surface. May’s annualized spending totaled $7.074 trillion, comprised of $4.144 trillion (59%) spent on Services, $2.092 trillion (29%) on Non-Durables, and $838.8 billion (12%) on Durables. Personal spending has jumped $875 billion (14%) during the past two years, and an incredible $1.852 trillion (35%) over the past five years. During this extraordinary five-year borrowing and spending boom, expenditures on Services has increased $1.12 trillion (37%), Non-Durables $521 billion (33%), and Durables $212 billion (34%).

Recognizing the significance of non-manufacturing, it is worth noting yesterday’s report that the National Association of Purchasing Management’s non-manufacturing index jumped to a much stronger than expected 52.1 (expectations of 47; above 50 indicates growth) from last month’s 46.6. The orders index increased from 48.6 to 53.1. The non-manufacturing sector is certainly where we are on the watch for heightened pricing pressures. From Bloomberg: "During the first quarter of 2001, property/casualty net premiums written showed the strongest growth since the tail end of the last hard market in the second quarter of 1987. This growth was fueled by robust price increases in both the reinsurance and primary Commercial-lines markets, according to an A.M. Best Co…Even personal-lines premiums began to show improved volume growth, as rate increases were implemented in the nonstandard market. A.M. Best data shows that net premiums written rose 11% over the comparable quarter of 2000..."

It remains my humble opinion that most analysts continue to overstate the influence of manufacturing on the general U.S. economy, while understating the role that has come to be possessed by the behemoth U.S. service sector. Similarly, it is conventional wisdom to view "production" as the theoretical epicenter of an individual economy’s performance, the sector creating the "wealth" that is the natural driving force behind, in this case, the U.S. service sector. Such perspective leaves one today with an analytical disadvantage. While I certainly do appreciate the tremendous importance and wealth creating capacity of a vibrant manufacturing sector, it is simply not the leading economic force today. The U.S. remains in an unstable position of a protracted and historic bubble economy, driven largely by monetary excess, resulting asset inflation, and massive imports. True economic wealth creation has sadly little to do with the current U.S. illusion of sound prosperity. Instead, one should look to the $100 billion of foreign goods flowing into the country on a monthly basis, and a fateful boom held together by endemic credit excess and perceptions of $10’s of trillions of perceived financial wealth.

Now, more than ever before, the evidence strongly supports our contention that money and credit growth are the key variables determining U.S. GDP, with real estate lending and valuations most important factors. All the apparent confusion as to why the U.S. consumer continues to spend freely in the face of a sinking NASDAQ and the resulting "negative wealth effect" is clarified instantly when one views recent mortgage borrowings, consumer debt growth, and real estate prices. Most unfortunately, it truly has become a consumer and consumption-based economy. And why does the consumer keep borrowing and spending? During a boom (especially when home prices are rising!), as long as credit is made easily available to individuals, businesses or governments, it will most likely be borrowed and spent. It’s just that simple. At some point, as we are seeing in telecommunications/Internet, previous lending excesses do lead to problematic losses and an abrupt retrenchment by the lending community. It’s not that Lucent, Xerox, or the Internet companies decided to cut spending; it was that they lost access to financings. Today, the seemingly insatiable apittite for credit card and mortgage-related securities provides the consumer the virtually unlimited access to borrowings that led so many in the tech sector to trouble. As history has proven time and again, such lending excess definitely sows the seeds of its own destruction. There will be a similar retrenchment down the road in real estate and consumer lending, and it will most likely commence with financial market dislocation. Unfortunately, this is a particularly grim prospect for the consumer-based and hopelessly over-borrowed U.S. economy.

Last week’s Bulletin discussed the profound (yet somehow unappreciated) transformation of the U.S. monetary regime into a credit system dominated by security issuance, speculation, and the vagaries of the financial markets. It is my contention that such a development is much a "fair weather phenomenon" that now significantly increases the fragility of the U.S. system. The weak link in the chain could prove the U.S. dependence on enormous foreign source borrowings and our nation’s unprecedented accumulation of foreign liabilities. In light of global financial developments, this is certainly an issue worthy of attention.

