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John Mauldin's Outside the Box

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As long time readers know, I get a lot of newsletters sent to me from around the world. Many are from private sources. Among the best is the HCM Market Letter written by Michael Lewitt of Harch Capital in Florida. Michael is one smart guy with a deep understanding of the markets, especially the credit markets, and how they work. The firm manages domestic and offshore debt and equity hedge funds and separate accounts. I really look forward each month to getting Michael's insights. For this week's Outside the Box we will look at his letter from late last week which, given the continued drop in the dollar, is more pertinent than ever. He also touches on interest rates, the problems with Credit Default Swaps and oil. It is a wide-ranging essay and one that I think you will enjoy pondering.

The HCM Market Letter (Vol. 4, No. 11)


"Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money."
Alan Greenspan

On Friday, November 19, Alan Greenspan made his latest attempt to quell financial market speculation. Speaking at a European Banking Congress in Europe, Mr. Greenspan made it very clear that interest rates are going to continue to rise. Despite the market reaction to Mr. Greenspan's words (it sold off a bit), one can't help but feel that we've heard these warnings before and that they will continue to fall on deaf ears. Mr. Greenspan's credibility has been undermined by his track record of easing rates at the slightest hint of real (Long Term Capital Management) or imagined (Y2K) crises, as well as statements claiming that he couldn't identify a bubble even as it was blowing up in his face.

Mr. Greenspan's warning came just a few days after Congress raised the U.S. federal debt ceiling to the 13-digit number above, and just as the U.S. dollar breached the $1.30 mark against the Euro for the first time (and for what appears to be a sustained period). A clear pattern has emerged - higher interest rates, lower dollar, slower economic growth, higher oil prices - but the benchmark-driven financial markets don't seem to be paying much attention.

As President Bush II enters his second term, he is faced with rising oil prices and a weakening currency (not to mention nuclear challenges in Iran and North Korea and worrisome signs of political backwardization in Russia). Second terms are notoriously problematic, and circumstances certainly suggest that Mr. Bush could be in for a rough ride, particularly with respect to the economy. The surest contrary sign of trouble ahead may be the stock market rally that began immediately after the election - if nothing else, the stock market has shown itself to be particularly clueless as an arbiter of anything other than its own psychology. It used to be said that the stock market discounts tomorrow. With the proliferation of hedge funds (more and more of which are just glorified day traders) and other short-term traders, about the best that can be said is that the stock market is trying to discount the next ten minutes based on how things felt the last ten minutes.

Christopher Wood's believes that "the re-election of Bush is US dollar bearish and gold bullish."1 The unhappy truth, as astute observers such as Mr. Wood and Stephen Roach keep repeating, is that America is facing a period of almost inevitable decline as a consequence of chronic and acute economic imbalances and a political system that fails to deal with them. Mr. Wood and others speak of "America's growing abuse of the US dollar's privileged role as the reserve currency of the world." The real question is whether Japan and China can even afford to let the dollar crack in view of their enormous dollar holdings, as well as the mercantile base of their economies. American hegemony may or may not be peaking, as HCM fears it is, but there is almost no question that the great symbol of that hegemony - the U.S. dollar - is likely to remain under pressure. The chart below, borrowed from Christopher Wood's GREED & fear report, tells the sad tale:

Chart 1

As The Bank Credit Analyst (November 2004, pp. 9-10) notes: "The dollar would probably have been in a meltdown a while ago but for large-scale dollar purchases by Asian central banks. These purchases have helped slow the dollar's descent, but will not prevent a decline if private capital flows continue to diminish, as has been the case this year...We do not anticipate a dollar collapse any time soon because Asian central banks will continue to be buyers of last resort for the currency. Nonetheless, the path of least resistance is down and the best that can be hoped for is that it will remain a benign process with the dollar falling without forcing U.S. interest rates higher."

