Lesson 16: International Investment

Those of you with post-kindergarten training may or may not know that governments keep international trade statistics. Even some of our current presidential candidates know that.  These statistics are found in something called the Balance of Payments Accounts and are found at bea.gov . 

While there are two equally groovy parts to the BOP figures most politicians only know about one part of it, the Current Account. The Current Account is on the top and we wouldn’t expect those people to actually read all the way down to the bottom, right? They are busy people. Also the history of the world and the solar system has emphasized the Current Account so it would be unfair to criticize our politicians for only knowing about the Current Account.

This Current Account is where we publish statistics that have to do with exports and imports of goods and services. We sell Chevys to China and they sell rice and replicas of the Great Wall to us. It’s a cool deal. Some of our political leaders have noticed that our dear country almost always has a deficit in our Current Account. And that burns them. After all – the word “deficit” is not a nice word. If your teacher said you had deficits in your behavior, you would feel injured and probably never get a PhD in science or classical studies. This deficit in Current Account means that we are buying more stuff from other countries than they are buying from us. This is especially true of China and since we have a very long list of other issues with China, our politicians complain and sometimes cry that this deficit with China is worse than Dengue Fever and needs to be stopped.

I have written thousands of posts (I exaggerate all the time) which explain why Current Account deficits are not necessarily bad things and I don’t won’t to repeat all that minutia here. I see the Tuna is already starting to nod off.

This post is about the other part of the BOP Accounts – the part at the bottom that most people ignore. It is the part that our politicians don’t have a clue about. So you should feel very special that I am doing this for you today and send either money or JD to thank me.

The second part of the BOP account is called the Financial and Capital Account (F&C Account). What a name! Can you imagine being in the first grade and having a name like that? No wonder no one looks at this account. But this account is the coolest kid on the block and has a lot to tell us.

The F&C Account records all the financial trades between countries. We don’t usually call these import and exports – instead we talk about outflows and inflows. If China invests in America we call that an investment inflow. We like it when foreigners open up US bank accounts and when they buy our bonds, stocks, and companies. All of those financial inflows are recorded in our F&C Account. At the same time, we also like it when US citizens invest abroad. We usually call that diversification. You don’t want all your eggs in one basket and you don’t want all your investments in US bonds, stocks, etc.

When foreigners invest in America we call that an inflow. When US citizens invest abroad we call that a financial outflow. Globalization means that citizens around the world have become increasingly interested in investments both at home and abroad. 

So as a public service and hopefully for money and booze I will acquaint you with some of the financial flow numbers. Below I will refer to some numbers from a close cousin of the F&C Account called the International Investment Account or IIA (the F&C Account focuses on the one period flows between countries while the IIA reports the resulting total ownership positions). 

As it turns out, there are some looming risks associated with the IIA account that we should be worrying about. Unfortunately our leaders are playing with their bellybuttons and/or are unaware of these trends.

I went to the bea.gov web site and downloaded a spreadsheet of IIA information from 2000 to 2015. Here is some of the information from that download:

                                         2000   2007   2015

US Ownership of F. Assets   7.6    20.7    23.3   

F. Ownership of US Assets   9.2    22.0    30.6
Data is trillions of US dollars
F. stands for Foreign

This little table tells you the following:

·       Globalization of financial markets was very evident in the new century with foreign ownership more than tripling from 2000 to 2015.

·       Most of that increase came between 2000 and 2007.

·       Then the activity slowed – especially with respect to US ownership of foreign assets. After growing by $13.1 trillion in the first period, it grew by $2.6 trillion between 2007 and 2015.

·       Foreign ownership of US assets slowed as well but it still increased by almost $9 trillion between 2007 and 2015.

·       If we focus on the 2007 to 2015 time period we see a much wider gulf – foreigners owned $7.3 trillion more of us than we owned of them. Nearly all of that gap can be explained by what is called portfolio investment (in bonds and stocks). That gap was $1.6 trillion in 2000; $1.3 trillion in 2007; and then $7.3 trillion in 2015.

What’s going on? Why are foreigners so interested in our financial markets?

First, since the financial crisis, the US has done better economically than other countries. A relatively stronger economic profile means more confidence in our financial products. Think Greece, China, and Venezuela.  

Second, think US government deficits and debt that have supplied a lot of investment opportunities to both residents and foreigners. Foreigners gobbled up our huge pile of new government bonds!

Third, while foreign companies did increase their acquiring and merging with in US companies, most of the gap mentioned above came from investments in private bonds, government bonds, and equities.

Fourth, notice that despite the gap, US citizens have shown a strong and growing appetite for foreign bonds and stocks. Despite a financial crisis foreigners continued to buy US assets and Americans continued to buy foreign assets.

What do we make of all this? When the gap is favoring US assets, this implies two important things. First, people need dollars to buy US assets so this has strengthened the dollar. Second, when foreigners buy our assets this pushes our asset prices up and interest rates down. With the huge increases in national debt and the needs of firms to finance their investment projects, this asset demand from foreigners prevented our interest rates from rising/stocks falling and thus helped to keep the US economy growing.  

And this is what concerns me. What happens when things turnaround? What happens when other major countries strengthen and their assets look more desirable to global investors? What happens when our government increases its debt even more as foreigners desert US financial markets? Financial globalization made the US wealthier when the rest of the world was weak and uncertain. Financial globalization will have the opposite impact if the US grows weaker relative to Europe, Japan, China, and other countries. Our politicians have complained loudly about the Current Account Deficit. Just wait to see what happens when buckets of money leave the US to be invested elsewhere. Then we will be clamoring about deficits -- deficits in the F&C Account!  