On the back of an incredible $308 billion of goods imports, the U.S. ran a $110 billion current account deficit during the first quarter (for comparison, this was more than triple the $34 billion deficit during 1997’s first quarter). During this period, U.S. holdings of foreign assets increased $156.9 billion, while foreign holdings of U.S. assets jumped $237.5 billion. It is interesting to look at these separate liabilities individually, and to note the stark contrast in the type of assets accumulated by U.S. and foreign holders. Of the almost $157 first quarter increase, U.S. holders of foreign assets purchased $3 billion of bonds and $26 billion of stocks. Direct foreign investment overseas came to $33 billion. The majority of the increase in U.S. owned foreign assets is explained by the $90 billion "U.S. claims on foreigners reported by U.S. banks." For comparison, this category increased a total of $76 billion for all of 1999 and $139 billion during the full year 2000. It would be interesting to know more about this category of bank assets. Could these be loans financing (directly or indirectly) speculative U.S. security positions? Or perhaps inter-bank positions associated with global derivative trading?

As for the first quarter’s $238 billion increase in overseas holdings of U.S. assets, foreign sources purchased $41 billion in equities, and made $42 billion of Foreign Direct Investment. There was also a $7 billion increase other various holdings (including $586 million of Treasuries). Meanwhile, during the quarter foreigners purchased a record $147 billion of "U.S. Securities other than U.S. Treasury Securities." For comparison, foreign sources increased non-Treasury security positions by only $63 billion during last year’s first quarter, and $344 billion for all of 1999, and $486 billion during the full year 2000. At the minimum, this is quite a significant development from not too many years ago when foreign buyers generally focused on "risk free" Treasury securities. Let’s hope that there is no change in the risk perception for non-Treasury securities going forward. This could also prove a critical liquidity issue.

I have written often that the U.S. has for sometime enjoyed the advantageous position of "trading securities for goods." Well, never has this been more the case than it is today, as one can see from the data. Further, it is unmistakable that foreign interest in U.S. direct investment is waning, especially compared to investments in U.S. securities. This is not at all surprising considering the technology bust, the abrupt halt to productivity gains, faltering corporate profitability, and the overvalued U.S. dollar. More than ever before, the global flood of dollars emanating from the U.S. consumer comes immediately back to U.S. securities markets. The ratio of Foreign Direct Investment (FDI) to "U.S. Securities Other than U.S. Treasuries" (FDI divided by non-Treasury, non-equity securities) has decreased from 37% in 1999 and 28% in 2000, to the first quarter’s 18%. As a percentage of total increases in foreign holdings, "U.S. Securities Other than U.S. Treasuries" has increased from 1999’s 42% and 2000’s 47%, to the first quarter’s 62%. This certainly increases the future vulnerability of the U.S. dollar and financial markets. It sure has all the appearances on an enormous bubble.

I am again reminded of an "Op-Ed" piece from the Financial Times awhile back espousing the view that the SE Asian financial crisis would have not been necessary if only the enormous foreign flows into the region would have been long-term "equity" instead of short-term "Hot Money." This article, along with most analysis, completely misses the critical point: speculative "Hot Money" players, often leveraged and with "one eye on the exit," specifically choose instruments where they perceive manageable volatility and favorable liquidity. Especially in the late stages of a boom when debt levels are stretched and financial structures become increasingly fragile, the type of liabilities created by foreign flows becomes a crucial issue and should be monitored closely.