In the aftermath of the election, talking heads spent countless hours discussing how divided the United States has become culturally and politically. But these so-called experts really missed the point - the culture and psychology of the United States have never been more united when it comes to matters of dollars and cents. A body politic claiming to have chosen its next leader based on stringent moral concerns continues to engage in fiscal profligacy that would make Donald Trump blush.2

The culture of debt has been so deeply instilled in Americans that it will require a true Armageddon event to dislodge it. HCM has no way of handicapping the probability of any such event. For the moment, the unwinding of the global debt bubble is likely to be a slow and tedious affair, interspersed with some brief sell-offs but managed by the Federal Reserve and Asian Central Banks that remain locked in a symbiotic dance of death. If they release their grasp on each other, they both will die. So they will continue to cling to each other and waltz in slow motion and pray that the dollar will deflate slowly, that fragile global demand trends will be sustained or at least not weaken, and that the Devil's bargain they've made with each other can somehow be redeemed for cash. But if it is redeemed for cash, it won't be in U.S. dollars.

Foreigners Still Jonesin' for Dollar Assets

It is very clear that foreign buying of dollar-denominated assets is driving the U.S. markets higher. According to the U.S. Treasury, foreign appetite for U.S. corporate bonds reached record levels in September 2004. Net inflows into this sector reached $44.6bn, up from $26.5bn in August. Treasuries received inflows of $19.3bn in September compared to $14.6bn in September. Those of us who are bearish on corporate credit at today's absurdly inflated levels need look no further than this data to understand where a lot of the buying is coming from.

The U.S. requires approximately $55bn each month, or $1.8bn each day, to fund its current account deficit. We are now half a year and 100 basis points into a Federal Reserve tightening cycle that HCM now believes has much further to run. The Euro has broken through $1.30 and foreign buyers are still piling into dollar assets (despite noises about diversifying their holdings). The world is awash in dollars, debt and speculation. Anticipating Mr. Greenspan's comments quoted above, Peter Bernstein wrote in The Financial Times on November 17 that "as Herb Stein, the late economist, put it: 'If something can't go on forever, it won't.' Private capital inflows into the US are already shrinking. There is a point at which one or other central bank will cry 'Enough!' and the house of cards will fall in." Mr. Bernstein is hardly an alarmist, and he has been warning for months that the current situation is unsustainable. He believes that the optimal solution would be a replay of the 1985 Plaza Accord - "an orderly appreciation of the main nondollar currencies against the dollar, which is a more benign method of curtailing America's appetite for imports while spurring the development of domestic sources of growth in the rest of the world. Without such an accord, the outlook for an orderly dollar devaluation is dim."

No such accord was reached at the European Economic Summit last weekend. But dollar weakness was abundant. Mr. Greenspan opined: "Given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point. International investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing the U.S. current account deficit and rendering it increasingly less tenable." The problem is that the markets don't seem to believe the Fed Chairman. Or everybody figures they can get out of the market before the sell-down occurs. A crisis will not happen until there is a crisis. By then, it will be too late for many investors to get out of the way.

Speculation Abounding

The tech sector remains overly exuberant (to borrow the discredited words of Mr. Greenspan). With Wall Street "research analysts" are telling John Q. Public to buy Google at 200+x earnings (just as Microsoft is taking aim at the search engine), one is hard-pressed to conclude that investors have learned any lessons from the last meltdown. In the most recent issue of The High Tech Strategist (November 5, 2004), Fred Hickey waxes eloquent about the speculative fervor that is motoring the markets forward. "In fact what we've seen in the last few weeks is the phenomenon of buyers driving the stocks up of companies with the biggest quarterly disappointments; the bigger the miss, the better. It's the kind of 'in-your-face-disgrace' activity that we saw so often in the late 1990s mania. It's the way the maniacs show that they're in complete control and it is very discouraging to tech stock players burdened with the notion that fundamentals have meaning, and that price should be a consideration when buying a stock." Come on Fred - don't you get it? They're just being contrarians!3

Mr. Hickey argues that it is no accident that the tech frenzy that began in 1995 with the Netscape IPO coincided with very loose Federal Reserve policy. The Federal Reserve has been extremely accommodative over the past decade when the financial system has been hit by crises: the Mexico crisis of 1994-95; the Asian crisis of 1997-98; the Long Term Capital Management Crisis and Russian default of 1998; the Y2K "I have some swampland in Texas I want to sell you" crisis; and the Nasdaq meltdown of 2001. The issue is a broader one, however; laxmonetary policy - in the form of low rates, the only tool the Fed really has other than the bully pulpit - has led to sharp price rises in virtually all financial assets. Tech is no exception to that, although it seems to attract the craziest of the crazies due to its cultural and psychological appeal to the masses (i.e. tech is cool). That doesn't mean that losing money in tech is cool,4 but investors seem to be tripping over themselves to learn that lesson all over again.

