Bridgewater Associates: Global Themes - November 2005
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Bridgewater Associates: Global Themes - November 2005

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. Bridgewater ® Daily Observations is protected by copyright. No part of the Bridgewater ® Daily Observations can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17,U.S. code). 1 Bridgewater ® Daily Observations 11/14/2005 Bridgewater® Daily Observations November 14, 2005 © 2005 Bridgewater Associates, Inc. (203) 226-3030 Bob Prince Jason Rotenberg Global Themes: Revised 3/10/2006 There are always a few dominant themes that are either driving market behavior now or will be driving markets over time. Our Daily Observations essentially represent a series of individual snapshots that we take in the context of these themes. Given a set of expectations that are formed by our assessment of the bigger forces, we overlay a series of objective observations to see whether things are playing out as we expect, remaining open to the possibility of being wrong. While we think and write about these conditions qualitatively, we objectively measure the forces more accurately by way of our systems. At any point in time our investment positions represent the collective pressures on markets that are coming from many directions; pressures that we broadly categorize under headings like macroeconomic conditions, valuation, intermarket action and capital flows. Where the forces line up we hold our biggest positions. Ultimately, our positions do not represent themes because managing money by way of themes is inherently dangerous: you can’t get enough diversification from betting on a handful of themes to generate consistent performance. Instead, our positions are driven by the unique forces on each market and the differences in forces across markets. But we think about the themes so that we are sure to measure the biggest forces, and because we enjoy it. We will briefly cover some of today’s major themes. Significant dollar imbalances remain. These imbalances will require a substantial decline in the dollar in order to restore U.S. competiveness in goods markets and/or a substantial repricing of U.S. financial assets in order to raise their expected returns in relation to financial assets abroad. The first stages of repricing occurred in 2002-2004, primarily in relation to the euro. But U.S. competitiveness in goods markets continued to deteriorate because Asian central banks, led by China, bought U.S. bonds at uneconomically low interest rates in order to hold their currencies down. U.S. consumers and businesses shifted their purchases toward cheap currency countries, which prevented what would have otherwise been a natural devaluation of the currency and improvement in the trade balance. By holding the dollar artificially high, the U.S. trade balance has continued to deteriorate and the need for capital has increased to about $775 billion per year, $300 billion higher than it was when private sector capital gave up on the dollar in 2002. This latent imbalance will undoubtedly be resolved, particularly against the yen, RMB and other Asian currencies. Despite the structural problems, this year the dollar has actually rallied, particularly against the yen. The rally was prompted by oil money flooding into dollars, speculative buying in the forward market and corporate repatriation. These forces drove the dollar up enough to prompt central banks to diminish their purchases, which capped the rally. The net result has been a relatively modest uptick in the dollar fueled by a massive increase in new purchases that will not be sustained. When these purchases go away, they will likely go away at a time when the Japanese economy is performing better and the Chinese economy is more equipped to deal with a volatile exchange rate. As a result, when the temporary purchases go away the Asian central banks will probably be less willing to intervene as they have in the past couple of years. This will require the U.S. to finance the current account deficit through private investor inflows, and these investors will require economic returns, which will force a repricing of both the dollar and U.S. assets.
