 |
||
| ...Starting with first principles | ||
| America First Trust services | ||
| Education, analysis, and advice for uncertain times | ||
| SECURITIES |
FOREIGN
FIXED INCOME |
| (Last updated October 1, 2003 by William Fox)
OVERVIEW
Foreign bonds should be a vital part of any properly diversified bond portfolio for a variety of reasons. First, at various times there may be foreign countries that offer higher interest rates, stronger currencies, and stronger economies than the US, so much so, in fact, that at certain times American fixed income products are generally a bad investment relative to certain foreign bonds. I think that we are in such a period right now. Secondly, the process of researching relative currency valuations (c.f. the “Big Mac Index described below), foreign economic policies, different inflation rates, and the trends in currency exchange rates force an investment strategist to ask questions that he should be asking any way even if he were restricted to only buying domestic bonds. Jim Rogers, the investment “biker” writer at www.jimrogers.compoints out that one often learns more about ones own country by being abroad than by staying at home, and studying foreign currencies and different national strategy issues works in a similar manner. “WE’RE MORE AMERICAN THAN AMERICANS” Every now and then I run into a news article that carries this theme, usually meant as a spoof, voiced by groups such as a Wild West reenactment group in Germany, a 1950’s car and culture club in Norway, a U.S. Cavalry horse club in Russia, or a group of descendants of Southern Plantation owners who fled to Brazil in 1865 who still fly the Stars and Bars at their 4th of July picnics. However, there is a more serious economic, political, and demographic dimension that is not quite so humorous. I explain in my “Learning the score” article that the original economic and political philosophy of America was strongly libertarian. There was no income tax and no central bank,. There was almost no government, in fact, with less than 1/30 the number of government bureaucrats per capita compared to a European country such as France at that time. Most Americans are unaware of the extent that American has changed in the last hundred years, and has turned its back on the basic free market principles that characterized its earlier success. In a Forbes interview in the late 1980s, Nobel Laureate Milton Friedman pointed out that virtually every item on the 1928 Socialist plank has become a reality in America today. In the early 1990s The Conservative Review ran an article by J.V. Raehn which claimed that there were then more de facto Marxists in America than in Eastern Europe. According to Raehn, Eastern Europeans had experienced Marxism first hand and were totally fed up with it, whereas in America, through a very subtle and incremental process, Americans had come to accept as mainstream ideas that would have been considered “Bolshevik” in the 1920’s and were not even aware of it. Although America once led the world in manufacturing prowess, Japanese firms adopted and perfected many innovations pioneered by Americans such as W. Edwards Demming in the 1950’s that were initially ignored by major American companies. They redacted these ideas back to Americans while taking away major market share. As discussed in my “Learning the score” section, the early American approach to economics has been redacted back to us by the “Austrians.” We are often hit with ironies such as Steve Forbes’ remark in the April 15, 2002 Forbes Magazine Fact and Comment section, “Early last year President Vladimir Putin junked Russia’s tax system and replaced it with a 13% flat tax…on this issue I never thought I would be outflanked on the right by a onetime KGB agent.” It may be wiser to invest in certain foreigners who act more like early Americans than to invest in certain contemporary fellow “Americans” who act “un-American.” TWO BASIC TYPES OF FOREIGN BONDS: Yankee bonds. These foreign bonds pay coupons in dollars and mature in US dollars. They are like domestic bonds, except they might pay slightly higher interest rates if foreign interest rates are higher. They do not carry currency exchange risk. The key questions here involve the credit worthiness of the foreign bonds and understanding why interest rates in a particular foreign country may be higher than in the US. Yankee bonds are best for situations where the US is bringing its own inflation under control, the dollar is likely to hold or gain in value relative to other currencies, and foreign bonds with higher interest rates are likely to avoid default. The “golden era” for Yankee bonds began at the peak of double digit interest rates in the early 1980’s and followed the gradual decline in interest rates for the following two decades. One class of bonds, called Brady bonds, actually carried US Government guarantees. Foreign bonds denominated in their home currency. These types of bonds have currency exchange risk. Under certain circumstances, this may be exactly what you want. The key question here is why the dollar is likely to decline relative to certain foreign currencies. Foreign bonds are best for a situation where it looks like the US is going to experience rising interest rates and inflation, therefore the investor wants to escape the domestic bond environment to avoid having the value of his bonds get slammed