John Wooden Print E-mail

 The Economy

Legendary basketball coach John Wooden led the UCLA Bruins to 10 national titles in 12 years. At one point John Wooden’s teams recorded 88 consecutive wins spanning four perfect seasons. Fittingly Wooden has been elected to the Basketball Hall of Fame (as a player and coach). He was recently awarded the Presidential Medal of Freedom. Few in the sporting world would argue with Coach Wooden’s leadership genius or his success. His was truly a sports dynasty. Ironically it was success, or more accurately the hubris that often accompanies success that Wooden viewed as the most daunting obstacle in his long, illustrious coaching career. He recognized that the enemies of continued success included complacency and over-confidence. Regarding competition Wooden’s motto was “respect all; fear none”. The great coach recognized the importance of concentration on constant improvement and execution to the highest level possible, mainly because quality opponents would be doing the same. He understood that when you are looking down from the top, leading the competition, respect for all could be most elusive. The loss of respect for competitors is often followed by a decline in motivation and will to sacrifice, to pay the high price that success demands. It is human nature to rest on one’s laurels and enjoy the fruits of victory. We view the past as prologue as though it secures our future dominance and hedonism. Many fear that this formula for decline threatens America’s hegemony at a time when the “techno-global revolution” levels the playing field and elevates the competitive capabilities of our rivals. Frankly our competitors are making improvements in their abilities and preparedness while America relies too heavily on past accomplishments. Consider that China will produce 3.3 million college graduates this year, India 3.1 million (all English speaking), the US just 1.3 million. China will produce 600,000 engineers, India 350,000 to America’s 70,000. America’s 15 year olds rank 28th world wide in math skills. Fortune Magazine’s July 25th issue points out that the US is not building human capital the way we used to. Our public schools are falling behind. Our universities educate an ever increasing number of foreign students who, upon graduation, return home to build the economies of their native lands. As our competitors multiply their capabilities in engineering and science, the building blocks for success in the era of the “techno-global revolution” America’s capabilities are in relative decline.  The philosopher Diogenes wrote, "the foundation of every state is the education of its youth.” The outsourcing of jobs that has alarmed American workers shows no sign of abating and will likely accelerate in the near future. American owned giants Coca-Cola, Procter and Gamble and Texas Instruments do most of their business and employ most of their workers outside the US.  Texas Instruments is betting its future on a new generation of micro-chips being developed not in Silicon Valley but in India-at 1/5th the cost. Production processes are becoming more and more standardized making it easier for companies to transfer jobs to the lowest cost labor markets.  McKensey Global Institute, a tech research firm predicts the US could lose as much as 52% of its engineering jobs and 31% of accounting jobs, 49% of it’s packaged software jobs, 44% of info-tech jobs,25% of banking jobs,19% of insurance jobs and 13% of pharmaceutical jobs, all to low cost providers in Asia. Estimates for job losses runs between 9 and 14 million. The effect of this outsourcing of jobs and the transfer of wealth that is occurring with the techno-global revolution is already becoming apparent. The largest banks and brokerages including Merrill Lynch, Citigroup and UBS AG are scrambling to find enough “wealth managers” to keep up with burgeoning demand. It seems the fastest growing market for millionaires is Asia. China boasts a 4.3% increase while the number of wealthy in India jumped 14%. Merrill believes that in the next 4 years individual riches in Asia will rise from $7.2 trillion to $10.1 trillion, an annual jump of nearly 7%. By comparison European wealth is expected to grow by 3.8% to $10.7 trillion and North America’s by 8.4% to $13.9 trillion over the same time frame. The Chinese are showing an aptitude for capitalism and an almost American appetite for mergers and acquisitions. The July 2nd issue of The Economist reminds us that China is becoming increasingly assertive on the global