As such, most recent foreign capital flow data into the U.S. is particularly discouraging. The data appears to confirm our view that the U.S. boom is being fueled by potentially destabilizing liabilities, likely associated more with "Hot Money" than long-term investment. The problem, of course, is that such flows are destabilizing and unsustainable. When bullish market conditions inevitably wane - the "game changes" - this "Hot Money" will head for the exit. It will be surprising if this does not become a key issue going forward, if, as I suspect, unprecedented speculative flows have been attracted specifically to play Greenspan rate cuts. As we have seen repeatedly over the past decade, markets with all the appearances of endless liquidity during the boom can falter in illiquidity almost overnight. Not only is the U.S. securities market-based credit system vulnerable to domestic liquidity issues, this enormous and growing issuance of securities to foreign holders is an increasingly risky proposition.

Yet, just like Mexico during its ‘92/’93 boom, Southeast Asia ’95/’96, and Russian ’97, there is in the U.S. today little concern as to either the quantity or "quality" of foreign flows and accumulated liabilities. Indeed, with the dollar so strong and global currency markets in increasing disarray, the perception is only solidified that the dollar is the pillar of strength and the U.S. will maintain its position as perpetual magnet for global finance. It certainly brings back memories of the complacency and amazing disregard for the acute market imbalances developing in NASDAQ during its final skyward move. Back then it was easy to scoff at our concern for what we appreciated as huge "Hot Money" speculative positions and resulting imbalances and distortions throughout this sector. But during the so-called "New Era," one could apparently ignore the explosion of margin debt and derivative-related leverage that had increasingly become the fuel for the final "terminal stage" of bubble excess.

We believe it is a problematic characteristic of contemporary financial systems to habitually feed speculative markets to wild extremes. As we saw in NASDAQ, it went to unimaginable overvaluation and then doubled in price with one final wild speculative melee. There is a great deal of financial damage inflicted during these final market dislocations. Certainly, the mammoth leveraged speculating community and proliferation of derivative trading strategies play key roles in this process. The "melt ups’ that ushered in the end of the technology bubble were exacerbated by players caught short individual stocks and the sector generally. At the same time, sophisticated derivative strategies ran amok, with a general market dislocation forcing players to aggressively purchase underlying shares to mitigate losses. Such market dynamics can quickly reverse into panic selling. With this in mind, we do not find the dollar’s rise all too difficult to comprehend. In truth, we see it in very much a similar light to NASDAQ’s unsustainable and acutely problematic divergence from underlying fundamentals. This strength in the face of the unfolding U.S. financial crisis is yet one more troubling example of the dysfunctional nature of contemporary financial systems.

I wrote a Bulletin back in January titled "50 Basis Points to Sustain the Unsustainable." I continue to believe very strongly in the validity of underlying analysis. Beginning in 1998, the U.S. boom went to significant bubble extremes, with GDP advancing 20% in three years. It is now the Fed’s intention to sustain this levitated degree of output, in what I view as a very dangerous policy error. I liken the situation to an accelerating automobile. Powered by unprecedented money and credit excess back in 1998, a U.S. economy that had come to operate at the maximum 60 mph speed limit then sprinted ahead to 80 mph. This acceleration only continued through year-2000. So the question today becomes: what speed is the automobile now traveling? What is a "safe" and sustainable speed?

And while I admittedly ponder this line of analysis, it does differentiate my views from others: I see the automobile (U.S. economy) as still traveling in an unstable manner, way beyond a reasonable "speed limit." And while others understandably focus on the rapid slowdown in U.S. growth over the past several quarters, the fact of the matter is that the country’s annual output (GDP) has maintained all previous gains and continues a slow expansion. There is also the issue of the unprecedented monetary stimulus that has again been thrown on a bubble economy, largely because of an acutely vulnerable financial system. So, is the current "speed" of GDP sound and sustainable domestically and globally? I argue that it is definitely not. Sure, there are job losses and other problems, but I certainly don’t see insufficient demand at the root of the problem (look at exceptional auto and home sales, what will likely be record mortgage lending, and continued household borrowing and spending growth!). Instead, the thus far moderate job losses are best recognized as a necessary adjustment following previous excesses and distortions - largely from the unavoidable bursting of the technology bubble. There is furthermore the issue of the overvalued dollar, and general global currency tumult, another manifestation of financial excess and distortions. The issue today is NOT insufficient U.S. growth/GDP (driving too slow), and desperate efforts to force the performance of the faltering auto will only exacerbate the worsening mechanical problems - financial fragility and global imbalances.