Paying for the Privilege of Investing at a Loss by Guest Blogger Buck Klemkosky

For the first time in recorded history, many European countries plus Japan have experienced negative interest rates. Government bond yields on short-term debt as well as debt up to 10-year maturity have turned negative in many countries, including Austria, Denmark, France, Germany, Finland, Switzerland, Sweden and Japan. More than 25 percent of European sovereign bonds sell with negative yields. Those governments can sell debt and get paid by investors for doing so. For investors, buying a bond with a negative yield means you won’t get all of your money back.

There have been many periods where real rates of return (inflation-adjusted) have been negative, but this is the first time nominal rates have turned negative. For example, if $100 is lent for one year with interest of 4 percent payable at the end of the year plus principal, the nominal yield or return, assuming annual compounding would be 4 percent. If inflation was 2 percent during the year, the real yield or return would be approximately 2 percent. If inflation exceeded 4 percent, the real yield would have been negative. This has occurred  many times and places throughout the world when inflation became higher than expected. This happened in the U.S. in the late 1940s, 1970s and recently in the 2000s. Bond yields reflect inflationary expectations, so unexpected or unanticipated inflation hurts bond investors as required yields go up and bond prices down.

What happens if an investor is willing to pay $105.50 for the same bond that pays $4 interest plus $100 of principal back at the end of the year? The investor is guaranteed a $1.50 loss and a nominal yield of -1 percent. If annual inflation was 2 percent, the real yield would be -3 percent. Why would investors pay $1.50 to lend or invest $100? Has the world turned upside down or have investors just gone nuts?

Investors would not usually lend or invest money at negative nominal yields if inflationary expectations were positive. But if deflation was expected, investors could still earn a positive real return. In the above example, if deflation was 2 percent for the year, the real return to the investor would be +1 percent. Deflation is good for bond investors because they are paid back in a more valuable currency that will have more purchasing power. If it is good for bond investors, deflation is bad for borrowers as they pay back interest and principal in a more valuable currency. Deflation usually occurs when economies are not doing well so it can be a double whammy for borrowers.

Deflationary pressures have plagued Japan for nearly two decades and Europe and the U.S. more recently. If not outright deflation, most countries have experienced disinflation, the slowing down of the rate of inflation. The consumer price index (CPI), sometimes called the cost-of-living index, measures on a monthly basis the cost of a fixed basket of goods and services purchased and used by a typical consumer. Typically, food and energy are stripped out of the headline inflation number, which includes all goods and services, because of their volatility and what is left is called core inflation. The difference between headline and core inflation numbers can be significant. In the U.S. for the 12 months ending in February, the headline inflation rate was zero, while the core inflation was 1.7 percent. For the 12 months ending in January 2015, the headline inflation rate was -0.1 percent. The Eurozone and other European countries have experienced deflation in both the headline and core measures. This has prompted most major central banks to target an inflation rate of 2 percent although this target has not been met for several years now.

Low inflation, deflation and deflationary expectations have been mostly responsible for the negative bond yields. Central banks have also played a major role, especially their impact on short-term interest rates. One consequence of the financial crisis and Great Recession is that central banks have loaded banks with excess reserves, those not needed to support loans and deposits. If banks do not make loans or invest, the excess reserves build up at the central banks. In the U.S., for example, excess reserves have increased from $20 billion in 2007 to $2.6 trillion today. The Fed pays banks .25 percent annually on excess reserves but the European Central Bank (ECB) charges banks -0.2 percent as an incentive for banks to lend or invest excess reserves. This negative 0.2 percent has put downward pressure on short-term interest rates here and in Europe.

A new regulatory environment has also impacted interest rates. In the U.S., banks must pay an insurance premium to the Federal Deposit Insurance Corp. The Dodd Frank Act requires insurance on nearly all deposits even though only those up to $250,000 are insured. The net result is that insurance premiums cost banks 0.2 percent annually on each dollar deposit and can be as high as 0.45 percent for a large bank with large deposits. J.P. Morgan recently announced that they will charge up to 5.5 percent on certain deposits meaning customers pay 5.5 percent annually for the privilege of depositing money at the bank, a negative interest rate for sure. J.P. Morgan and other big banks are obviously trying to eliminate high-cost deposits by charging fees for large deposits. This has further reinforced low and negative short-term interest rates.

Another regulatory factor is the new liquidity rules banks in the U.S. and Europe must cope with. Banks must hold high-quality liquid assets equal in amount to the deposits that may run or be withdrawn in times of stress. To meet this requirement, banks are investing in U.S. Treasuries and other sovereign bonds with zero risk of default. U.S. banks, for example, own $2 trillion of U.S. Treasury bonds. European banks are doing the same. Add in the amount of sovereign bonds the central banks own or will own and there is a shortage of high-quality sovereign bonds available for other investors, putting downward pressure on interest rates. The U.S. has experienced negative interest rates on overnight borrowing using U.S. Treasury securities as collateral because of their scarcity. The ECB quantitative easing (QE) program that just started in Europe plans to purchase $1.2 trillion of European sovereign bonds over the next 18 months. Many question whether this is even possible but it surely will be a drag on European interest rates.

European interest rates are lower than the U.S. because of a weaker Eurozone economy and the start of its QE program. This is true for the corporate sector as well where European bond yields are 1.5 percent less than equivalent U.S. yields. Nestle was the first corporation to have a negative yield on its debt, prompting a new slogan, “In Nestle We Trust.” Many U.S. corporations are rushing to Europe to issue new debt in euros to take advantage of these low rates. There may be more corporate debt with negative yields in the future.