by rising interest rates. (C.f. my discussion of this problem in my “domestic fixed income” article). Since 2000, bonds of countries such as Australia, New Zealand, and Canada have performed very well, benefiting from the eighteen month slide in the dollar beginning in late 2001, as well as a reduction in the Purchase Power Parity (PPP) valuation gaps between the currencies of those countries and the US dollar (C.f. my PPP-related discussion later in this section). A BASIC ANALYTICAL APPROACH In trying to find countries whose currencies are likely to appreciate against the dollar, I usually take two steps. First, I read what experts in the field say, to include veteran mutual fund managers with proven track records. John Templeton, who reached age 90 in the year 2003, is a good example of a veteran fund manager with a proven track record. I saw him on CNBC in early 2002 where he stated that he was completely out of the US stock market which he referred to as the “Great Insanity.” He had bought bonds in currencies he felt were likely to retain their value, specifically mentioning New Zealand, Australia, and Canada. I then went the next step and went through the analysis provided below. I discovered from the Big Mac Index (cited below) that the currencies Templeton mentioned were indeed considered undervalued. I discovered from Doug Noland’s Credit Bubble Bulletin that the US dollar was on a serious inflationary track, and learned from other sources that the campaign by Clinton’s Secretary of the Treasury Robert Rubin to artificially strengthen the dollar had finally reached its “tipping point” and the dollar was likely to commence a long term downward slide against other currencies. After making a reasonable effort to try to make sure I was right, then it was time to go ahead with foreign bonds. Now both I and many of my clients are grateful that we have been riding a money-making trend for over a year now. Whether analyzing domestic bonds, foreign bonds, or stocks, I like to start with a relatively simple, laissez faire, “ground up” economic model and then add in the complexities and exceptions. Once a person understands basic, classical economic relationships, then it becomes easier to understands how political considerations often turn these principles on their heads -- in the short run. Let me emphasize the short run, because in the long run fundamental market principals tend to be more powerful than various forms of interventionism. In the long run, market relationships tend to regress back towards basic value parameters despite all of the efforts of the interventionists to disguise them. Below I will start with a basic, almost deliberately naïve “classical” economic approach, and then discuss some complexities and exceptions. The analogy between currency value and stock prices. In the long run, a unit of currency is similar to a share of stock in a company. It acts like a share of the economic output of a country just like a share of stock reflects an ownership portion of the assets and output of a company. If a country continually adds to its base of wealth and productivity, and keeps its money supply constant, the value of each unit of currency will go up proportionally. Something similar happened to the US dollar in the 1800s when it was on the gold standard. Despite some war-related inflationary outbursts (the Lincoln Administration cut the value of the dollar nearly in half during its war against Southern independence), the dollar was worth about 50% more in 1900 than it was in 1800. This analogy may seem a bit strange to contemporary Americans, since we are so conditioned to ever depreciating currencies both at home and abroad. Since the creation of the Federal Reserve Banking System in 1913, the dollar has lost over 95% of its value. Europe currencies have generally been on the skids since World War I. Only Switzerland stayed pegged to gold up until recently. Despite all of this, please bear with me. In the long run, if the value of a currency rises against the currencies of other countries, this is a good thing, just like a rising stock price for a company. It means that a country is operating more productively, is commanding control over more wealth and resources, produces more goods that others want, and at the same time is respecting the property rights of its citizens by not depreciating the value of the currency out from under them. Please recollect that inflation is usually a sneaky form of taxation, in which the government gets to spend up front what later becames a real loss in purchasing power for its citizens. Governments typically resort to inflation because they know they do not have the political clout to honestly raise funds by formally authorizing new tax legislation. This kind of thinking was fairly typical in America and Europe in the early 1800s when there was a much higher standard of honor and integrity in society as a whole and government. During this period US and European currencies generally appreciated over time compared to currencies everywhere else in the world. As libertarian economist Dr. Hans-Hermann Hoppe has pointed out, the lights started going out with the advent of World War I. European countries got off the gold standard to help finance their continued mutual slaughter in the trenches. Then in the post war period they toppled the last vestiges of privately owned government (monarchy