In 'The End of Detroit,' Micheline Maynard chronicles the series of missteps by the three major US automakers as they have attempted to maintain their domestic market share against an onslaught of competition from the Japanese, European and most recently, Korean auto makers. I found the book particularly interesting given the role the auto companies have played in shaping a range of financial markets recently. The recent downgrade of GM and Ford to below investment grade status was the culmination of several months of substantial spread widening as the corporate bond market worked to come to terms with what the downgrade of two of the three largest corporate borrowers would mean for the high yield market. Some market commentators were quick to suggest that the US automaker woes were a reflection of a weakening overall economy and that we should be bracing for a significant global slowdown. In this view, spread widening in other unrelated sectors is not just a technical reaction to increased high yield supply, but also fundamentally justified as needed compensation for the deterioration in credit fundamentals that the entire corporate credit universe would soon face.
Maynard, however, tells a story which is for the most part very specific to the auto industry and the competitive position of the US firms within that marketplace. She argues convincingly that by focusing on high margin trucks, SUVs and minivans, the US companies ceded an important part of the market, family and economy cars, to the overseas firms. Without effectively challenging these firms in the core segments, it was only a matter of time before the US firms would get substantial competition in the higher value areas. This took place against a backdrop of a continued quality and satisfaction gap which Detroit has been unable to close.
The history of foreign firms locating manufacturing facilities in the US is also covered. Locating in lower wage, non-union states in the southern US, the Asian and European firms were able to utilize a younger labour force, without the same health care and pension costs, as well as a range of incentives that state governments were willing to offer up. This left Detroit trying to hold its market share through costly incentives such as rebates and zero financing plans, which sharply eroded profitability and conditioned consumers to wait for better and better deals.
To me, this did not sound like the equivalent of the canary in the coal mine signalling something broader and equally devastating for the US economy as a whole. While fears of slowdown were reaching their peak, we found that US consumers were buying cars at an annual rate of 17.5 million, a decent increase over the last 12 months of sales. This was followed with a very good US payroll report which showed 274,000 jobs added in April as well as substantial revisions to previous reports. Finally, continued willingness to spend on the part of the US consumer was underscored by the April retail sales report which more than made up for the weakness in March. This seems to validate the thesis that the US economy in March might have been a little weak but it was over amplified in the data due to an early Easter and colder than usual weather.
If there is an overarching theme for the economy in the Ford and GM saga, it is the role that cheap currencies have played in adding to the auto industry's problems. Maynard gives this virtually no coverage stressing the move to manufacture in the US for the US market. While I would be the first to grant that cheap foreign currencies are by no means the dominant source of their problems, almost half of the cars sold in the US by foreign firms still come from abroad, particularly those which are at the more expensive and profitable end of the product line ups. Furthermore, it is not clear how the true value added breaks out on the US manufactures of the foreign firms given that parts that include significant value added come from all over the world, particularly from the home country. This is not to criticize this approach of globally integrated sourcing and manufacturing. It has allowed the US consumer to enjoy a range of high quality low cost products. I simply make the point that as long as currencies in Asia and other parts of the world are pegged at artificially low levels or aggressively restrained by interventionist central banks, foreign firms are going to be more competitive than they If there is an overarching theme for the economy in the Ford and GM saga, it is the role that cheap currencies have played in adding to the auto industry's problems. Maynard gives this virtually no coverage stressing the move to manufacture in the US for the US market. While I would be the first to grant that cheap foreign currencies are by no means the dominant source of their problems, almost half of the cars sold in the US by foreign firms still come from abroad, particularly those which are at the more expensive and profitable end of the product line ups. Furthermore, it is not clear how the true value added breaks out on the US manufactures of the foreign firms given that parts that include significant value added come from all over the world, particularly from the home country. This is not to criticize this approach of globally integrated sourcing and manufacturing. It has allowed the US consumer to enjoy a range of high quality low cost products. I simply make the point that as long as currencies in Asia and other parts of the world are pegged at artificially low levels or aggressively restrained by interventionist central banks, foreign firms are going to be more competitive than they
Where this ranks on the list of Detroit's problems, I will leave to the automobile experts. I will, however, gladly place misvalued currencies at the top of my agenda for soothing the imbalances that currently afflict the global economy and potentially the financial markets.