Buying a bond with a negative yield does not necessarily mean investors expect a loss. Foreign investors may buy a negative yielding bond if they think the currency the bond is denominated in will appreciate, making money on the currency change not the interest yield. The Swiss franc has been unpegged from the euro and has appreciated considerably, which is why the yield on the 10-year Swiss government bond has been negative as well as Nestle’s. The strong dollar has made investing in the U.S. more attractive and has put downward pressure on U.S. interest rates. While it guarantees a loss if a bond is held to maturity, some investors may assume interest rates will be even more negative before the bond matures enabling them to sell at higher prices prior to maturity.

It appears that investors are more worried about “return of capital” versus “return on capital” and are willing to accept negative interest rates. Given the flight to quality, investors are willing to lose a little to make sure they don’t lose a lot.

Is the bizarre world of negative interest rates coming to the U.S? Probably not as the Federal Reserve contemplates raising short-term interest rates in 2015. There is a big divergence in global monetary policies as the U.S. tightens and Europe and Japan maintain loose monetary policies. The U.S. economy is doing better than Europe and Japan so higher relative interest rates are justified. But they may not move significantly from the historically low rates that exist today. Great for borrowers but repressive for savers. But it is strange and unprecedented historically to pay someone to borrow money from you.

The AIIB -- A Gift Horse in the Mouth?

The latest popular addition to the alphabet soup of global financial institutions is the AIIB, slated to begin operations this year.  Be thankful for this abbreviation as it stands for Asian Infrastructure Investment Bank. Drink three Old Fashions (made with JD) and then say Asian Infrastructure Investment bank 17 times while doing 11 burpees. See what I mean? AIIB is much easier. The name, however, is misleading and the new politics it brings is even stranger. Like not knowing which branch of Islam is the good one, understanding AIIB can be pretty confusing.

The first confusion is the term Asian. Calling this bank Asian is like calling any team with LeBron James something other than LeBron. Cleveland Cavaliers? Really? The AIIB should be called China and her friends. China will be the main stockholder despite being joined by almost 30 other countries. Key US allies are now trying to decide whether or not to join including Australia, Japan and South Korea. Britain, Germany, France and Italy have also promised to think about joining. The objective of the AIIB is to provide project loans to developing countries. These loans will focus on building infrastructure.

Since it will have representatives from all world regions it is hard to call this bank "Asian". AIIB is another Chinese development bank. Since the US sponsors similar world financial organizations with names like the World Bank and the Asian Development Bank (ADB), everyone knows these institutions are very much dominated by the US. Thus you can see why the US  is concerned when so many countries jump on China’s latest bandwagon. Are these countries with us or China? This reminds me of the grammar school basketball court when my team was unable to recruit the tall agile kid. The US feels threatened. 

We are hearing a lot about the AIIB mostly because we worry about our basketball team. No not really. Some US officials are worried that the AIIB will somehow steal our luster. But the truth is that worrying about the AIIB and China is a lot like worrying that the new handsome kid at school is wooing your girlfriend – when the truth is that she was about to dump you anyway.

Think about how we in the US sometimes think about the World Bank and and ADB. "There they go again  -- giving away our hard-earned money to creepy countries filled with graft, corruption and people who continue to insist on speaking foreign languages."  Yes, we are sometimes very upset that our money is not used more successfully by foreigners who rarely send a thank-you card. Or who sometimes forget to pay us back what we are owed in full. We should be thanking China for risking their renminbi in these same places rather than our dollars.

You are not convinced. You are worried that China will be better at this game than we are. You are worried that China will not only help these countries invest development funds more wisely but these other countries will then be so appreciative so as to shower their new Chinese friends with bouquets of Plum Blossoms and endless deep tissue Swedish massages. China and these developing countries will then skip off into the horizon holding hands and singing songs about Mao Tse Tung.  

But think about it a minute or three. First, China is facing difficult economic challenges. Their own development plans have floundered and growth is barely half of what it used to be. And even with all the past China Kudos, the average person in that huge country earns in a year about what the average American earns in 6 weeks. Okay China has some money to lend. But please – if the money comes with Chinese advice or partnership, are we really worried about competition from them?

Second, let’s get back to the girl who wants to dump you. We are less than appreciated by many developing countries. Why? We are nice guys and we look really good in Levis and yoga pants! One reason we are not fully appreciated is that they don’t always like our advice. It’s like when Mummy tells you to do your homework before you go online to Addictinggames.com. Or when Frau Merkel lectures Alexis Tsipras on financial management. When YOU want a loan you don’t appreciate the banker telling you how to spend it. These countries often do not like the US advice that comes through world financial organizations.

So she might dump you because she doesn't appreciate your advice. But the final point is to wonder why you liked her to begin with. Okay she has blue eyes and she dances like Madonna – but maybe she just isn’t your type. Look around the world. Developing countries are not doing well financially and in many cases once prospering countries replaced past rulers with “democratically” elected dictators. Do you prefer to dance with Cuba or Argentina? Columbia or Haiti? Maybe getting dumped isn't such a terrible thing. Buck up Charlie. 

The bottom line is that some of these developing countries are dubious candidates for our affection. If China wants to lead a brigade of unsuspecting lenders to steal the affection of the developing world it might help to notice that China has little to help them with and the developing countries have little promise to improve. If we are really worried about China then we should be gleeful about the fact that the AIIB will both weaken China, its partners, and all those politically delinquent countries who seem quite unhappy with US help. It is okay -- you may now do a happy dance. 

LIBOR: The Biggest Financial Scandal Ever?

Thanks to Buck Klemkosky for being our guest blogger this week. Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article recently appeared in the Korea Times.

Barclays, a 300-year-old British Bank, just paid a $453 million fine for manipulating LIBOR. Why the big fine? LIBOR (the London Interbank Offered Rate) is the most important short-term interest rate benchmark in the world. More than $10 trillion of securities and $350 trillion of derivative contracts are tied to LIBOR. Do the math and it is easy to see what impact a 1-basis-point change (one hundredth of one percent) could have with trillions of dollars involved.