scene. In China both companies and the government (a distinction not easy to make sometimes) are flush with cash thanks to their trade surplus. Transactions involving a Chinese buyer and an international target jumped from $2-3 billion per year to $23 billion over the past three years. In May IBM sold its personal computer division, Lenovo to the Chinese. Weeks later Chinese manufacturer Haier bought struggling American rival Maytag. Then in a move that has the congress and the pentagon buzzing, CNOOC, the Chinese National Offshore Oil Company trumped a bid by US oil company Chevron to buy US oil company Unocal, by $2 billion, in an all cash offer .The Chinese are targeting foreign acquisitions in commodities, oil and steel to feed an economy growing at a 9% annual clip. But the acquisitions are also aimed at securing access to modern internal manufacturing processes, and strategic thinking. The Chinese are positioning their nation to become a formidable player on the global economic and geopolitical stage. Cheap labor, annual current account surpluses in the $billions and a glutinous world-wide demand for inexpensive goods provides China with awesome financial potential. The most frightening aspect of this financial might for China’s neighbors, and to a lesser extent the U.S., is the growing strength of China’s military capabilities. What must the old coach be thinking when he considers how our great country squandered valuable resources to the tune of $5 trillion on the dot com debacle or as fat cats at WorldCom and Enron and Health South plotted to steal $billions at the expense of employees and shareholders. Symptoms of America’s financial malaise include our staggering budget deficits and the hedonistic consumption of foreign made goods paid for by leveraging our homes and collective futures. The availability of cheap easy money has allowed Americans to liquidate hard earned assets in favor of immediate gratification. All the while we whistle walking past the graveyard , transferring wealth to Asia, hollowing out our middle and working classes and helping our competitors become millionaires at a rate even the banks and brokers cant keep pace with. Yes the great ball coach must be shaking his head at how the American “dynasty” has taken its gifts for granted and failed to work, plan, save and invest for future seasons. Our rivals grow wiser and stronger at our expense.

The Fed

Has anyone seen my copy of the U.S. Federal Reserve Monetary Policy Manual?  You know, the one that explains how raising or lowering interest rates directly effects the U.S. economy.  It isn’t important if you haven’t seen it.  I suspect that it is not worth quite as much as it once was.  The manual that I am patiently waiting for now is the U.S. Federal Reserve Monetary Policy Manual for a Global Economy.  The problem is, however; that no such manual exists.  While neither of the hypothetical manuals I wish to see exist, you or I will most likely not lose much sleep over it.  Alan Greenspan and the rest of the Federal Reserve on the other hand are much more in need of such a blueprint.  In our last correspondence, there was concern about a potential storm on the horizon that was starting to rumble under the guise of weakening economic reports and scaled down forecasts.  Well, here we are today and that storm has yet to materialize.  It appears as though the U.S. economy is firmly entrenched in a prosperous recovery.  Faced with high energy prices domestically, strong global demand for oil and sagging economic indicators, the U.S. economy that many feared was slowing clocked in at 3.8% annualized growth for the first quarter of 2005, mirroring the pace set in the last quarter of 2004. And that brings us back to Alan Greenspan and the Federal Open Market Committee.  The U.S. central bank has raised its key federal-funds rate nine straight times since last June, elevating the rate from 1% to 3.25%. Typically, when the Fed raises short term interest rates by way of the Federal Funds rate, long term rates follow suit.  Today, that is not the case, as it appears the game has changed and so have the rules.  In the past a tightening period such as the one we are currently in the midst of would cause a series of events.  First, banks faced with a higher cost of funds would increase scrutiny on lending practices.  Second, the bond market would take its cues from the Fed and in turn, push long term rates higher.  In the past, this practice would result in a buildup of excess capacity and a subsequent decrease in inflation.  