The Interest Rate Outlook

Investors no longer have the wind at their backs as the Federal Reserve appears to be in the early stages of a tightening cycle that is likely to take the overnight rate to the 3.5 4.0% range. The Open Market Committee's November 10 statement noted that "Angelfter moderating earlier this year partly in response to the substantial rise in energy prices, output growth appears to have regained some traction, and labor market conditions have improved modestly. Despite the rise in energy prices, inflation and inflation expectations have eased in recent months." Leaving aside for the moment the kind of parsing of this statement that makes one think that Jacques Derrida missed his calling and should have been a Fed watcher, the clear intent of this language suggest continued interest rate hikes.

There is another reason, however, why it may be time to re-evaluate our earlier views that the Federal Reserve will stop raising rates when the overnight rate hit 2.5%. Inflation remains benign, and economic growth fragile, but there may be other factors working on the Federal Reserve's thinking. One of the main goals of raising rates is to reduce speculation in the financial and real estate markets, and the Federal Reserve has been singularly unsuccessful in accomplishing that objective. Mr. Greenspan and his colleagues read the papers, and they are well aware of concerns about the prices of financial assets that have been inflated by the low cost of money. But even after 100 basis points of hikes (and another 25 to come in December), speculation and borrowing are still running rampant.

Rates are still sufficiently low to provide plenty of incentive for economic actors of all types to engage in carry trades. Perhaps that is why Mr. Greenspan made his comments warning unhedged investors about future interest rate increases - he sees that the interest rate hikes haven't worked and now he is pulling out the bully pulpit in an attempt to soften the blow. HCM believes that it may require at least another 100-150 basis points to break the back of the current speculation. Moreover, speculation is so deeply embedded in the structure, incentives and psychology of the markets that sustained higher rates probably will be necessary to prevent it from returning. The backdrop of a weakening dollar makes higher than previously expected interest rates more likely. In HCM's view, a steady stream of monthly 25 basis point hikes of the overnight rate are certain to continue through most of 2005 (barring an unforeseen exogenous event). With bond yields at historic lows and spreads as tight as they are, 2005 is likely to see a bond sell-off. For the moment, however, it seems like it will take something extraordinary to tip a sell-off into a route.

Inflation remains muted because the excesses of the late 1990s have not yet been purged and the economy is still operating below capacity. But there may be more factors at work in view of the fact that loose monetary policy, a swelling fiscal deficit, a weak dollar and rising oil and commodity prices have failed to move prices higher. HCM suspects that the explanation lies in the increasing globalization of the economy, the need for U.S. companies to compete with Asian and Indian companies that aren't saddled by pension, healthcare and litigation costs. After all, companies like General Motors and Ford are now on the cusp of being downgraded to junk status (an event that will create enormous opportunities for investors in the less-than-investment grade markets) as they spend more per vehicle on employee healthcare than steel. Add to this the bottomless appetite of Asian banks for U.S. dollars to sustain their domestic-demand-starved, mercantile economies, and you end up with the Fed raising rates and the market knocking them back down. The path of least resistance (to borrow a phrase from The Bank Credit Analyst) remains upward.

Fixed income investors may need to start thinking outside the box to properly gauge the risks they are facing at current bond levels. Inflation was the last war - it may return, but it is unlikely to return soon or in the same incarnation as before. Investors would do better to focus on the dollar and the levels of speculative excess driving the markets in handicapping the extent of the current tightening cycle.

Waning Economic Growth?