The problem is that LIBOR is not a market-based rate but one set daily by survey. Each morning at 11:00 a.m. London time, 18 banks are asked the rate at which they could borrow from other banks in 15 maturities, from one day to one year, and in 10 currencies. Thomson Reuters aggregates the rates by rejecting the four highest and lowest and calculates the average LIBOR from the remaining 10 rates. This process is repeated 150 times for the 15 maturities and 10 currencies. Once calculated, the LIBOR figures are published and disseminated throughout the world. The most important of the 150 rates is the three-month dollar LIBOR.

LIBOR acts as a benchmark or reference rate for trillions of dollars of financial securities such as credit cards, corporate loans, home mortgages and just about any security that has a floating interest rate, as well as derivative contracts such as interest rate and currency swaps are tied to LIBOR. The impact of changes in LIBOR to borrowers and lenders is significant. For comparison, a one basis point (.0001) change on one $1 trillion of securities is $100,000,000. Given the $300 trillion to $400 trillion conservative estimate of securities and derivative contracts that are tied to LIBOR (some estimates are as high as $600 trillion), the amounts involved are huge.

Barclays had manipulated its LIBOR figure hundreds of times from 2005 to early 2009. Some were at the urging of its traders to help positions they had in derivative contracts and other securities. Also, during the financial crisis of 2008-2009, the bank purposely lowered its LIBOR bid because a higher rate at which banks could borrow would signal higher default risk. The banks that were too big to fail were under severe pressure at the time and any sign of weakness would have prompted massive withdrawals and/or a call for more collateral as counterparty risk was perceived to have increased. An interesting question is how involved or complicit were regulators during this time? They also were under tremendous pressure at the time to stabilize the whole financial system.

One thing you can count on in finance is contagion. The scandal has already spread from Barclays to other large banks that are under investigation or face lawsuits alleging LIBOR was manipulated. In Britain, the Financial Services Authority is involved, in the U.S. the Department of Justice and Commodities Futures Trading Commission, and Brussels in the E.U.

The LIBOR mess will be in the news for years to come. But it is not the only financial instrument to set rates by survey. There is TIBOR (Tokyo Interbank Offered Rate) and EURIBOR (Euro Interbank Offered Rate) that are similar to LIBOR. Many swap prices are also set by survey as well as other financial instruments.

LIBOR is the most important short-term interest rate in the global financial markets as the 10-year Treasury bond yield is for longer-term interest rates. The problem is that LIBOR does not reflect market prices or transactions as does the 10-year U.S. Treasury bond yield. Going forward, LIBOR and its equivalents should be based upon actual rates and prices at which banks have lent to or borrowed from one another, not estimates. At this time, LIBOR transactions are not publicly reported so there is a lack of transparency. There may not be current prices each day for all 150 LIBOR quotes but reported transactions should be the starting point, and that data used to fill in the blanks for those quotes not having transactions.

LIBOR has been around since the 1980s and has become one of the most important rates in the financial markets with huge financial implications for consumers, corporations and governments. And the market has been under suspicion of being manipulated for several years, but regulators never seriously investigated until recently. It is obvious that the present process of computing LIBOR is deficient. Given the amounts involved, the incentives to manipulate it are too large. Banks should not be able to profit from the level of LIBOR set by the banks themselves.

LIBOR may end up being the largest financial scandal of all times, given the trillions of dollars impacted by the rate. As mentioned previously, LIBOR will be in the  news for years to come. But what a global financial calamity it would be if LIBOR were to collapse. Hopefully in the future a better process can be devised to set a benchmark short-term interest rate that all lenders and borrowers can have confidence in as a real rate and not an artificial rate.

There may be alternatives to LIBOR. Some would suggest U.S. Treasury bills which are owned globally and traded in a liquid and efficient market. But they are subject to the creditworthiness of one country as opposed to 18 global banks. Another possibility would be to use the repo rate, which is the rate for financing securities. The borrower puts up securities for collateral for a loan and agrees to repurchase them at a later date at a specified price. So don’t be surprised if something replaces LIBOR.

Outsourcing Common Sense and US Jobs

President Obama quoted others in calling Romney and his past colleagues at Bain Capital “Pioneers at Outsourcing.” The President smiled and puffed out his chest as he proclaimed that in contrast he was the one who saved the auto industry.  Romney denied that either he or Bain Capital were responsible for outsourcing. But given the chance he did not take the opportunity to stand up for free trade. Thus they both want us to think that outsourcing is something evil that hurts US employment. As an aside, I think they used the wrong word – outsourcing instead offshoring. Their rhetoric works better for locating businesses abroad. But I suspect they like neither offshoring nor outsourcing.Both appear to hurt US employment. But keep reading please...

One quick thing to ask the President… he proudly bailed out the auto industry.  Is there any other industry that has done more offshoring of jobs? Does GM not have a plant in virtually every country of the world? Why is he so proud of saving the auto industry when he is so against offshoring? Has he vilified GM for all those jobs created abroad rather than at home? Why is it okay for GM to offshore but not okay for Bain to help other companies who want to offshore?

Those of you who are very worried about employment in the USA want your politicians to stand up for jobs in America. The disappointing labor department report last Friday underscored our concern for jobs.  But please, both these guys are agreeing on the wrong thing. Yammering against globalization is just wrong. It is very wrong.  Obama continues to take his eye off the ball. Employment suffers in the US because we have no fix for finance, housing, and a fiscal cliff. Yet he finds something new to talk about each week – he will talk about anything that diverts our national attention from what matters.  Romney does not do much better. I don’t care if he worked for Bain Capital or Micky D’s – I want a clear exposition of what he is going to do as President. Neither of these guys lived normal lives with paper routes and lemon-aid stands. I doubt either one would know the right end of a lawn mower.  Get over it. Both are running. What are they going to do once they get into office? This offshoring thing is a red herring.