In the new game, banks are easing lending standards and extending credit to anyone that wants it.  The bond market hasn’t followed its old blueprint either, with 10 year Treasury rates hovering around 4.15% vs. 4.58% when the Fed began raising short term rates in the summer of ’04. The only questions left to answer are why is this happening and where do we go from here.  The desire for a Monetary Policy Manual for a Global Economy now becomes more clear.  Much of the reasoning behind the current state of the credit markets is attributed to our friends (?) in Asia.  Countries such as China and India are awash in savings that is cause for an insatiable appetite of U.S. Treasuries.  The result of this binge on Treasury’s by our neighbors to the East has kept U.S. long term rates artificially low.  This presents what Alan Greenspan has labeled a conundrum and is the impetus for my desire to get my hands on that elusive U.S. Federal Reserve Monetary Policy Manual for a Global Economy. The path that the Fed follows going forward will most likely not be determined by their past actions.  The actions of the Federal Reserve Bank must now be tailored to impact a Global Economy rather than the tried and true method of U.S. Monetary Policy.  For these reasons, I along with Mr. Greenspan and the rest of the Fed will play a wait and see game to understand what those moves will be. According to the most recent press release from the Fed, dated June 30, 2005; “Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually.”  The release went on to say that inflation pressure has stayed elevated, but well-contained.  This language can be interpreted to mean that the Committee will continue to raise the Fed Funds rate at a measured pace (25 bps).  But, we cannot be sure how many more times the Fed will raise the rate.  The Fed will remain very cautious in its approach, because as Mr. Greenspan has commented, the Fed doesn’t know what number represents a neutral rate for Fed Funds, but it will know when it gets there. At ICM, we feel the economic climate is warmer than our previous projections.  In past commentary, we have forecasted 3% Fed Funds by mid-year and 3.50% by the end of the year.  Currently, the economy is faced with 3.25% Fed Funds and a question mark for the year end of 2005.  As of today, there are four remaining Fed Committee meetings on the calendar for 2005.  We believe the Fed will continue to raise rates by year end to 3.75% or 4.00% predicated on continued economic strength.  The current yield spread between 2 and 10 year Treasury’s has contracted to an anemic 34 bps, down from 72 bps at the start of the 2nd Quarter.  A yield spread between 2 and 10 year Treasury’s within 50 bps historically represents a flat yield curve.  As the curve continues to flatten or invert, the market is signaling that an economic slowdown could occur in 2006.

Market Recap

The yield of our benchmark 2 Year Treasury began the second quarter of 2005 at 3.73% and ended at 3.62%. In between the 2 Year treasury yield touched a high of 3.75% on May 9th and a low of 3.47% the first of June.  During the quarter the Federal Reserve adjusted overnight lending rates to 3.5% from 3% in two equal moves. As investors looked at economic data during the quarter concerns arose about the strength and sustainability of the recovery. As a result of the economic uncertainty, the 2 Year Treasury yield remained range bound, refusing to climb in lock step with the Funds Rate. Market driven 10 Year Treasury yields departed from the generally accepted script and fell during the quarter mystifying even Fed Chairman Greenspan who referred to the phenomenon of falling long rates in the face of tightening Fed policy as a “conundrum”. Please see graph #1 for a history of Fed Funds and the yield of the 10 Year Treasury. Some market pundits advanced the opinion that the “conundrum” is nothing more than a signal of a slowing economy and controlled inflation and thus predict the end of the tightening cycle is near. Others feel that long rates are falling because of increasing demand for long term securities by insurance companies, pension funds and the foreign holders of US Dollars. A third group of market savants point to the glut of corporate savings turning to long Treasurys because of the scarcity of solid investment opportunities. In fact, over the past three years corporate profits have soared while corporate capital spending has remained weak. If corporate chieftains view the 4% return on a 10 Year Treasury more