and aristocracy) in favor of mass suffrage. They went towards the other extreme, creating social welfare states where pork barrel politics became more noble than respecting property rights and private entrepreneurial capital formation. The cost of government on average climbed from about 10% to over 50% of GNP. The fact that virtually almost all advanced industrialized countries today have a policy of continually depreciating their currencies does not invalidate my argument, it simply makes it more relative. So in other words, it is usually a good thing when we find a country that debauches its own currency at a slower rate than other countries. Balance of trade surpluses are good and deficits are bad If we had a balance of trade surplus, this would mean that foreigners are demanding more of our goods for export than we are demanding of theirs. In the long run, this can imply that our goods have a superior quality to price ratio compared to goods offered by other countries. Examples on a global level of export goods with high demand can range from expensive high-end items such as Mercedes cars made in Germany to relatively cheap items such as computer chips made in China or Malaysia. As long as a country is steadily increasing the quality of certain goods while decreasing their relative prices, whether it is focusing on high end or low end items, and doing this better than other countries, it should be able to sustain export growth. All other things being held equal, you want to buy bonds in foreign countries that run sustainable balance of trade surpluses or at least avoid sustained deficits. As a rule of thumb, countries with continued deficits over 5% of GDP are at high risk of seeing their currencies slide against trading partners with trade surpluses. At some point trading partners get tired of accumulating excess currency from the country running trade deficits, sell it off, and drive the value of the currency down. All other things being equal, you want to avoid buying bonds in countries running chronic trade deficits since their currencies are more vulnerable to a major correction. . The normal adverse consequences of money supply growth on currency value Just as one generally should stay away from companies that have a nasty habit of diluting their stock without increasing net asset value or earnings per share, one should be wary of countries that accelerate the rate of money supply expansion without any real underlying productivity growth, asset growth, or other worthy gains. It may take a few years for accelerating money supply growth to show up in the inflation figures, but the effect on bond holders is usually bad. As I mention in my domestic income section, for an American who owns bonds here in America, the value of his bonds gets hurt in two ways by inflation. First, inflation erodes the real value of his coupon payments and the redemption value of his bonds at maturity. Secondly, rising inflation usually means rising interest rates, which then hurt the market resale value of his bonds. For an American who holds a foreign bond denominated in a foreign currency, something similar happens, only it is a little bit more indirect and more relativistic. If the foreign country is inflating its currency faster than the US, then that should eventually hurt the value of the foreign currency relative to the dollar, and hurt the value of foreign coupon payments when exchanged back into dollars or the value of the foreign bonds upon redemption at maturity. The Purchase Power Parity concept The idea is fairly simple. It addresses the question of whether current exchange rates actually allow us to exchange our dollars and buy roughly the same quantity and quality of goods in a foreign country as we could buy with the same dollars here in the US. When exchange rates get really out of whack, supposedly this will tend to self-correct over time through an international trade environment with relatively low tarriff levels. Therefore, over the long run, currencies that have large purchase power parity differentials tend to converge back towards parity. Other things being equal, I would prefer to buy foreign bonds in First World countries whose currencies are very much undervalued relative to the US dollar, and where there are no significant structural reasons why their currencies cannot revert back to parity with the US dollar. An interesting application of the PPP has been the “Big Mac” index developed by The Economist Magazine in 1986. According to “McCurrencies” in the April 24, 2003 Economist:
Everything is relative What makes foreign bond investing really different from investing only in domestic bonds is the additional relativity aspect of currency exchange. For an American holder of a foreign bond, if the US dollar depreciates more rapidly than a foreign currency, this will probably be beneficial and more important than the nominal rate of return of a foreign bond relative to the rate of inflation inside the home country. A different example of relativity was provided in the interview by James Puplava on Feb 22, 2003 with Dr. Marc Faber, editor and author of Tomorrow’s Gold -Asia’s Age of Discovery. He explained how American holders of Argentinian assets might have seen net deflation from a currency collapse despite strong internal inflation. This also provides some other interesting insights on the inflation-deflation issue.