Both these guys think they can score points with workers by pointing out that outsourcing/offshoring (o/o) hurts national employment. But stopping o/o is not going to save US jobs. It is important to see that o/o is not much different than importing goods and services from abroad. If we o/o or if we import we are buying things that are produced abroad rather than at home. On the surface it sounds pretty bad to import or to outsource. But luckily that is not the whole story.

We cheer for our good guys when export sales increase. When a firm on US soil sells more peanut butter to China, we acknowledge the extra jobs that are created in the US. Imports do just the opposite. Imports are goods that we buy and consume here that are produced abroad by workers in Brazil or Spain or Botswana. Clearly if those goods were produced at home this would create more job opportunities for Americans. But what has the president done about imports? During his watch US imports from the world increased from $2.54 trillion in 2008 to $2.66 trillion in 2011.  In 2011 US exports to the world were $2.1 trillion so we had a net deficit in goods and services of more than half a trillion dollars. That half a trillion dollars represents the difference between jobs gained through exports and jobs lost through imports. That’s a lot of jobs.  Why isn’t Mr. Obama traveling around in his fine bus ranting about all those imports? Clearly neither he nor previous presidents wanted to stop this trade deficit. It has gone on for decades. A Buy America program has done almost nothing to reverse all this.

Why is it okay to let imports replace US jobs but not to let o/o do the same? The answer is that it isn’t okay. Globalization is a two-way street. We all realize that you can’t have exports without imports. You can’t have in-sourcing without out-sourcing. A policy to reduce imports or o/o would surely hurt our exports and the desire of foreigners to invest here. Worse yet, it would be very inefficient and costly. Many imports reveal our own decisions to specialize. Importing things where we have no real business edge makes no sense. It would simply mean less choice and higher prices.  That is not what we are after.

Along similar lines, it makes sense to produce abroad rather than at home.  China and other parts of Asia are growing rapidly. They need a lot of goods to support the growth. Given the distance and cost of traversing it – it often makes sense to produce for those markets in Asia. Producing in the US would be more costly and we might lose in the competition with Asian, German, and other firms who also want to serve those markets. The reason the President doesn’t rail again GM plants abroad is that he knows that a global foot print makes GM a stronger company and more able to sustain its jobs at home as it spreads employment and production around the globe.

Why has Obama been so silent about the recent decision of Airbus to locate a production facility in Alabama? Obama does know that Alabama is one of the 57 US states, doesn’t he? I realize Alabama is a right-to-work state but even non-union workers count in the national employment statistics, don’t they?  Why did Airbus decide to locate in the US? Did they do it to irritate French workers? The Wall Street Journal says the location decision was made because Airbus wants to be able to produce for the US government. To be competitive in government procurement a company must have factories in the US. Is it not possible that many US companies locate abroad for similar reasons – whether they serve government or private purchasers? Isn’t Airbus made stronger by locating a plant for US buyers in the US? Are not jobs in France and other places in Europe made that much more secure because Airbus is stronger? So it makes sense for France and other countries to o/o.

Let’s take a look at offshoring in a comparative sense. You will see below that the US is just doing what everyone else is doing. We are clearly not alone.   In 1990, the US owned $732 billion in foreign capital (Foreign Direct Investment, FDI*. A more complete definition of FDI is given below.) That is, US cumulative purchases over many decades of foreign productive capital across the globe amounted to $732 billion. That amounted to 13% of our GDP in 1990. We have since experienced more than 20 years of rapid globalization and now own $4.8 trillion capital abroad. That amounts to an almost 7-fold increase. FDI was 32% of GDP in 2010. Offshoring is very evident for the US.

The below table compares the US to 10 other countries and the EU: (this data comes from the United Nations Web Table 8. FDI outward stock as a percentage of GDP, 1990 to 2011. Stock values are in trillions of dollars). http://archive.unctad.org/Templates/WebFlyer.asp?intItemID=6018&lang=1

The stock of FDI owned by the EU was almost twice as large as that for the US in 2010.  The listed countries own from $340 billion (Switzerland) to $1.7 trillion (UK) of FDI in other countries. What matters more, however, is how large the ownership compares to the size of the country.

For the Netherlands, FDI was 123% of the economy in 2010.  The US position was 32% which ranks it about 9^th in this list – at par with Australia. Only Japan and Italy have FDI lower as a percent of the economy than the US.

Consider the increases in dollar value since 1990. The US FDI increased 7 times. That sounds like a lot but over these 20 years only Japan had slower growth in FDI at 4 times. Spain’s FDI increased 41 times! The median country’s FDI increased 8 times. Spain, France, Switzerland and the EU all found FDI increasing in double digits.

Globalization means investing at home and abroad. Countries that don’t do it will lose out on opportunities and will not compete well. Between 1990 and 2011 US non-farm employment increased by 23 million jobs. Private sector jobs increased by 19 million. The New Age of Globalization saw American jobs at home increase by more than 20%.

                   Stock      FDI        Fold increase

                    FDI         %GDP       Since 1990

                    2010      2010

EU            $8.93tr      57%               11times

US              4.84        32                    7

UK             1.69        72                    7

France        1.52         62                  14

Germany     1.42         44                    9

Netherl         .89        123                   8

Japan           .82         15                    4

Spain            .66        46                  41

Canada        .62         41                    7

Italy              .48        24                    8

Austral         .40         32                  11

Switzerl        .34         80                   8

  

*FDI is meant to capture the value of purchases of companies abroad for the intent of management control. It does not include purchases of foreign stock that are made for the purposes of only financial investment. That is, most international bodies distinguish between FDI and portfolio investment. FDI involves the purchase of companies through merger, acquisition, or simply enough shares to lead to some managerial control. It also includes greenfield sites which would include building a new plant or business firm in a foreign country.