favorably than the potential return on capital investments in plants and technology it hardly represents a vote of confidence for the sustainability of the recovery. Economists at JP Morgan feel that some corporate leaders may view consumer strength as hinged on rising home values and continuing equity extraction, both threatened by tightening Fed policy. The spotlight falls upon FNMA again this quarter as congress considers ways of improving regulatory oversight of the mortgage giant. Mr. Greenspan continues to echo the position of the administration in his call for a drastic reduction in the portfolio of mortgages held by FNMA because” it is a highly leveraged operation and because it requires sophisticated hedging of interest rate risk, it is imparting significant risk to the American financial system.” If one sees the Feds insistence on pushing the funds rate higher as an attempt to raise mortgage lending costs to deflate a potentially dangerous housing bubble then it would appear that Fed policy is at odds with FNMA’s business model of accumulating home mortgages for investment. Just one more good reason to steer clear. In the near future we believe  rates will move slightly higher across the yield curve in response to the Fed’s cycle of tightening but that the major determinant of the slope of the yield curve and the general level of rates will be a function of inflation readings and foreign demand for US Dollars and securities. The yield of our benchmark 2 Year Treasury began the second quarter of 2005 at 3.73% and ended at 3.62%. In between the 2 Year treasury yield touched a high of 3.75% on May 9th and a low of 3.47% the first of June.  During the quarter the Federal Reserve adjusted overnight lending rates to 3.5% from 3% in two equal moves. As investors looked at economic data during the quarter concerns arose about the strength and sustainability of the recovery. As a result of the economic uncertainty, the 2 Year Treasury yield remained range bound, refusing to climb in lock step with the Funds Rate. Market driven 10 Year Treasury yields departed from the generally accepted script and fell during the quarter mystifying even Fed Chairman Greenspan who referred to the phenomenon of falling long rates in the face of tightening Fed policy as a “conundrum”. Please see graph #1 for a history of Fed Funds and the yield of the 10 Year Treasury. Some market pundits advanced the opinion that the “conundrum” is nothing more than a signal of a slowing economy and controlled inflation and thus predict the end of the tightening cycle is near. Others feel that long rates are falling because of increasing demand for long term securities by insurance companies, pension funds and the foreign holders of US Dollars. A third group of market savants point to the glut of corporate savings turning to long Treasurys because of the scarcity of solid investment opportunities. In fact, over the past three years corporate profits have soared while corporate capital spending has remained weak. If corporate chieftains view the 4% return on a 10 Year Treasury more favorably than the potential return on capital investments in plants and technology it hardly represents a vote of confidence for the sustainability of the recovery. Economists at JP Morgan feel that some corporate leaders may view consumer strength as hinged on rising home values and continuing equity extraction, both threatened by tightening Fed policy. The spotlight falls upon FNMA again this quarter as congress considers ways of improving regulatory oversight of the mortgage giant. Mr. Greenspan continues to echo the position of the administration in his call for a drastic reduction in the portfolio of mortgages held by FNMA because” it is a highly leveraged operation and because it requires sophisticated hedging of interest rate risk, it is imparting significant risk to the American financial system.” If one sees the Feds insistence on pushing the funds rate higher as an attempt to raise mortgage lending costs to deflate a potentially dangerous housing bubble then it would appear that Fed policy is at odds with FNMA’s business model of accumulating home mortgages for investment. Just one more good reason to steer clear. In the near future we believe  rates will move slightly higher across the yield curve in response to the Fed’s cycle of tightening but that the major determinant of the slope of the yield curve and the general level of rates will be a function of inflation readings and foreign demand for US Dollars and securities.