A 'Walmart' economy: the US current account deficit
The fact that the US is not competitive at current price/exchange levels is glaringly obvious from the dramatic expansion of its current account deficit. In short, the rest of the world sells a lot more to the US than the US does to the rest of the world in the current "Walmart Economy." Recently, the issue started to attract a lot of attention not just in economic and policy circles but also in the popular financial press. This is not surprising given its truly historic size of more than 6% of GDP. The chart right shows the history of the US current account. As you can see, the only other time the deficit was above 3% of GDP was in the mid 1980s and that triggered a currency depreciation of 29% on a trade weighted basis in order to bring the current account into balance.
Current account deficits of this magnitude are rare for good reason. When a nation purchases goods/services from abroad, it gives the seller/creditor country its currency, which is a claim on its own nation's goods/services. If the seller/creditor nation repeatedly finds nothing that it wants to buy, the buyer/debtor nation's currency will fall relative to the seller's until its goods are attractive enough to warrant purchase. The other alternative is that the seller/creditor country may prefer an alternative to goods and services, the buyer/debtor country's stocks, bonds and real estate. These assets amount to a future claim on goods and services. As these foreign holdings grow, typically a debtor country must offer incrementally higher returns. Increased returns are needed to compensate for the increased concentration/lack of diversification risk that external asset buyers/creditor are forced to assume as these liabilities grow. Typically, asset buyers/creditors also want an increased inflation/depreciation premium given the temptation that the seller/debtor country might have to increase its own money supply and pay back its debts in depreciated currency.
Not surprisingly, the logical candidates to run large current account deficits are small countries in the process of exploiting a valuable resource base, such as productive farm land, mining/minerals or energy. Importing capital for this purpose makes sense because the opportunity has a high enough expected return to justify the increased cost of finance, which may come via expected equity returns, high real interest rates and appreciation of the currency as the resources come to market and produces future current account surpluses.
What makes the US situation so striking is that it is very far from the text book example of a very large current account deficit country. In order to fund the US's near 6% of GDP difference between what it produced in 2004 and what it consumed and invested, foreigners were willing to give the US access to at least 80% of the world's excess savings. This figure is set to rise above 6% to perhaps as much as 8% of GDP over the next three years unless the US economy slows sharply relative to the rest of the world or the dollar falls substantially in the very near term.
Continuing to run current account deficits of this magnitude will push the US net foreign debt up to levels seen when other countries have experienced foreign exchange crises.
Cars for Treasuries: foreign central bank reserve accumulation
So why is the rest of the world so eager to invest their excess savings in the US? One plausible reason might be that the returns on these investments might be seen to be exceptionally high. If this were the case, we would expect to find increased flows into the US equity market, the natural vehicle to express a view on a country's high future productivity. In fact, net equity investment by foreigners has been falling with net outflows of nearly $70 billion a year in 2003-2004. The story with direct investment is similar with net outflows of $134 billion and $80 billion in 2003 and 2004, respectively. Equity and direct investment at the end of 2004 constituted only 38% of foreign holdings of US assets. While the equity market has been experiencing net outflows, the bond market has seen large inflows. This again is not private investors aroundthe world seeking high yielding corporate securities. Rather it has been central banks around the globe, but primarily in Asia, building dollar reserves and investing them in low yielding Treasuries and agencies.
The chart right shows how the foreign interest in the Treasury market has grown to nearly 50% of the total market and almost 70% of the net new issuance. These figures are only part of the story because of the incompleteness of the data relating to Treasury holdings.
When looking at the reserve data of just the Asian central banks in 2003 and 2004, their net new accumulation is almost 90% of the net issuance by the Treasury. If other central bank reserve increases were included, it would be well over 100% of the total new issuance
Clearly, these are not risk/return optimizing private investors who see the best use of their funds to be a 4.00% 10-year government bond in a currency with a larger than 6% currency account deficit and still projected to move higher. These are other governments who are making a policy decision with respect to the value of their own currencies versus the dollar. The fact that these reserves have gone up so sharply speaks to the fact that these currencies are undervalued versus the dollar. In effect, private investors are unwilling to hold dollars whether to buy goods from the US or hold dollar denominated securities at the prevailing equity prices, interest rates and exchange rates.
Will this US consumer/foreign central bank test drive continue?