The Death of Equities?

Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared yesterday, June 25, 2012.

 The Financial Times published an article last May about the end of the cult of equities.  If you are a member of the equities cult, you believe that an investment in equities will provide a superior risk-adjusted return in the long term relative to bonds. Even though risk may be greater, the equity risk premium (equity returns minus bond returns) will more than compensate for the additional risk. Equity returns come from two sources, dividends and capital appreciation. While dividend yields were low by historical standards, investors believed that most equity returns would come from capital appreciation.

Because equities are riskier than investment-grade bonds, for decades dividend yields exceeded bond yields. That all changed in 1956 when 10-year U.S. Treasury bond yields exceeded equity dividend yields for the first time in the U.S. going back a century. Bond yields exceeded dividend yields from 1956 to 2011-2012 when the relationship reversed after more than half a century. Recently the S&P 500 dividend yield was 2.2 percent versus the 10-year bond yield of 1.6 percent.

So the cult of equities started in the 1950s and certainly accelerated in the 1980s and 1990s as equities became the asset class of choice for institutional investors such as pension funds and endowment funds and individual investors through direct ownership of equities or indirectly through mutual funds, which grew rapidly during this period. Individual equity exposure also increased through their pension plans.

What started the cult of equities? One word: performance. From the beginning of 1950 to the end of 1955, equities, as represented by the S&P 500, provided annual returns of 25.2 percent versus 1 percent for long-term corporate and government bonds. As a legacy of WWII, the Federal Reserve, much like today, had suppressed long-term interest rates until 1950. As long-term interest rates rose, bond prices declined and annual returns were minuscule and less than inflation.  As the stock market crash of 1929 and the Great Depression became distant and faded memories, the appetite for equities increased.

Equities continued to outperform bonds from 1956 for the rest of the 20^th century, although bonds did as well as equities in the 1970s. From 1956 to the end of 1999, equities provided annual returns of 10.4 percent versus 6.0 percent for long-term corporate and government bonds. Inflation ran about 4.7 percent annually during this period, so real (inflation adjusted) returns were lower.

So what has caused investors to lose their appetite for equities? Again, one word: performance. The first decade of this century experienced two devastating bear markets in which investors lost at least half of their stock market wealth. The first bear market was a result of the dot.com bubble and an overvaluation of stocks in general. The S&P 500 peaked at 1527 in March 2000 and hit bottom at 777 in October 2002, a decline of -49.1 percent. Five years later, the S&P 500 hit a new peak of 1565 before it started a dramatic decline of 56.8 percent to 677 in March 2009. This was the worst bear market since 1929 and the first since then to have been caused by a financial crisis from the collapsing of credit and housing bubbles.

The end result has been an ugly first 11 years in this century for equities. From 2000 to 2010, the S&P 500 had an annual return of only 0.4 percent versus annual returns of 8.0 percent for long-term corporate and government bonds. Given annual inflation of 2.4 percent during this 11-year period, real returns were negative for the first time since the 1970s. Today the S&P 500 is still well below its March 2000 peak.

In addition to mediocre equity returns since 2000, equity volatility has also been at historic highs. The combination of low returns (negative real returns) and higher risk has been the primary factor for increasing investor risk aversion and decreasing appetite for equities. But not the only one. Other factors would include the financial crisis and the Eurozone crisis, increasing economic uncertainty, increased globalization, regulatory reform in the financial sector, tax rules favoring bonds over equities, high-frequency trading and the flash crash in 2010, less liquidity in the market and the growth of government debt and deficits. So institutional and individual investors have reallocated billions of dollars from equities to bonds and other financial assets since the financial crisis of 2008-2009.

In addition to investors losing interest in equities, corporations have also been reducing equity in their capital structure by repurchasing stocks, and raising billions of dollars in the bond markets, whether needed or not, because of historically low interest rates. The implications of the de-equitization of the financial system can be serious. Equity is the risk capital in a financial system and the absorber of economic shocks. Less equity will result in a more volatile economic system. Plus emerging companies usually publicly access the capital markets first in raising equity capital via an Initial Public Offering (IPO). Despite the publicity, good and bad, associated with the Facebook IPO, fewer companies are going public, annual average of 130 since 2001 versus 503 in the 1990s, which could eventually have a major impact on economic  growth. And investors have fewer choices today; the number of publicly traded companies has declined since 2000.

What should equity investors do going forward? If you are a contrarian or value investor, the Financial Times article could be good news. Many remember the BusinessWeek article in 1979 titled “The Death of Equities.” The 1970s were not a good decade for equities or bonds. Nominal equity returns were 5.9 percent annually, similar to long-term bonds, but inflation was 7.4 percent, so real return were negative for both bonds and stocks. The BusinessWeek article was widely quoted and publicized, but after the 1981-82 recession, the stock market enjoyed returns of 18.5 percent annually from 1982-1999, one of the best periods in stock market history. The media have a long history of bad-timing articles, perhaps this time also. A 1950s scenario of raising interest rates may benefit equities relative to bonds.

Investing in equities always involves uncertainty. There have been many unexpected events since 2000 impacting equity returns in a negative way: the dot.com, credit and housing bubbles; two recessions, one severe; the financial crisis; the Eurozone crisis; and acts of terrorism and wars, to mention a few.  Hopefully there will be fewer such events in the future and investors will regain their appetite for equities. Equities are one of the few ways in which investors can participate in the economic growth of companies and countries. A healthy equities market in which investors have confidence is important for the economy.

