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During
the second quarter, U.S.
economic activity remained strong, and there were
also pockets of economic vitality around the globe,
notably in China
and Southeast
Asia.
Financial markets recovered nicely in the
second quarter from very weak results in the first
quarter to the point a broadly diversified, currency
hedged investor would have experienced moderate
single-digit positive returns for the first six
months of 2005.
However, the unhedged U.S. dollar investor
achieved only breakeven or low single digit returns
due to currency losses.
Economic
Review
The
Fed created new threats when it acted decisively after the
Internet bubble and the 9/11 tragedy to avoid world
recession and even deflation. The
long string of interest rate cuts, aided by the fiscal
policy stimulation of income tax cuts, limited economic
contraction and allowed developed western countries to
avoid the dreaded “D” word.
However, the policy direction threatened to
overstimulate the economy and reignite inflation, as
short-term interest rates reached a 45-year low.
Accordingly, in early 2004, the Fed reversed course
and began a series of increases in the Fed funds rate,
hoping to engineer a “soft landing” and simultaneously
reduce the U.S.’s
twin deficits and housing bubble.
So
far the Fed has been successful in many respects.
The economy has been strong enough for solid jobs
creation (about 180,000 jobs per month on average so far
this year) and a small drop in unemployment, but inflation
has remained under control (annualized core inflation of
1.2% in the second quarter, down notably from a 3.3% annual
rate of increase in the first three months of the year).
Further,
recent economic reports have shown that consumer spending
is resilient, despite high gasoline prices.
Business spending is picking up.
Manufacturing is rebounding.
Corporate profits continue to beat expectations.
Although job creation is gaining momentum, there
still is slack in the labor market with many people out of
the workforce. In
summary, Federal Reserve Chairman Alan Greenspan reaffirmed
on Wednesday, July 20, 2005, in testimony to Congress what
a growing body of data has made clear: despite high energy
costs and other concerns, economic growth is on a “firm
footing” while inflation remained in check.
Furthermore, he indicated “our baseline outlook
for the U.S. economy is one of sustained economic growth and contained
inflation pressures.”
Outside
of the U.S., the
economic picture remained mixed. In
Europe,
continued high unemployment (unemployment rates topped 10%
in both France
and Germany) prompted
further calls for an easing of monetary policy. However,
already-low short rates and the rise in commodities prices
(particularly energy prices) made any policy adjustments
difficult. Thus, second quarter forecasts for
Europe
’s GDP
growth in 2005 and 2006 were extremely modest. In the Asia
Pacific region, China’s
impact continued to be a significant positive. Nonetheless,
much of the region, particularly Japan, is
sensitive to the negative impact of higher oil prices.
Thus, recent growth has been choppier, and forecasts have
become less consistently positive.
Also
on July 20, Greenspan reiterated his concern about
low long-term interest rates, which have stayed down
despite the Fed’s hikes in short-term rates.
That situation, which Greenspan called a
“conundrum,” has depressed mortgage rates,
helping to create what Greenspan called “froth”
in the housing market.
This easy credit and low cost of financing
also contribute to the U.S.trade deficit by encouraging demand for imported
goods.
We
believe global forces are behind the conundrum of
low long-term interest rates and also the surprising
strength of the U.S. dollar. The
twin dynamics of the global economy are:
1.
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The
world’s most populous country is
undergoing a rather rapid transformation
from a government-
run, socialist economy dominated by
state-owned enterprises with no profit
incentives to a modernizing economy with
huge, emerging, manufacturing businesses
operating on a capitalistic, profit-seeking
basis. The
Chinese export industry has grown in leaps
and bounds because of an unlimited supply of
industrious, low-cost labor, a fixed rate of
exchange for the Yuan guaranteeing continued
global price competitiveness, and abundant
financing funded by a combination of good
domestic
savings and foreign investment.
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| 2. |
In
search of good customers, the Chinese have
found a seemingly insatiable one, the
richest, most credit-worthy country in the
world. Stimulated
by record low interest rates, tax cuts, and
a housing refinancing boom to offset the
wealth lost in the Internet stock market
bust, the
U.S.
consumer stands ready to buy what
China
produces.
The result is our record trade
deficit, much of which is with
China
. Because
the Chinese development program requires
continued demand for their exports, the
Chinese have recycled the dollars they
receive from U.S.
consumers by buying U.S.
financial instruments like U.S. Treasuries.
This recycling in effect extends
liberal trade credit to us, keeping U.S.interest rates low and supporting the value
of the U.S. dollar on international currency
exchanges. In other words, it perpetuates the
cycle. Former
Fed Chairman Paul Volker recently mused:
“If I were a biologist, I’d call this a
perfect example of symbiosis. Contented American consumers matched
against delighted foreign producers. Happy borrowers matched against
willing lenders.”
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As
Volker correctly implies, other foreign countries,
such as India
and Japan,
are engaged in the same process, to greater or
lesser degrees.
Also, English and European consumers are
emulating the U.S.
consumer to some extent with their own large
purchases of cheap Asian imports.
What is noteworthy regarding the U.S.’s
bilateral trade deficit with China,
in addition to its size, is that its growth is rapid
and accelerating.
Almost
every economist agrees that change must come.
The debate is over how, not whether, the
global economy rebalances: Will it be smooth,
through some combination of declining dollar and
accelerating foreign demand?
Or will it be chaotic, with a dollar
collapse, much higher U.S.interest rates, and perhaps a global recession?
The
assembled brainpower at PIMCO in Newport Beach, including the well-respected bond gurus of the
firm, as well as prominent outside economic and
financial experts, has concluded that the symbiosis
has legs, there will be only a gradual decline of
the dollar, and long-term interest rates will stay
low. Mr.
Greenspan is also sanguine.
Capitalist economies, he believes, always
have imbalances but are also continuously
reallocating resources and capital to correct them.
Thus, imbalances seldom become crises.
“The number of forecasts of crises…is far
in excess of the number of crises that actually
occur,” Mr. Greenspan told a recent audience in Chicago. “There
is something equivalent to an invisible hand which
continuously is readdressing market imbalances to
reach equilibrium.”
Finally, Fed staff research shows that in the
past, when a big, rich country has a large current
account deficit, it usually narrows without crisis.
For example, homes may be overvalued but are
much harder to trade than stocks and thus unlikely
to collapse abruptly.
Market
Perspective
Economic
conditions are reenacting the “Goldilocks” economy of
the late 1990’s-not too hot, not too cold.
That perception has been a key catalyst behind the
stock market’s rally this spring. U.S.
stock investors can take further solace that corporate
earnings have been catching up with valuations.
Thus, price to earnings and price to book value
ratios, though above historical norms, have at least
improved. If
PIMCO and Greenspan are correct, the framework is in
place for reasonable returns from global financial markets,
along the lines of historical averages, for the balance of
2005.
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