As mentioned, although markets tend to win in the long run, the following are examples of departures from classical theory in the short run that are often caused by forms of government, central bank, or speculative intervention or unusual trading relationships. The analogy between currency value and stock prices. A country can play games with its currency exchange rates just like a company can manipulate its stock. Let me start with a corporate example of stock manipulation. A company with a dangerously high level of debt might decide to go yet deeper into debt in order to buy back its stock and drive its stock price higher. Sometimes insiders do this so that they harvest their stock options or to fool the public prior to a secondary offering in order to get a higher price for their stock. This may in fact work very well in the short run, but in the long it could be a disaster if a company’s heightened vulnerability to bankruptcy results in an actual default and reorganization. If a gambit to run up the stock price succeeds, this reflects financial engineering rather than any real improvement in the underlying operations, earnings, and other fundamentals of the company. Similarly from 1995 to 2000, U.S. Secretary of the Treasury Robert Rubin pursued a strong dollar policy by buying up dollars. He artificially increased the value of the dollar against other currencies. It gave the impression of American economic strength, when in fact America’s balance of trade deficits kept growing and America kept going deeper into debt. I invite the reader to look at the upward slopes of the personal, corporate, and national debt-related charts at the Grandfather Economic Report web site, and then consider the long term level of wisdom of Rubin’s maneuver. Also, in the short run currencies can be heavily influenced by investment flows rather than physical trade goods, analogous to the way stock prices can move on flows of speculative capital rather than changes in fundamentals. As an example, in the late 1990’s, the Australian dollar became unusually depressed relative to the US dollar because Australians were investing vastly greater amounts of money in US stocks than Americans were investing in Australian stocks. One often hears Wall Street analysts comment that a slide in the dollar is a good thing, because it makes American exports cheaper and foreign imports more expensive, therefore creating a self-corrective mechanism to help eliminate American balance of trade deficits. It is true that a declining dollar should stimulate our exports, but there is deeper question here, analogous to the value stock investor who tries to decide whether a dip in a company’s stock price makes a good investment a better value, or whether it is symptomatic of a company that is fundamentally going down the tubes. Unfortunately there is evidence of both in the case of the US. In the last few decades, manufacturing jobs have declined from 30% down to 15% of the work force, while America’s total indebtedness continues to skyrocket. An important issue with companies is whether they can continually produce goods that have a competitive price to quality ratio, and whether their internal culture and organizational discipline allows their workers efficiently reinvest in plant and equipment and boost their level of skill and innovation. Beyond a certain point, when the US continues to export manufacturing and service jobs overseas, this reflects a vote of no confidence or greedy short-sightedness by American managers regarding their ability to get an adequate payback from reinvestment in American workers and American infrastructure, and that is a bad sign. In discussing exceptions to my currency and common stock analogy, it is important to address two issues:. First, please note that there are prominent economists on both the left and the neoconservative internationalists “right” who really hate the comparison of currency with common stock and want to keep this old-fashioned idea flushed down the Orwellian memory hole. This is because the independent currency concept can become a “territorial thing” and have right wing nationalist connotations. So, for example, if certain European countries retain their own currencies rather than stay blended together under the Euro, and their currencies start to appreciate, this might give rise to more national pride compared to other countries that always have problems getting their economic act together. Pride could possibly lead to more competition and more ethnocentrism and racism and ultimately maybe even war, conquest, and imperialism. In order to avoid these kinds of things at all costs, they think the answer is for all countries to get more laid back and depreciate their currencies all together or merge everything into one common currency. This is one reason why the International Monetary Fund forbids countries from linking their currencies to gold. Depreciating ones currency is supposed to be cool and trendy, like the folks on MTV who wear hip-hop grunge and rings through their lips and ears. In Keynesian economic ideology, this is also supposed to be more humane, because the steady money supply growth and government spending that leads to steady currency depreciation allegedly provides more macro economic stimulation to reduce unemployment. Another possible exception to the currency and common stock analogy is the fact that certain Asian countries such as Japan, China, and Malaysia appear to have vastly benefited from keeping their currencies either low or