T HIRD QUARTER 2004 O CTOBER 2004 Sea Change interest would INSIDE put this other- GRAPHS: wise undistin- u u u u u u guished career officer in a posi- tion to change · Graph 1: Capital Market the course of Returns—page 2 history? But that is exactly what · Graph 2: Fading Stim- Commander uli—page 2 Rochefort did. The five months · Graph 3: Net Saving as a following the Percentage of Gross Na- attack on Pearl tional Income —page 3 Harbor were an especially de- · Graph 4: Current Account pressing time Deficit—Page 3 for the free world. Nazi · Graph 5: 200+ Years of Germany con- United States Interest Rates trolled virtually —page 5 oseph Rochefort had a per- all of Europe and North Africa, and J fectly uninspiring career. He Japan controlled all of the western Pa- enlisted in the navy in 1918, cific and East Asia. Malaysia, Singapore, · Graph 6: Dow Jones In- earned an ensign’s commission, and was the Dutch East Indies, Papua New dustrial Average (1896- known principally as a lover of cross- Guinea, and the Philippines fell quickly Present) —page 6 word puzzles. Stationed on the USS Ari- to the Japanese onslaught (see map). zona in 1925, he shared this love of Neutralizing Australia and India were crosswords with his CO, Commander the next official Imperial war objectives, Chester Jersey. Later that year, when the to be followed by attacks on Alaska and navy decided to double its cryptanalysis the west coast of the United States. In department (to two), Jersey remembered conquering this immense area, Japanese and recommended Rochefort on the forces lost not a single battle, and their grounds that skill in crossword puzzles sureness of divine invincibility appeared qualified one for cryptanalysis. Along the justified. way, Rochefort picked up Japanese, and Before Imperial Japan could be in 1941 was the obvious choice to head defeated, it had to be stopped. Perhaps Station Hypo, the navy’s communica- that sounds obvious, but before a trend tions center at Pearl Harbor. Who could can reverse, it needs to be stopped in the have imagined that a crossword puzzle first place. It is only in hindsight that we 429 Santa Monica Blvd., Suite 500 u Santa Monica u CA u 90401 u (310) 393-6300 u (310) 393-6200 Fax u www.angelesadvisors.com PAGE 2 THIRD QUARTER 2004 Graph 1 Israel, down 17% in these Capital Market Returns three months. We draw no political conclusions from REITS, 18.3% these data. Convertibles, 5.1% ontributing to the 5-Years US Bonds, 7.5% modest rebound in Int'l. Equities, -0.9% bonds last quarter is US Equities, -0.1% C evidence of a slowing econ- REITS, 25.6% omy. Nothing dramatic here, Convertibles, 11.5% as the economy is still chug- 1-Year US Bonds, 3.7% ging along, but most of the Int'l. Equities, 22.1% recent indicators have taken US Equities,14.3% a dip, from retail sales to employment growth. Oil REITS, 8.2% Convertibles, -0.8% over $50/barrel may be US Bonds, 3.2% partly to blame for this slow- 3Q04 Int'l. Equities, -0.3% down, but two other factors US Equities, -1.9% are probably much more -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% important. Tax cuts provided a big stimulus to the econ- omy in 2003, but the effects are now fading. The biggest confidently identify a turning point, as much as in battles retardant to growth is probably the large decline in mort- or wars as in financial markets and economies. But turn- gage equity withdrawals (see Graph 2). These stimuli ing point is a poor description for how events unfold; kept spending (and economic growth) higher than would rarely do trends just turn and go the other way. This was have otherwise been. In the four years prior to 2001, real true in the Pacific War in 1942, and has been so in finan- spending kept pace with real pre-tax income, both grew cial markets throughout time. And we think this is where at 5% p.a. In the subsequent four years, real income we are today: a transitional period between very different growth fell to just 1.5% p.a., but spending only fell to investment regimes. 3% p.a. So spending was boosted by 1.5% p.a. relative to t’s been a seesaw year in most of the capital income, or about $150 billion. But these economic tail- markets. In the first three quarters of 2004, winds are fading, and near-term drivers of growth are I stocks were up/up/down while bonds not clearly visible. The concern is that slower economic were up/down/up, with little overall progress made. growth with modest hiring will lower productivity Following a gangbuster 2003, stocks now trail bonds year-to-date, which would make four out of the past five Graph 2 years that bonds trumped stocks, if Percent of disposable income Percent of disposable income 3 3 the trend continues a few more Year-to-year Effect of: months. Of course, a lot can happen Personal Tax Changes Energy Prices in a few months. 