Economic growth in Japan and Europe appears to have hit stall speed again. The Financial Times wrote on November 13: "The latest economic data leave the eurozone and Japan looking more than ever like two enfeebled old men unable to progress at more than a stagger." During the third quarter, Japan grew at an annualized rate of just 1%, while Germany and France grew at an even weaker 0.4% annualized pace. Japan also grew at 0.4%. Both regions experienced a drop in net exports resulting from slower demand in the U.S. and China and the strength of their currencies. One key problem is that drivers of domestic demand just aren't there, as The Financial Times points out: "The eurozone and Japan stand exposed as still almost entirely dependent on final demand generated elsewhere. These economies lack resilience to shocks, perhaps because of weak confidence, inflexible markets, sluggish policy responses and limited access to debt to smooth spending. Many economists have hacked back their estimates of potential growth in both economic regions. This implies that even though they have grown sluggishly in recent years there may be little scope for faster growth in the years to come." The fact remains that the U.S. and increasingly China are the main engines of global economic growth. Whether this fact will place a limit on how high the Euro and Yen can rally remains to be seen, but it is likely that the dollar would have dropped even more dramatically if it had some decent competition from the European and Japanese economies.


HCM has been reading that one of the reasons the stock market has rallied post-election is that oil prices have fallen from their highs. Again, we must be missing something. Oil may not be at $55 a barrel, but it isn't at $15 a barrel either. There are few commodities with as much impact on the global economy (never mind politics) as oil. In a terrific new book about the oil economy, Paul Roberts writes: "Energy and economic activity are in fact two forms of the same substance: the one cannot occur without the other. Historically, the more economically active we humans have been, the more wealth we have created, and the more energy we have used to create it with. It is an endless cycle: more wealth leads to more purchases; more purchases increase demand for products, which in turn calls for more factories, more raw materials, and more trips by truck and train from factory to warehouse and from warehouse to the Wal-Mart and the Pottery Barn. The entire global economy is like a huge machine, steadily converting energy into wealth."5 If Mr. Roberts is correct (HCM thinks he is), higher oil prices should not be taken as lightly as they are by the markets.

Martin Barnes, brilliant editor of The Bank Credit Analyst, agrees that higher oil prices will suppress economic growth: "The recent rise in crude oil prices has been unambiguously bearish for the economy and the stock market. Consumer spending power and confidence have been undermined and profit margins have been squeezed, adding to the business sector's already cautious move. On a more positive note, the oil shock does not yet seem large enough to induce a recession....Oil prices have risen at a time when there are plenty of other reasons for businesses and consumers to be cautious about spending. The implication is that the economic soft spot will persist for a while longer."6 HCM believes that the impact of higher oil prices has not yet been seen. Unlike investors piling into speculative stocks and bonds, however, HCM does not have to see the effects to know they're coming. Arguments comparing today's oil prices to the inflationadjusted prices of the 1970s are red herrings. They are used by the doyens of Wall Street to dismiss legitimate concerns about the future and keep investors chasing their own tails.

From the perspective of early this year, oil prices look mighty high to us (and to consumers and businesses, we dare say). Of course, from the perspective of the last ten minutes, oil with a four-handle looks better than oil with a five-handle. If ten-minute trends are a reliable market guide, the rally will continue. A sober look at the oil situation and the global energy situation suggests, however, that such optimism is misplaced. Sustained oil prices above $40, or even $30, are going to weigh on economic growth. Slower economic growth will have an enormous impact on the U.S. budget deficit, as tax receipts are highly leveraged to the GDP number. Oil makes the world go round; it also slows it down when it gets too expensive.

Credit Default Swaps

HCM has received a lot of questions concerning Credit Default Swaps (CDS). The CDS market has exploded over the last couple of years as investors seeking ways to hedge credit risk (or speculate on credit risk) have piled into swaps. As with all good ideas, this one is being taken to extremes never imagined when first hatched by Wall Street. Today, the CDS market appears to swamp the cash market in size. That means that derivative contracts are being written in amounts much larger than the reference obligations (i.e. underlying cash bonds) on which they are based. The original use of the market - to hedge long positions or short positions in bonds - has been supplanted by speculative activity that makes credit bets through CDS transactions. CDS can be an attractive way to play credit, but they are untested under stress conditions. We are assured (as we always are, just before the proverbial you-know-what hits the fan) by Wall Street that all of the players are satisfactorily hedged and that the positions will be unwound without disruption. HCM may not know much, but we know what we don't know, and we know that those assurances are a bunch of bull. Nobody knows what will happen when the next 12th standard deviation event occurs, but we can say with confidence that whatever happens it won't be good (particularly for investors who are long credit).