pegged to the dollar. In my view, the real exception has to do with the unique geopolitical sponsorship that the US has provided these countries, and not with the underlying economic principles involved. In essence, these countries have enjoyed a relatively high level of free trade while enjoying dollar parity, a similar benefit as if their national legal tender were in dollars. From a purely economic viewpoint, they have enjoyed similar benefits as if they comprised a 51st state in the Union, or to use a different analogy, as if they were “East German brethren” relative to West Germany after the Berlin Wall came down. A corporate analogy might include the CEO of a company that gives special price advantages to another company even though it hurts his own company’s profitability and stock price because of non-business factors such as nepotism (his son runs the other company), corruption (the other company is giving him kick-backs under the table, reminiscent of the “Chinagate” allegations regarding Chinese campaign contributions to the Clinton administration), or pride and ego factors (the CEO likes to play Santa Claus). What is really different from a broad historical viewpoint is that these Asian countries have been allowed a high degree of national sovereignty and political-military independence while receiving the economic benefits of free trade, dollar parity, and intimate export relationships. For starters, after WWII the US allowed Emperor Hirohito and the Japanese industrial elite to stay in power and retain control and ownership of their economic order. The same has applied to China in the post Nixon era in regard to the Chinese Communist Party and Red Army heirs of Mao Tse Tung. America has also allowed these countries to retain their own armed forces and their own racial, ethnic, and cultural homogeneity and/or their own de facto ethnic and racial balances without demanding that they accept masses of alien immigrants, eliminate all restrictions on importing US goods, copy American institutions, accept US work place-related and union-related regulations, accept permanent US administrators, and subject themselves to American taxes. In other words, they enjoy all the economic benefits as if they comprised a 51st state in the Union dealing in dollars with very little of the real costs and obligations born by the other 50 states. Admittedly there have been other countries that have tried to peg their currencies to the dollar and experiment with free trade, such as Argentina, and have screwed it up, so I will not take away from the Japanese, Chinese, and Malaysians the credit they are due for the strong work ethic, social discipline, and business savvy required to pull off their economic success. However, their political and economic deal with the US has still been pretty sweet by historical standards, and this has given them a strong incentive to keep playing the game and continue keeping their currencies artificially weak. Compare all of this to the 19th century, where generally speaking, in places where British capital built manufacturing facilities and other business-related infrastructure overseas, one often found the British flag, British troops, British administrators, British colonists, British law -- and British taxes. Consider how styles of foreign involvement have changed. In the 1840’s FDR’s grandfather Capt Warren Delano made his fortune trafficking Opium to the Chinese and the British fought a war in China to keep that market open. In 1900 British, American, French, Russian, and other troops marched on Peking to suppress the Boxer Rebellion . American gun boats roamed Chinese rivers, in fact, that is how in 1937 the American gun boat Panay was accidentally-on-purpose sunk by Japanese planes on the Yangtze River. Or consider that in order to enjoy freer trade with the US, and remove an international boycott, white Rhodesians were coerced into giving up white rule in Rhodesia. Blacks gave Rhodesia the new name Zimbabwe, and the country has since turned into an economic basket case. Consider how the U.S. Government pressured white South Africans into relinquishing control of South Africa, and how that country is currently deteriorating in the same general direction as Zimbabwe. Consider how white Southerners wanted to renegotiate their economic relationship with the US Government in 1861 because they were tired of paying 80% of the tariff income to the US Government. To add insult to injury, tariff rates were nearly tripled at the onset of the newly elected Lincoln administration to about 45%. Lincoln baited the South into firing the first shots, and his administration proceeded to wage total war. It destroyed half the wealth of the South, killed one out of four white southerners of military age, obliterated their elected government (Confederate States of America), and for many years of the Reconstruction era, Lincoln’s political heirs prohibited white Southerners from voting as former black slaves and carpetbaggers ran their legislatures and confiscated their lands by hiking taxes. To summarize, I think the US Government has been a lot nicer to certain ruling elites in Japan, China, and Malaysia in the last thirty years than it has been towards white Rhodesians, white South Africans, and white Southerners. And getting back to the British, mentioned at the beginning of this paragraph, I have not even gotten into the pre WWI history of some stressful British economic relationships with the Irish, Scots, Boers –or with American Revolutionaries.