Old cults never die, they just fade away for a while; maybe the cult of equities is just lying dormant like in the 1970s, ready to spring back to life after a couple of years. Long live equities.

Bond Markets Will Rule

 Thanks to Buck Klemkosky for being our guest blogger this week. Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared on Dec. 11, 2011.

Recent elections in Europe show popular support for anti-austerity fiscal programs. But the results of elections may not be the final arbitrator of fiscal policies, especially in Europe. As contagion spreads from country to country, it appears as if the bond markets will be the primary force imposing discipline on European governments, central banks and commercial banks.

Two of the primary signals for sovereign debt problems are credit spreads and credit insurance. Investors compare sovereign bond yields to those of Germany or the U.S. to assess the probability of sovereign debt default or some sort of restructuring. As credit default spreads widen, the market places a higher probability on potential default. Investors also pay attention to how much it costs to insure against sovereign debt default in the credit default swap market.

Of course, politicians don’t like discipline, especially market-imposed discipline. Their first reaction is to blame higher bond yields on evil speculators. But politicians lose sight of what markets do. One of their primary functions is to process information and set prices for financial assets. For bonds with fixed coupon rates, the bond price determines the yield to maturity, if investors buy today and hold the bond to maturity. Once the coupon rate is set, if investors want a higher yield because of higher default risk, they can get it only by buying the bond at a discounted price. So there is an inverse relationship between bond yield and bond price. Bond investors also do not have to buy the bond and hold to maturity. They can anticipate or speculate on changed in yield and hold for time period less than maturity.

Burt the basic question is: Should you trust the markets? If you believe that the bond market for sovereign debt efficiently processes information, then bond prices do reflect public and private information. This is referred to as the Efficient Market Hypothesis in finance. Informational efficiency is a matter of degree, but research shows that bond markets are fairly efficient at processing information and setting prices and yields.

What does it take to have an efficient bond market, even with speculators? Foremost, you need a large number, not all, of investors who are rational and compete for information to value bonds. The incentive to search for and analyze information comes from trying to maximize returns for a given level of risk. Markets can also be efficient even with speculators present as long as they have diversity of opinion, independence of thought and use multiple sources of information. Speculators invest their own capital and assume risk, so they have a big incentive to get it right. So speculators do not necessarily separate the financial markets from the real economy or make prices more volatile than economic fundamentals warrant. Speculation also does not necessarily cause asset bubbles (irrational markets). So the collective wisdom of markets and the self-interests of investors can provide the most efficient prices.

Of course, hindsight shows that asset bubbles do occur:  technology stocks (1996-2000), housing in many parts of the world (1996-2006) and various commodities. But the bond markets have not been as subject to irrational exuberance and collective investor euphoria as other asset classes. If bond yields don’t reflect economic fundamentals in many countries today, it is because central banks have kept interest rates abnormally low as a monetary tool to help slow-growth economics.

Governments have proposed or imposed various rules and regulations to curb perceived speculation: place a tax on financial transactions, ban short selling, put position limits on derivatives contracts and eliminate or curtail the use of some products such as credit default swaps. Most of these are imposed with little empirical evidence as it is easier to blame speculators than to address real economic problems such as deficits, promises that can’t be met and sovereign debt.

What the bond markets are telling us is that the euro zone has massive problems that probably can’t be fixed in the short term. The PIGS (Portugal, Ireland, Greece and Spain) have been replaced by the PIIGS (add Italy). The source of the financial contagion has been the European Central Bank and the politicians doing too little too late.  While politicians in some countries worry about moral hazard by reducing incentives to reduce deficits and restructure economies, others believe that austerity programs will cause recessions and widen deficits and increase the sovereign debt problem.

The interconnectedness of European banks and sovereign debt has created a perfect storm in which investors are losing confidence in some euro zone countries and banks.  Investors realize that some of the countries are too big to fail, but also perhaps too big to save, given what has been proposed thus far. The probabilities of the collapse of the single euro zone currency have increased and will continue until bold actions are taken to stop the contagion. Confidence has to be restored decisively.

So European politicians and bankers have not liked what has been happening in the bond markets. More than one has denounced the markets and stated the need to establish or re-establish the primacy of government policy over the markets. But the bond vigilantes are a tough group. If they could speak with one voice, it would be: “The markets aren’t the problem. It’s the banks and the politicians who caused the mess. If you don’t like what we, the markets, do, don’t borrow money in the bond markets.”

As James Carville, advisor to President Clinton, famously stated, “He wanted to be reincarnated as the bond market so he could intimidate everyone.” Market discipline will work when everything else fails, especially politicians and government.

Haircuts, Hazards, and Hand-Grenades

I need a haircut. It has been more than six weeks since my last visit to the Crosstown Barber Shop and the little hairs on the back of my neck are looking unsightly.  But the market’s down and I was hoping to get a little more mileage on the last haircut. And there is the odd chance that government, feeling sorry for old people like me, might come to my rescue with a haircut subsidy.

While the above sounds really silly it is not a bad description of what is happening today around the globe.  Today we use the term haircut to describe the ability or willingness of the private sector to share at least part of the credit losses that have occurred in the last several years. A haircut means that a creditor agrees to take less than the promised or expected return on an asset. When it comes to housing in the US, Ireland and a few other places the haircut has to do with financial institutions that hold bad mortgage loans and/or derivatives tied to these loans. When it comes to European and other banks it has to do with banks and other financial institutions that are holding sovereign debt or the official government debt of Greece and other European nations.

We are not used to talking about haircuts in this manner. In the past, banks and financial institutions that held bad investments were seen as poor decision makers and we generally believe they needed to take care of their own business problems.  If they made bad investments and could not stand behind their debts then they should go into bankruptcy or go out of business. One such institution might try to sell its investments and willingly take a price reduction or haircut in order to maintain cash flow. But this decision was a private one – taken by a troubled financial institution to resolve its difficulties. It was not a matter of public policy.

