The Great Unwind
08/15/08
The U.S. trade deficit for goods and services fell to $56.8 billion in June from $59.2 billion in May. Expectations had been for an increase of $62.0 billion. Taken by itself, today's trade figure will push second quarter GDP to roughly 2.3% and underline again, how beneficial the falling dollar had been for exporters and by extension to the economy. Export growth boomed during the quarter, increasing 4.0% month-over-month, ranking among the four strongest of the past 15 years. On a year-over-year basis, exports are up 21.1%, the best since record-keeping began in 1995. The non-oil deficit was just $20.42 billion in June, down sharply from $26.4 billion in May and the lowest in seven years. Given that the economy has increased by about $4 trillion since then, today's $20.4 billion is far smaller in comparison. The deficit as a percentage of GDP has been shrinking ever since it peaked at $67 billion in October 2005. Back then, the deficit was 6% of GDP; today it is 4.7%. The "non-oil deficit" was just $20.42 billion in June, down sharply from $26.4 billion in May and the lowest in seven years.
Perhaps the trade deficit is not going to kill this country and its currency. Perhaps it will be another disease, but excessive shopping (as many predicted for many years) and by extension imports from Asia will not worsen the trade deficit any longer. The dollar has caught on to that notion and continued to rally just as oil futures continued to tumble over the last two weeks. We predicted both in April and May and hereby claim the "broken clock is right twice a day" award. In a self-feeding process, the recent decline in commodity prices has resulted in a capital flight out of numerous asset classes whose fate was linked to commodity prices and back into dollar-based assets. Investors not only had bought commodities outright, they had bought the stocks, bonds and currencies of those countries that were beneficiaries of rising commodity prices. All of these trades are unwinding now. The big unwind of commodity-linked trades will help consumers regain a bit of purchasing power, both from the capital flight/capital repatriation into the dollar and dollar-based assets and from the commodity drop itself. Another reason for the dollar rally may be the changing international perception of the depth of the U.S. sub-prime crisis, which long ago mushroomed into the financial crisis and threatened to become the U.S. financial system crisis. It may be no coincidence that the net portfolio holdings of Maiden Lane, the limited liability company formed to acquire certain assets of Bear Stearns and to manage those (supposedly worthless) assets, increased in value in the week ended Aug. 6, according to data released late Thursday by the Federal Reserve. The portfolio holdings increased $40 million for a third consecutive week to $29.105 billion in the latest week compared to the previous week. It was the fourth consecutive increase. One might even think that Bernanke made a smart purchase. Perhaps the threat of an American Way of Life crisis was overblown, mmmmh?
Even the battered consumer refuses to become gloomier. Preliminary results of the University of Michigan's August consumer sentiment survey basically met expectations. The index increased to 61.7 from 61.2 in July and 56.4 in June, which had been the lowest reading since May 1980. The back to back increases are the first since September and October of 2006. An improvement in views on inflation boosted confidence. The consumers' one year inflation expectations fell to 4.8% from 5.1% in July, moving further away from the 28-year high of 5.2% set in May. Further improvement on this front is likely. It is ironic that the Bureau of Labor Statistics just this week reported the worst inflation data since 1991 while consumers and fixed income markets have already moved past that inflation scare. Let's have one last look at past inflation data.
Official inflation data as measured by the Consumer Price Index (CPI) have reached a 17 year high in July. However, the drastic fall in commodities since then promises better comparisons going forward. The markets have anticipated that as inflation expectations embedded in the Treasury's inflation-indexed securities have fallen to their lowest level (2.20%) since last September and close to their lowest level since January 2004. The second chart shows you the University of Michigan Consumer Confidence Index. Believe it or not, the index has bounced of the 28 year low reached in June. Looking at this ugliness of a chart, I can only think of the old Doors song and paraphrase: "They have been down so very long that it looks like up from here." The U.S. consumer is in a sour mood and in no position to help this economy through spending. Repair of household balance sheets and the repayment of debt take precedence over credit and consumption. Some call it "The Great Unwind"; others (myself included) call it deflation in the making. Regardless of your own nomenclature, what we are witnessing is the beginning of a structural downshift in US consumption. Personal consumption reached over 71% of GDP in recent years (driven by equity withdrawal from housing), against an average between 1975 and 2000 of 67%. A reversion to that mean should be expected and most likely will constitute a headwind for the next several quarters. The retrenchment of the American consumer is not only affecting the U.S. economy but the rest of the world is feeling it also. The diminished appetite for goods from abroad shows up in the cost of shipping those goods, which is reflected in the Baltic Dry Index (BDI). The BDI is a yardstick of commodity demand and, by extension, global economic growth. It has fallen 37% since hitting a record on May 20 and therefore already reflects the new frugality of the U.S. consumer. This does not mean, however, that the average American household has taken care of the problem. On the contrary. Repairing a balance sheet always takes longer than wrecking it and we can expect several years of sub-par consumption. But where there is risk, there is reward and this potential reward can be found in the banking sector. Let's look at one last indicator.
The yield difference between 10-year treasury notes and 30-year conventional mortgages is closing in on the 22 year high reached in March. This means that conventional mortgages have not been this profitable since 1986. Naturally, this reflects the distressed state of the housing market, but it also reflects the reward that can be reaped by well financed and prudent lenders. I still believe that the greatest returns for the remainder of this year can be found in the banking sector. Every excess dollar that does not go into consumption and therefore go to Asian economies, will stay in the country and will be used to pay off debt. The great unwind will benefit the banks.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