  • 2. World and U.S. interest rates are too low. The combination of fears of deflation in the developed world and fears of appreciating exchange rates in the underdeveloped world has led to a massive global infusion of liquidity in the past few years. This has caused the global value of money to fall, seen most clearly in the prices of everything that money buys rising in money terms. We showed the following table last week. It shows the price changes of all kinds of stuff since world real interest rates fell substantially below world growth rates rose since 2002. Oil 111% Natural gas 246% Gold 48% Silver 66% Copper 177% Coal 112% CRB index 51% Homes (existing) 27% S&P total return index 41% MSCI World-X-US total return index 75% EMBI+ index 72% If the only thing that you knew was today’s level of world real interest rates you would think that we were in the worst global recession in decades. Instead, when you consider a true global picture, one that includes emerging markets, world economic growth is strong and excess capacity is shrinking. Given today’s economic conditions the current level of interest rates is about 1.25% to 2.0% too low. And the longer that they stay too low, the greater the inflationary risk, and the more too low they will be. This would not be a problem if the yield curve was steep. But the yield curve is remarkably flat (due mainly to the currency intervention discussed above). Therefore, incremental increases in short-term interest rates will drag bond yields higher. Fed tightening is not about to stop. Bernanke will have to prove himself as an inflation fighter just like every other central banker in their early months of service. And as China allows their exchange rate to rise, they will also allow their interest rates to rise. And as Japan recognizes their transition from depression to normalcy they will also allow their interest rates to rise. And with those conditions, currencies and interest rates across Asia will rise substantially to more normal levels. This will increase the required return on U.S. bonds at the same time that U.S. external financing shifts from public sources to the private market, putting downward pressure on the dollar, U.S. bonds and U.S. stocks. One of the interesting wrinkles in the interest rate picture is that the overvalued dollar and undervalued RMB has made capital investment within the U.S. (and most of the developed world) a bad deal and capital investment in China and other emerging markets a good deal. As a result, capital investment is shifting rapidly to China and other emerging markets. True “global” capital expenditures are now rising again, which is one reason that we see rising commodities prices. But the related demand for capital that is needed to finance this expansion is focused on China and to a lesser extent on other emerging markets, where interest rates and currency values are manipulated and currently being held too low. This has masked what would otherwise be upward pressures on global interest rates. But the pressures remain and over time market prices will adjust. 2 Bridgewater ® Daily Observations 11/14/2005 U.S. and global stocks are fairly valued, but risks remain in 2006-07. The 2000 to 2002 bear market in stocks had two distinct waves. In the first wave down, earnings collapsed faster than prices, i.e. PE ratios rose. This represented an implicit expectation a V-shaped recovery in earnings and economic conditions. In the second wave down PE’s collapsed as prices fell faster than earnings. The markets threw in the towel on the V-shaped recovery. Since 2002 earnings have rebounded, fueled by much better profit margins. In particular, increasing demand and weak labor markets have allowed productivity to rise much faster than wages. Now, earnings are at or above trend and the share of revenues going to labor is near 100-year lows. This presents a risk that earnings growth will slow, and it probably will. But it is important to realize that since earnings rebounded, they have risen faster than prices at the same time that interest rates have fallen. This
  • 3. 3 Bridgewater ® Daily Observations 11/14/2005 has allowed PE ratios to fall while interest rates fell. The net impact is that implied earnings growth rates are down to only 3%, the lowest level in 25 years. Another way to say it is that the breakeven PE ratio between stocks and bonds, 10 years hence, is only 13.7. At the same time, corporations are awash in liquidity. Business managers are not paid to hold cash. And what we have seen over the past year is a transition toward de-liquification and increasing leverage; companies are using their cash to buy back stocks and buy other companies. On top of that, they are borrowing money to re-leverage their balance sheets. Back in 2000, at the peak of the bubble, the biggest buyers of equities were U.S. corporations, by a wide margins. At last count the demand for equities by U.S. companies was about two-thirds of what we saw in 2000 and rising rapidly. Looking further into the future the risk is the next recession. If that recession begins with interest rates too close to zero, the Fed and other central bankers will not have enough room to reverse the recession through interest rate cuts. This raises the risk of deflation and will require more unusual and less frequently tested monetary policy measures, like monetization. Successful monetization requires a lot of boldness. It requires a central banker to fight their basic instinct by a) printing money and b) printing loads of it. Japan underestimated how much monetization was required. The U.S. would likely do the same. Surely, monetization is a blunt instrument that is not used very often, hence risky. The depression in Japan is over. After fifteen years of muddling, culminating in about five years of aggressive debt reduction, Japanese businesses have restored their balance sheets. The root source of poor Japanese economic performance in the 1990s was debt liquidation. Japanese companies owned too many assets, that carried too little value, were financed by too much debt, lent by banks that had too little capital. It took fifteen years to unwind the problem. But Japanese balance sheets are now as solid as any time since the late 1970’s and debt ratios as good as those in the U.S. They are generating substantial gains in profitability and cash flow but have routed these funds into debt reduction instead of expansion, making the benefits less immediately visible. But debts are now reduced while cash flow is still