Today things are different. Today we are in a financial crisis in which the proportions of the problem go well beyond a few firms, a few industries and beyond a few countries. The proportions also go well beyond an amount of debt which could easily be paid with government assistance from a single country or even a consortium of countries. Simply put, the financial crisis has most of us in a very deep hole. If it was not such a deep hole, we would have been out of it by now. If it was not such a deep hole, we would not have so much discussion and such little real action. This is not only a deep hole but it is a new one. Financial crises have come and gone. But most of these past financial crises have been limited to one or a few countries. 

These crises came before the age of GLOBALEV. GLOBALEV is a time when leverage became excessive. GLOBALEV is a time of global interconnectedness that turned the financial industry into a highly interdependent organism.  GLOBALEV is a time when housing and financial market bubbles burst and the negative impacts were quickly transmitted to financial institutions in most countries.

In short, we find most countries of the world sharing a very large financial burden. While bankruptcy and debt reneging/renegotiation might have been appropriate in the past, these solutions won’t work in GLOBALEV. There is too much money involved and too many countries that would be part of a downward cycle of default. Asking private investors to assume the whole load of this debt crisis is like asking me to lift a building. A more relevant question, however, is to ask HOW MUCH of the current debt crisis could realistically be carried by the private sector. That is, how much of a haircut are private financial institutions able to take? One might argue that they should take 100% of the burden. This is the way things ought to work in more normal times. But in GLOBALEV it is not possible.  If we asked all financial institutions to clear their nonperforming debt by tomorrow, the world’s financial system would grind to a quick halt.

Many are quick to point out the phenomenon of moral hazard. And they are correct to do that. If you do not make private financial firms assume the full burden of their investments, then they will assume that they will never have to do that in the future. Whatever harmful practices got them into the current problem would surely continue in the future. So the moral hazard issue is real and worth considering when determining the size of the haircut. With the financial crisis so deep and wide, a moral hazard cannot be avoided.

So if the private financial firms cannot withstand full responsibility for their bad investments, then they must be assumed by society.  GLOBALEV implies there must be a shared responsibility. 

This issue reminds me of people who live in flood plains whose property is destroyed by over-flowing rivers and oceans. Whether they were insured or not, it always seems to be the case that society ends up sharing the costs when homes are destroyed by flooding waters. I always gripe that this is unfair to those of us who do not live near water. But it seems to go on and on. After the waters recede people rebuild in the very same places. It sounds crazy but I think about the outpouring of both private and public relief that is mobilized every time there is severe human misery inflicted by Mother Nature. If tax-payers are unable to protect themselves from irrational home location decisions, it seems that we are equally impotent when it comes to deep financial crises.

Some of you are grinding your teeth right now. But I think it is unavoidable that a financial bailout will be part of the solution to our financial crisis. It will send the wrong signal to bailed-out firms and it will not prevent future disasters from happening in the future, but it will be part of a solution that might work.  It might work because the problem is so deep and it requires more assets than the private sector can now provide.  GLOBLEV requires a tax-payer contribution and the only question is HOW MUCH of the total amount is paid through government. Many options are possible. At one extreme the government can shoulder 99%.  At the other tax-payers might fork over 1%. But more than likely, the amount paid by tax-payers will be somewhere in between. 

Unfortunately HOW MUCH the taxpayer pays has become a political/ideological stick of dynamite. Inasmuch we are several years beyond the beginning of the financial crisis and we have little in the way of policy progress. Much has not been legislated and much of what has been legislated has not been put into practice. Stalling, or not deciding HOW MUCH the taxpayer contributes, is the one and only reason why we are staring down the barrel of a double-dip shotgun and why we have made little or no progress in employment.

Right now most of the news is about Europe and the lack of progress on their sovereign crisis. This negative cloud is hanging over all of us. Why? This cloud exists because Germany leads a group of countries that insists on a larger haircut and a small government contribution. France is part of a block that thinks a larger social portion must be paid. In Europe the usual problem of who pays gets even tougher and more political because it not only pits the creditors against the tax-payers but it pits country against country. If most of the debtors are in southern countries and the richer tax payers are in the north, then it is much more difficult to find a sharing solution that seems fair.

What’s happening in Europe is no different than our experience in the US. We continue to have a huge overhang of mortgage debt. We continue to have banks that sit on a razor’s edge of financial stability. We wonder why housing prices keep falling and no clear end to the housing crisis is in sight. But our politicians, like their cousins in Europe, do not want to admit or deal with deciding on the private haircut and the public split. Conservatives want the market to bear the full brunt.  Liberals want the tax-payers to pick-up a larger share of the debt.  Yet nothing will be accomplished until they admit the reality of the situation and get on with a compromise. In the meantime no jobs bill will restore demand or supply to a nation that sees no solution to GLOBLEV. So long as GLOBDEV remains, banks will not lend and houses will not sell.  Firms will continue to have less than sanguine expectations and will see no need to expand employment.

I personally have no frog in this race when it comes to deciding the size of the private haircut. As I said above, the smaller it is the bigger is the problem of moral hazard. Furthermore, the more tax-payers bear the burden the more our national debt increases and the more our financial reputation is a stake. Shifting the burden of finance from the private to the public therefore has its risks. But then the bigger you make the private haircut, the larger the risk you take with respect to the crumbling of global financial markets. This is a deep hole and there is no free lunch. But the more we pretend this is an ideological problem the more we stall a solution and the longer we languish in economic purgatory. We need some experts to decide the proper ratio of public to private responsibility and then we need politicians to bring home the solution. I am not optimistic we will get what we need anytime soon.