A recent Fitch report on the CDS market7 (brought to our attention by our friends at Protege Partners) raises important questions about this multi-trillion dollar market (to place that in perspective, that's a little more than half as big as the U.S. deficit limit that titles this issue). The Fitch report points to some of the risks with which HCM has been concerned. First, there are a limited number of dealers in this market, with J.P. Morgan reportedly enjoying 50% market share (akin to the high yield market share Drexel Burnham Lambert, Inc. enjoyed in the late 1980s) and the ten largest participants holding 70% market share. There are also concerns that banks are unable to track their total CDS exposures as a result of different business groups engaging in different degrees of CDS activity. We would raise the same concern with respect to the Prime Broker community, which often has overlapping exposures that are difficult to monitor and can cause trouble if a large company or industry sector comes under stress.

This CDS study comes at a time when HCM is reading and hearing more about the lowering of credit standards among Prime Brokers. This is closely related to the lunacy we see every day in the corporate bond market, where somebody is buying CCC- and B-rated credits at single digit yields. It's difficult to get anybody to actually admit that they're doing this, but they have to be doing it or else it wouldn't be happening. But they aren't buying the kind of distressed large capitalization names like Nextel that led to spectacular returns in 2003. Instead, they are buying mid-sized LBOs that offer high risk and low reward. From HCM's perspective, these investors are inhabiting a parallel universe in which all risk has been wiped out by some secret power. They will be fine as long as they don't have to re-enter the real world, which doesn't have the luxury of banishing economic and geopolitical risk.

The following graph, borrowed from our friend Jim Grant, shows the extent to which corporate bond spreads have narrowed over the last two years. In HCM's opinion, spreads are not only below trend, they are beyond sanity. When one considers the high default rates of B- and C-rated bonds, one can only attribute current trading levels to a liquidity-induced bubble.

Graph 1

And the problem isn't just that past default rates suggest trouble ahead. The competitive environment for leveraged companies today is far more challenging than it was when earlier default statistics were recorded. Globalization and manufacturing sector deflation remain the dominant characteristics of today's global economy, rendering the competitive field much tougher than in earlier periods. As a result, investors are paying more for less, much like they did for internet stocks in the late 1990s.

Perhaps the most worrisome aspect of the CDS explosion is the way in which the opportunity to hedge offers a psychological veneer of stability where underlying stability needn't necessarily exist. In HCM's opinion, CDS have had the effect of further loosening already lax credit standards. A portfolio manager is less likely to lose sleep over a long bet on credit if he believes he has hedged out all the risk. Moreover, CDS have created additional demand for underlying cash bonds as investors who put on a CDS position then attempt to put on the cash part of the transaction. In recent months, the corporate bond market has been hit with a slew of failed bond deliveries (i.e. counterparties have been unable to deliver cash bonds to close out trades), which is a direct result of the boom in CDS issuance. Regulators have reportedly told at least one big CDS player to stop selling bonds it doesn't own, resulting in fewer offers from that broker and less liquidity in the high yield bond market. HCM can't help but feel that the high yield market is a pressure cooker preparing to blow. We certainly wouldn't be long any but the shortest maturity fixed rate debt at these levels.

1 GREED & fear, November 4, 2004.

2 Actually it is unlikely that anything could make Mr. Trump blush. What better archetype for our "all flash, no cash" culture than Donald Trump, who just this week dropped his casino empire into bankruptcy for the second time.

3 No less contrarian that corporate bond investors, who seem to react to each new company release confessing one sin or another by bidding bond prices up even higher. The quest for zero yields continues.

4 Then again, part of our culture seems to be saying that failure is cool, if one considers Mr. Trump's rise to the top of the television ratings as his only public company stumbles into Chapter 22.

5 Paul Roberts, The End of Oil (New York, Houghton Mifflin Company, 2004), p. 147.

6 The Bank Credit Analyst, November 2004.

7 Fitch Ratings, "CDS Market Liquidity: Show Me the Money," November 15, 2004.


I trust you enjoyed this edition of Outside the Box. Michael agreed to pull the copyright on this one, so feel free to use it, but make sure he gets credit if you do. Also, I should note that my firm and affiliates do not do any business with Harch Capital.

Have a great week,

Your hoping his shadow can keep up this week analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. 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. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 11-29-2004 4:03 AM by John Mauldin