strong. They are paying higher dividends and will put the rest of the money to work one way or another. As for capital expenditures, Japanese manufacturers have learned the value of outsourcing to China and are expanding their margins as a result. But this is holding down domestic investment, and domestic employment and domestic prices and domestic interest rates. Over time Japanese corporations will use funds to increase their rate of full-time domestic hiring, which will improve consumer income, consumer psychology and consumer spending. Better spending and better balance sheets will make banks more amenable to lending, which will reinforce the upswing. And this will all take place within a regional Asian economy that is vibrant, reinforcing the rise. Japanese stocks are still discounting a meager rate of earnings growth, the yen is still being held down as if the Ministry of Finance is fighting deflation, and bond yields still reflect a zero interest rate policy. The transition from depression to normalcy will reverse all of this. It will support stock prices by allowing positive earnings growth, support the yen by eliminating the need to fight deflation while lacking interest rates as a monetary policy tool and ultimately push JGB yields higher, roughly in that order. Koizumi’s bold political move didn’t fundamentally change anything, but it was an important psychological catalyst that reinforced the favorable conditions that already existed and will be remembered as a turning point. The wealth shift to emerging markets, particularly China, has decades to run. First hand experience with a number of businesses shows us that no matter what you make, you can make it at about half the price with equal or higher quality in China. Such low prices make import tariffs somewhat impotent because import tariffs are based on a percentage of price. And a very low price times a high percentage is still a low dollar figure. That is the micro view. The macro view shows that when you compare a common basket of goods the pricing of the RMB is about 50% below its fair value, about the same valuation that is implied by the anecdotal micro view. And while the currency is undervalued by 50%, productivity is rising much faster. For example, we know of a golf club manufacturer whose cost of production fell by a third from one year to the next, at the same plant, solely through the competitive drive and ingenuity of the manufacturer. Multiply this by 1.3 billion people and you’ve got a formidable competitor. Now relate this to the currency. If last year’s cost of production was half of the U.S., it would have taking a 50% decline in the dollar to equalize
  • 4. 4 Bridgewater ® Daily Observations 11/14/2005 the competitive position. But if the currency didn’t change, and the cost of production in China fell by another third (it didn’t change in the U.S.) then the dollar must fall by another third to offset the shift in relative productivity. RMB forwards are only discounting a 3.9% appreciation of the exchange rate in the next year. This is less than the productivity differential between the U.S. and China. So there is no discounting of a true normalization of prices. The PBOC continues to restrain the appreciation of the RMB. One reason is because the infrastructure of the country is not ready to handle a volatile exchange rate. But they are rapidly approving new dealers among the banks and encouraging companies to set up treasury and accounting operations that will allow them to manage their risks. Once the currency begins to rise, the cost advantages are so extreme and the productivity differences are so large that the competitive advantage will barely be dented. This means that for a number of years China will enter a sweet spot where it can have its cake and eat it too. Their global wealth will increase at an accelerating rate both through the appreciation of their exchange rate and simultaneously through money inflows derived from balance of payments surpluses. You will see the Chinese increasingly convert their vast holdings of U.S. Treasury IOU’s into real assets, including real estate, equities, energy and direct business holdings. Beyond China, numerous emerging market countries have opened their economies and are experiencing similar trade and balance of payments surpluses, either because they produce the natural resources that are being consumed by global growth, or because they have cheap, productive labor that can be married to new technology to produce significant cost advantages. Many of these countries now have significant pools of private domestic savings. This is leading governments to transition from U.S. dollar financing to domestic currency financing, which is creating liquid bond markets in many local EM currencies. This is good for investing and good for alpha generation. It also reduces the risk that is imbedded in EM government balance sheets by matching the currency denomination of their debt with the currency denomination of their revenues. The process of holding down their currencies has produced substantial increases in foreign currency reserves. In many countries these reserves are sufficient to provide for years of upcoming debt service payments. This surge in liquidity has driven emerging market credit spreads to low levels. In the EMBI+, only two countries now have credit spreads above 4%, Nigeria and Ecuador. But this surge in government liquidity resulted from active intervention against what would have otherwise been a rise in their currencies. In other words, the same rise in liquidity that drove credit spreads down also kept currencies below fair value. This makes their currencies and their local currency debt attractive investments. These are five of the most significant themes that either are or will be driving global market movements for a while. From an investment standpoint, what is more reliable is the process of measuring the particular forces that drive individual markets, defining an optimal response to known conditions and responding to changes in conditions as they unfold. This measurement process leads us to a set of positions that are consistent with the themes above, but include many other positions that fly under the radar, which produce diversification and consistency in a way that is not achievable through a thematic approach alone. Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Bridgewater research is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it do not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.