 

The yield of our benchmark 2 Year Treasury began the second quarter of 2005 at 3.73% and ended at 3.62%. In between the 2 Year treasury yield touched a high of 3.75% on May 9th and a low of 3.47% the first of June.  During the quarter the Federal Reserve adjusted overnight lending rates to 3.5% from 3% in two equal moves. As investors looked at economic data during the quarter concerns arose about the strength and sustainability of the recovery. As a result of the economic uncertainty, the 2 Year Treasury yield remained range bound, refusing to climb in lock step with the Funds Rate. Market driven 10 Year Treasury yields departed from the generally accepted script and fell during the quarter mystifying even Fed Chairman Greenspan who referred to the phenomenon of falling long rates in the face of tightening Fed policy as a “conundrum”. Please see graph #1 for a history of Fed Funds and the yield of the 10 Year Treasury. Some market pundits advanced the opinion that the “conundrum” is nothing more than a signal of a slowing economy and controlled inflation and thus predict the end of the tightening cycle is near. Others feel that long rates are falling because of increasing demand for long term securities by insurance companies, pension funds and the foreign holders of US Dollars. A third group of market savants point to the glut of corporate savings turning to long Treasurys because of the scarcity of solid investment opportunities. In fact, over the past three years corporate profits have soared while corporate capital spending has remained weak. If corporate chieftains view the 4% return on a 10 Year Treasury more favorably than the potential return on capital investments in plants and technology it hardly represents a vote of confidence for the sustainability of the recovery. Economists at JP Morgan feel that some corporate leaders may view consumer strength as hinged on rising home values and continuing equity extraction, both threatened by tightening Fed policy. The spotlight falls upon FNMA again this quarter as congress considers ways of improving regulatory oversight of the mortgage giant. Mr. Greenspan continues to echo the position of the administration in his call for a drastic reduction in the portfolio of mortgages held by FNMA because” it is a highly leveraged operation and because it requires sophisticated hedging of interest rate risk, it is imparting significant risk to the American financial system.” If one sees the Feds insistence on pushing the funds rate higher as an attempt to raise mortgage lending costs to deflate a potentially dangerous housing bubble then it would appear that Fed policy is at odds with FNMA’s business model of accumulating home mortgages for investment. Just one more good reason to steer clear. In the near future we believe  rates will move slightly higher across the yield curve in response to the Fed’s cycle of tightening but that the major determinant of the slope of the yield curve and the general level of rates will be a function of inflation readings and foreign demand for US Dollars and securities. The yield of our benchmark 2 Year Treasury began the second quarter of 2005 at 3.73% and ended at 3.62%. In between the 2 Year treasury yield touched a high of 3.75% on May 9th and a low of 3.47% the first of June.  During the quarter the Federal Reserve adjusted overnight lending rates to 3.5% from 3% in two equal moves. As investors looked at economic data during the quarter concerns arose about the strength and sustainability of the recovery. As a result of the economic uncertainty, the 2 Year Treasury yield remained range bound, refusing to climb in lock step with the Funds Rate. Market driven 10 Year Treasury yields departed from the generally accepted script and fell during the quarter mystifying even Fed Chairman Greenspan who referred to the phenomenon of falling long rates in the face of tightening Fed policy as a “conundrum”. Please see graph #1 for a history of Fed Funds and the yield of the 10 Year Treasury. Some market pundits advanced the opinion that the “conundrum” is nothing more than a signal of a slowing economy and controlled inflation and thus predict the end of the tightening cycle is near. Others feel that long rates are falling because of increasing demand for long term securities by insurance companies, pension funds and the foreign holders of US Dollars. A third group of market savants point to the glut of corporate savings turning to long Treasurys because of the scarcity of solid investment opportunities. In fact, over the past three years corporate profits have soared while corporate capital spending has remained weak. If corporate chieftains view the 4% return on a 10 Year Treasury more favorably than the potential return on capital investments in plants and technology it hardly represents a vote of confidence for the sustainability of the recovery. Economists at JP Morgan feel that some corporate leaders may view consumer strength as hinged on rising home values and continuing equity extraction, both threatened by tightening Fed policy. The spotlight falls upon FNMA again this quarter as congress considers ways of improving regulatory oversight of the mortgage giant. Mr. Greenspan continues to echo the position of the administration in his call for a drastic reduction in the portfolio of mortgages held by FNMA because” it is a highly leveraged operation and because it requires sophisticated hedging of interest rate risk, it is imparting significant risk to the American financial system.” If one sees the Feds insistence on pushing the funds rate higher as an attempt to raise mortgage lending costs to deflate a potentially dangerous housing bubble then it would appear that Fed policy is at odds with FNMA’s business model of accumulating home mortgages for investment. Just one more good reason to steer clear. In the near future we believe  rates will move slightly higher across the yield curve in response to the Fed’s cycle of tightening but that the major determinant of the slope of the yield curve and the general level of rates will be a function of inflation readings and foreign demand for US Dollars and securities.