2 2 Real estate securities had a Mortgage Equity Withdrawal bear market (down 20%) the first few weeks of April, and have been on a 1 1 tear ever since, posting the best re- turn of all major asset classes, not just 0 0 last quarter, but now over each of the past 1-, 3-, 5-, 7- and 10-years. The -1 -1 most curious result for the quarter just past was that the best stock mar- ket in the world was Egypt, up nearly -2 -2 50%, while the worst performer was 1998 1999 2000 2001 2002 2003 2004 Chart courtesy Goldman Sachs 429 Santa Monica Blvd., Suite 500 u Santa Monica u CA u 90401 u (310) 393-6300 u (310) 393-6200 Fax u www.angelesadvisors.com M ARKET COMMENTARY PAGE 3 growth and push up labor costs, result- Graph 3 ing in lower profits and/or higher 16 Net saving as a percentage of gross national income prices. Growth drivers for the econ- 14 omy are obscured because of a large 12 structural imbalance in savings. This applies worldwide, but we’ll address the 10 US side first. The savings rate has been 8 in a structural decline (see Graph 3), but it can’t get much lower. It’s possible that 6 savings out of income declined over the 4 past twenty years as outsized capital gains were available for spending, but 2 this era has ended. The private savings- 0 | | | | | | | | | | | | | | | | | | | | to-investment balance plus the public - - - - - - - - - - - - - - - - - - - - sector’s balance combine to form the 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 current account balance, the difference Source Bureau of Economic Analysis between domestic savings and invest- ment that must be financed with foreign capital. This is of each Treasury auction. So, for the moment, it’s good not a choice; it is an accounting truth. The US current politics, but questionable economics, to buy our debt at account deficit is now over 5% of GDP (see Graph 4), current prices. That may continue for some time, but so we need foreigners to send us about $2 billion more then again, maybe it won’t. each day than the previous day. Of course, they do Our point is not that we are at that turning (because they have to—remember, this is just account- point; we won’t know that till after the fact. Incomes are ing), but the question is, at what price? Currently, the growing, productivity is still high, and it is certainly pos- price (Treasury yields) is pretty low, but private foreign sible that we resolve our savings deficit through a com- capital flows (presumably somewhat rational investors) bination of rising exports relative to imports and main- have slowed to a trickle, and the slack has been picked taining our high productivity. But the risks are clearly by foreign central banks, who are generally guided more shifting: the tax stimulus and mortgage equity withdraw- by politics than by economics, and are now buying half als are ending and debt levels are high. It seems more Graph 4 6% 30% Current Account Balance % GDP US Real Trade Weighted Dollar 20% 4% Capital flows drive up dollar 10% Chart 4 2% 0% 0% -10% Financing hurdle -20% -2% -30% Dollar drives down trade balance -4% -40% -6% -50% 70 74 78 82 86 90 94 98 02 Graphs Courtesy Bridgewater Associates 429 Santa Monica Blvd., Suite 500 u Santa Monica u CA u 90401 u (310) 393-6300 u (310) 393-6200 Fax u www.angelesadvisors.com PAGE 4 THIRD QUARTER 2004 likely that savings rates will rise, tax rates will rise and cycle can turn vicious, affecting (infecting?) everyone on foreign capital flows will slow, all implying that the econ- both sides of the Pacific. omy will face some strong headwinds. Of course, there’s a more palatable resolution ur savings imbalance is mirrored with to these imbalances. Asians can develop domestic de- the opposite problem in the rest of mand by adopting consumer- and investor-friendly poli- O the world, especially in Asia. If Ameri- cies, Americans can save more, the dollar can adjust cans don’t save enough, Asians save too much. Histori- downward gradually and the path between stagflation cally, there have been good reasons for excess savings.