Trade surplus countries sometimes postpone or intervene to prevent a day of reckoning for trade deficit countries. This can help to disguise underlying economic realities for the foreign bond investor who is invested in a trade deficit country. There are many motivations for why a surplus country may decide to avoid a mass sell-off of the currency of a deficit country that would cause a major currency slide. A trade surplus country might be a staunch ally of country that is inflating its currency and running huge deficits in time of war, as was the case of the US as the surplus country during its special relationship with Britain during World War II. A country may want to help hide economic realities that could disrupt the creation of an important new alliance. One example involved the passage of the North American Free Trade Agreement in early 1994. Many major money center banks wanted NAFTA to help stimulate the Mexican economy to help them recover on their Mexican loan exposure, regardless of the consequences to US workers, and on top of this the Clinton administration wanted to pander to the Mexican-American vote. Not long after NAFTA passed, then Mexico’s current account deficit chickens came home to roost in late 1994 and the peso collapsed by 50%. But by then the fix was in. Last but not least, trade surplus countries may avoid or postpone selling off currency to avoid antagonizing a Leviathan trading partner. They may also want to keep their export prices low in order to build up national manufacturing and export infrastructure, maintain full employment, and out-compete their low cost neighbors. This is the name of the trade game that Japan, China, and Malaysia play with the US. For trade surplus countries, if they don’t “sell it” (that is, sell off their surplus dollars in the global currency markets and drive down the value of the dollar), then they may exercise other options such as “shop it,” “hold it,” or “eat it” to avoid impacting the currency exchange rates. In regard to “shop it,” surplus countries can use their dollars to directly buy US assets, such as stocks, bonds, and real estate, or they can buy US trade goods they really do not need (US farmers always want the Japanese to buy more agricultural goods). By “hold it,” they can simply accumulate more and more dollars, except here they run the risk that the dollars could lose more value from a continued currency slide. By “eat it,” I mean cases where the central bank takes excess dollars presented by merchants and swaps them for the home currency created out of thin air, which creates inflation in the home country. In essence the inflation in America that contributes towards a declining dollar then gets exported into the currencies of countries pegged to the dollar. Since inflation in the home country tends to depreciate the home currency, this helps to keep the exchange rate low, and may even help make the balance of trade surplus even worse. (Henry C.K.Liu, Chairman of the Liu Investment Group and writer for Asia Times, has some interesting e-mail discussions under the topic “Bernanke” about some vicious circles involved in the convoluted trade situation between the US and Japan at the Post-Keynesian Thought discussion archive). . Sometimes when a country inflates its currency, the impact on currency exchange rates may not be felt for many, many years. The analogy here may be a company that can wring out extra concessions from buyers and suppliers of its products due to some quasi-monopolistic advantage or some other type of unique position in an industry. The late French President Charles DeGaulle once referred to the ability of Americans to cover import deficits with dollars that foreigners were happy to hold and keep as money as the “exorbitant privilege of the dollar.” This privilege was based on the status of the dollar as the premiere global reserve currency. When excess dollars are circulated within the US, they tend to boost prices within perhaps a six month to one year lag time. Economists refer to the rate in which money changes hands as the “velocity” of money. Inflation is a function of both the total amount of money in existence and its velocity relative to total goods and services and productivity within an economy. When foreign banks stash increasing amounts of excess dollars into inventory rather wash them back at the US, they are slowing down the global velocity of money. This reduces the appearance of inflation, and helps to further disguise the vulnerability of the dollar to a slide in its exchange rate with other currencies. The Purchase Power Parity concept The Economist magazine points out that its Big Mac Index has a slight flaw in that Third World countries tend to show a certain level of sustained undervaluation:
Free graphical displays of foreign exchange rates around the world by Oanda. Yahoo guide to top performing world bond funds. Post-Keynesian Thought Discussion Forum:
Country analysis: Economist Magazine country briefings:
International Monetary Fund Country Information. Provides links to country central banks that typically provide money supply growth data. The World Bank Group Countries & Regions Central Intelligence Agency World Fact Book country profiles. Specific country data: Australia: Reserve Bank of Australia monetary aggregates; 2,5, and 10 year treasury bond yields updated monthly Canada: Bank of Canada monetary aggregates M2++ growth rates.
|
| Flag carried
by the 3rd Maryland Regiment © Text and web design by William Fox. Sometimes William Fox offers viewpoints that are not necessarily his own to provide additional perspectives. |
at the Battle of Cowpens, S. Carolina, 1781