The critical "speedometer" variables - to be monitored for gauging the appropriate level of economic "output" (used loosely) – would today be household savings and our trade position. The current negative savings rate and prospective $450 billion current account deficits are simply unsustainable and dangerous – indicative of an economy operating much beyond a safe speed. These critical economic fundamentals, ignored for too long, will regain their deserved prominence. Looking at the "speedometer", I see the car speeding at 85 mph in a 60 mph zone. As such, current Federal Reserve policy is ill advised, as it specifically fosters continued excessive household borrowing and spending, with the precarious accumulation of domestic debt and foreign liabilities.

Last week’s Bulletin discussed the dilemma of it now taking tremendous credit growth to keep the vulnerable U.S. financial system liquid. At the same time, the acutely imbalanced U.S. bubble economy demands continuous monetary largess from both home and abroad. Is it then any surprise that this dual requirement of unrelenting monetary excess is increasingly destabilizing for markets both domestically and globally? And while the debate always seems to be focused on whether this ends in "inflation" or "deflation", the near-term predicament is one of continued extraordinary marketplace volatility, general price instability, and faltering global financial market liquidity. But, then again, what would one expect from such an historic monetary disorder? If it is not a speculative bubble pushing NASDAQ prices to the stratosphere, it is something similar inflating prices in convertibles, agency debt and mortgage-backs. If it is not a semiconductor industry capital-spending boom (followed inevitably by bust), then it will be one in the energy sector. If too much optical fiber becomes problematic, the system just redirects its efforts to build more luxury homes and office buildings. If the household sector gets burned in the stock market, no problem as long as they can turn their speculative passions to the real estate market. When emerging markets falter, speculative interest simply moves on to levitate the value of the dollar. The bottom line is that too much debt and endemic speculation are in no way compatible with a sound and stable environment.

Thus far, the U.S. has perversely benefited tremendously from its transformation to a consumption/service sector-based/bubble economy. There is, however, no example of a nation borrowing and consuming itself to sustainable prosperity. Still, such a strange beast does avail itself seductively well to extreme credit excess and asset inflation, while traditional inflationary manifestations remain generally disguised from the Fed and markets. One major problem with such a system, and its complementary unconstrained credit mechanism, is that it lacks self-regulating or correcting mechanisms. Once the car begins hurling dangerously down the road there is nothing to slow it down until it finally either has an accident or runs out of gas. When I look at the present situation, with dangerous money creation, precarious global capital flows, and global markets coming under heightened stress, there is no doubt in my mind that the U.S. bubble is running up against an increasingly untenable position. This speeding Chevy Suburban (U.S. economy) is consuming too much gas (credit and resources) and taking up too much space on the road, while the required fuel is coming increasingly from dubious sources.

This afternoon on CNBC Larry Kudlow stated that the problem today is a shortage of dollars, and that the Fed needed to "pump out more." No, the problem today, both in the U.S. and globally, is certainly not a shortage of dollars, but the consequences of years of too many dollars, too much debt, too much speculating, and the resulting dangerous maladjustments throughout the global economy and financial system. A major global crisis has been building for years, and there should be no denying that U.S. profligacy has been at the heart of major financial and economic imbalances. And for too long this dangerous situation has been either ignored or misdiagnosed. This is especially the case in the U.S., where instead of heeding repeated warning signs policymakers choose to recklessly stave off inevitable crisis with more money, credit and speculation. Perhaps things are now finally going to come to a head; it’s clearly long overdue. It does appear much of the world is increasingly impatient with U.S. self-indulgence.

For reasons both domestic and international, the U.S. economy remains today in desperate need of significant financial and economic retrenchment. Certainly, a major adjustment is unavoidable. Most unfortunately, it may take a financial market dislocation to force the issue.