Given that central banks, not private investors, have been the marginal buyers of U.S. dollars and Treasuries, it makes sense to examine whether these institutions will continue to build reserves, effectively offering an interest rate subsidy to the US, as well as backstopping private investors, as they hold the range of dollar-denominated assets. While the vast consensus of respected academic work argues strongly that the US current account deficit must come down to a more sustainable level (usually targets of 3.0-3.5% of GDP), a few commentators have suggested that the present system of large current account deficits is sustainable over an intermediate and even longer time horizon. The most respected of these, Micheal Dooley, Peter Garber and David Folkerts-Landau, have argued in a series of papers that the current system is analogous to the international monetary order after World War II (Bretton Woods) where Europe and Japan ran pegged exchange rates to the dollar as they rebuilt amidst very high growth rates. In "Bretton Woods II", the Asian and other emerging economies have formally or informally tied their currencies to the dollar, making the judgment that the benefits of weak and stable exchange rates (higher growth/resource utilization) are greater than the costs of reserve accumulation.
While it clearly explains what has happened over the last four to five years, will this paradigm hold going forward given the changes that have taken place during this period? I would argue that there are at least four reasons why this system is unlikely to hold in its current form over the next two to three years.
First, Bretton Woods I was as much a political as an economic system. The US had a tremendous interest in rebuilding Europe and Japan as bulwarks against Communism. Later, when these regions became very competitive at the pegged exchange rates, there was a recognition that holding dollar reserves and not redeeming them for gold at the US Treasury was an important part of the Western alliance and the political/security umbrella that went with it. Even with these incentives, persistent current account deficits of a much smaller size than the US has currently spelled the end of the system and ushered in the world of floating exchange rates in 1973. It seems hard to imagine that cooperation within the Western alliance facing the threat of both the Soviet Union and China can be analogous to the US cooperating with China and the rest of Asia when it is very likely that at some point in the future it is China that becomes the chief geopolitical/economic rival to the US. Tensions are already high as the US has threatened a set of retaliatory measures if China does not change its exchange rate regime.
Second, while China may have domestic political concerns which make the growth versus reserve accumulation trade-off sensible over the intermediate term, it is hard to see why additional reserves make sense for many of the other countries in the region. Unlike China, these countries do not have endless amounts of unskilled labor which they have a political interest in occupying for reasons of social stability. The major reserve countries such as Japan, Korea, Taiwan, Malaysia, and Singapore have far less slack in their economies. Why should they want to borrow for very short terms from their own populations in their own currencies and then invest that money in Treasuries of a longer maturity? This will inevitably lead to large losses as the dollar is forced to correct as part of the current account adjustment process. Continuing to support the dollar versus their own currencies will build larger reserves and make the loss that much bigger when it ultimately arrives. This divergent interest with China should give greater incentive to allow their currencies to appreciate over time even if China tries to stick to the existing system.
Third, exchange rates which are so far removed from equilibrium distort a range of economic decisions both in the undervalued countries as well as the US. An overly cheap exchange rate encourages excess capital allocation to export industries and insufficient investment in domestic oriented sectors/infrastructure. In the US, an expensive exchange rate stands in the way of capital flowing to export sectors and has set off a consumption boom which has left the US savings rate near 1% of GDP. Additionally, the low interest rates, pegged by the massive recycling of foreign central bank reserves into Treasuries, has provided the fuel for rising asset prices in real estate, equities and fixed income spread product. This also fuels consumption as consumers feel comfortable tapping rising assets for current purchases. These misallocations have the potential to make the ultimate adjustment considerably much more painful.
Fourth, large reserve growth is hard to sterilize, particularly in China. In order to sterilize these dollar flows, the Bank of China must mop up the domestic currency by selling local currency bonds. This has been at best an incomplete process as domestic money supply has increased and spilled over into rapid expansion of credit. This creates the potential for more irresponsible lending and speculative excess, particularly in an overheated real estate market. Ultimately, it can make it hard to control inflation since these countries effectively import US monetary policy against the backdrop of faster growth and resource bottlenecks.
Does this imbalance lead to a crash?
While many see the Bretton Woods II system lasting for some time, other commentators have suggested that an imbalance of the magnitude of the US current account is bound to be resolved in a rather violent fashion. Negative outcomes usually focus on an extreme fall in the dollar which results in a fall in other US asset prices. The usual causation is that US interest rates would have to rise to give foreigners incentive to hold US debt. Higher interest rates would then have a knock on effect to other assets, such as real estate and equities. This would then lead to a fall in consumption demand which sees the US economy slow sharply, perhaps leading to a recession. Other countries would not be immune as many would be faced with the loss of their key export market against the backdrop of weak domestic demand in their own economies (Japan, Europe).
