Foreign Investment in the U.S.: Is Bernanke Facing a Death Spiral?

Thomas Hobson ran a thriving carrier and horse rental business in Cambridge, England around the turn of the 17th century. He rented horses mainly to Cambridge University students, and was known for not giving his customers a choice as to their mount – it was simply “this or none,” i.e. Hobson’s choice.

Fast-forward to November 2007, and one cannot help wondering if the U.S. economy has taken on the guise of a modern-day Hobson, really offering no choice at all. And on the receiving end is Fed chairman Ben Bernanke facing an increasingly recessionary economy. A worsening housing situation, and the likelihood that significantly more credit losses lay ahead leave him with what Richard Russell (Dow Theory Letters) describes as a “brutal problem.”

Before digging a bit deeper into the alternatives available to Bernanke and the monetary authorities, let’s focus on the graphs of the Philadelphia Housing Index, and Bank Index for a snapshot of the market’s assessment of these two intransigent sectors.

Source: StockCharts.com

Source: StockCharts.com

These are downright awful pictures, and are especially disconcerting because the stock market as a matter of course discounts the real economy by anything between six and 18 months. This in itself spells bad news for the outlook for U.S. economic activity.

Should Bernanke and his cohorts drag their feet with interest rate cuts, there is more than a sporting chance of the U.S. economy slipping into recession, and dragging the rest of the world down. This will, in my opinion, unleash the forces of deflation with rather dire consequences, especially given the highly-leveraged state of the U.S. economy.

On the other hand, should Bernanke throw increasing amounts of money at the problem and cut interest rates aggressively, the dollar can fall down a precipice. Inflating the economy out of its quandary, however, may be the only policy option with a chance of success.

This raises the question of how foreign investors are going to react to the trillions they have invested in the U.S. dwindling in non-U.S. currency terms. Anybody under the impression that U.S. equities and bonds have been performing reasonably well this year, must think again. The graph below shows the Dow Jones Industrial Index in both U.S. dollar terms (red line), and euro terms (red line). Whereas U.S. investors are showing a return of 9.08% for the year to date, euro investors are in the red to the tune of -0.81%. (Although I am using the euro in this example, the same logic applies to most other non-U.S. dollar currencies.)

Source: StockCharts.com

The next graph illustrates the same principle for bonds by comparing the U.S. Treasury Note Price Index in U.S. dollar terms (red line) with the same Index from the viewpoint of a European investor (blue line). The results are as bad as for equities.

Source: StockCharts.com

And for good measure, the hard numbers are summarized in the following table:

RETURNS FOR US STOCKS AND BONDS (US DOLLAR AND EURO)
Index	Return
	Year to date	Aug 17 – Nov 2
- US dollar	9.08%	5.70%
- Euro	-0.81%	-1.89%
10-year US Treasury Note Price Index
- US dollar	3.23%	2.70%
- Euro	-6.13%	-4.67%

Source: StockCharts.com

How much longer will foreign investors put up with a plunging dollar eating away at their returns? On the last count, the formation of 17 Sovereign Wealth Funds (or varieties thereof) have already been announced. It is an open question how much of these countries’ existing U.S. investments will be redeployed to non-U.S. dollar pastures through these entities. Somewhere down the line, a point will be reached where America will start offering bargains galore to the non-U.S. dollar investor, but we may not have arrived at that juncture yet.

It is perhaps too early to conclude that Bernanke is facing a death spiral, but it would appear that he is confronted with the proverbial Hobson’s choice – inflate or die. With stocks still in overvalued territory, and bonds looking equally toppish, this really leaves few investment avenues other than cash or gold (in whichever shape or form). Although gold may be overextended in the short term, it should remain the ultimate reflation/safe-haven play for the foreseeable future. That, at least, is the way I will play the markets until such time as Hobson reappears to offer Ben a few additional choices.

Source: Jim Sinclair’s Mineset

Comments

[Malkiel]

I seem to recall that in the mid '80's after the recession the Japanese handled this problem by buying U.S. commercial real estate and other tangible assets at bargain prices instead of U.S. paper investments (though they failed to stop buying as those assets climbed in price toward the end of the decade, got burned after the crash, and withdrew from our market in the '90's, but that's a different side of the story). We see evidence that the Chinese are tuning in to the bargains in our real estate, perhaps aided by a sizeable population of Chinese Americans available to scout the bargains...

[HARM]

<i>I seem to recall that in the mid '80's after the recession the Japanese handled this problem by buying U.S. commercial real estate and other tangible assets at bargain prices instead of U.S. paper investments</i>

I seem to recall the Japanese using bubble equity from their own twin RE & stock market bubbles and paying top dollar for inflated U.S. real estate (recall "Rising Sun", Rockefeller Center & Pepple Beach anyone?). And then having their asses handed to them.

RE: "bargains" in U.S. real estate, yeah right --at 11:1 median price:median HH income ratio, those CA properties are looking mighty "affordable". Keep repeating the "everyone wants to live here", and "wealthy foreigners will pay any price" mantras --maybe it will come true through will power alone.

Q: Are you a real estate agent or mortgage broker (or both?)

[HARM]

--"Pepple Beach"
+"Pebble Beach"

Must remember to spellcheck.

[Malkiel]

I said COMMERCIAL real estate, though many trophy properties like mansions will also be viable investments. If you want to take out your anger at the real estate bubble, check out the LaLand blog at the Latimes.com instead. And no, I have no connection with selling real estate.

[Brian Croner]

To draw an analogy, in reproductive biology it would be called "the point of no return." Or, failing that, when you're on your way to a sneeze and you can't stop yourself from sneezing unless somebody chops your head off. The dollar is dying.

[droskoph]

Few grasp that inflation pushed to a breaking point threatens a deflationary accident. We are following Japan's folly in maintianing the facade of "good receivables" in floating these MBO's, CDO & SIV's. Then, the BOJ let the bubble inflate and were blamed for the being behind the curve. Now, our FOMC is doing all it can to maintain the facade. They have no option given their charter - short term fix. They're becoming irrelevant as oil will jam the global gears and reassert reality before higher interest will. It's a fiated bubble and commodity prices are the pressure gauge. We are headed into an economic storm.