While it is true that an imbalance of this magnitude presents real risks to the global economy, the greater likelihood is that the situation can be handled without a dramatic fall in global GDP. First, while the dollar will have to fall on a trade weighted basis, and particularly versus those countries which have not seen their currencies move or which have built large reserves, this does not have to cause a sharp drop in output in either the US or the other countries. In the US, this will stimulate the tradable goods sectors and lead to more capital investment in this area. Correspondingly, the rest of the world will have to be prepared to rely more on domestic demand for their growth, meaning that more stimulative domestic monetary and fiscal policies may be needed to offset the export drag. The notion that this transition must lead to a sharp contraction is not borne out by historical examples of other adjustments.
Second, US rates will have to rise as central banks reduce their reserve accumulation and thus have a diminished appetite for Treasury and agency securities. A lower dollar will also impart some inflationary impulse from the import sectors as margins are unable to absorb the price hikes implicit in the dollar's fall.
Since import sectors are a relatively small part of the overall US economy (15%), the result is unlikely to be too onerous. Between 1995 and 2002, US inflation was between 2-3% annually. Only after the stock market crash of 2000-2002 and the events of 911 2001 did it fall below. Very stimulative policy stopped inflation from falling and has now turned it upward at a modest pace. It likely stabilizes in the 2-2.5% range as the Fed takes short rates to between 4.0-4.5% over the next year. With 2.0-2.25% real rates in the front end of the curve, the 10-year sector is likely to have a real interest rate of between 2.5 and 3.0% creating a nominal yield of 4.5 to 5.5%. Less stimulative policy/higher real rates will encourage more savings and less consumption, also an integral part of reducing the US current account deficit.
Third, major shocks to real estate and equity markets are unlikely without higher rates. In fact the current environment of rising incomes and wage gains, combined with extremely low real interest rates, is very supportive for these markets. Clearly, there are questions about valuations in both areas, particularly in many real estate markets. While I have always viewed a sharp fall in real estate prices as a major risk to my view of the economy and financial markets, I am very heartened by the historical experience of other countries that have had big real estate declines. In virtually every instance, the decline came after a substantial rise in real interest rates, something which certainly has not occurred in the US to this point.
What's around the corner for the portfolio
While the timing of the adjustment may be uncertain, I find it very hard to imagine that the US current account is sustainable at this or higher levels for any substantial period of time. The portfolio implications of this are first, we have a view that the dollar will have to fall on a trade-weighted basis particularly versus Asia, which has not borne much of the dollar depreciation so far. Additionally, the dollar's fall will likely impart some modest inflation impetus to the US economy. This is not to say that domestic slack created by a weaker than expected economy could not more than balance this, but very low real rates, which historically have been supportive of growth, do not point in this direction.
It also stands to reason that real interest rates should rise, as foreigners are asked to continue to fund the largest current account ever for a large, developed nation in the context of already very high net foreign debt levels. This would have happened already had it not been for central banks restraining their currencies versus the dollar, something which will not go on indefinitely.
Asa result, we believe current interest rates in the US are well below sustainable levels. In other areas of the portfolio, we continue to think that inordinately low US rates have compressed risk premia beyond what is reasonable over an intermediate time horizon. As a result, we are still sticking with our credit steepener. In some sense the auto companies are a good illustration of why this is structurally a good strategy. While the long term prospects of both Ford and GM are in serious question, transparency over the next 2 years makes it very unlikely that they cannot pay their creditors in that time horizon. For the vast majority of the more healthy companies, somewhat wider credit spreads for longer dated assets may come as the result of increased uncertainty or higher rates which reduce the need to reach for yield in other assets.
These concerns also underscore our fairly conservative approach to the mortgage market where we have lower than normal allocations and are focusing more on relative value within the area.
Finally, one bright spot is still likely to be emerging markets where, despite the rally, fundamentals have improved so much that many countries still offer value versus other spread product.
Drake Management LLC was originally founded by Anthony Faillace and Steve Luttrell, who previously worked together at both Pacific Investment Management Company (PIMCO) and BlackRock. Presently Drake manages over $3 billion in capital, including a multi-sector fixed income absolute return fund, a global opportunistic hedge fund, and a low volatility fixed income hedge fund.