The Tide is Turning

Slowly but surely, the flow of funds out of assets and into cash that defined the vicious bear market of 2008 seems to be reversing. Certainly some investors who never dreamed that the Dow could fall below 10,000 in the first place are convinced that a bottom in stocks has been reached. But that's not the whole story.

Wiser investors, seeing a tidal wave of new money rolling off printing presses around the world, have lost enthusiasm for all the paper they had previously stuffed into their piggy banks. It is beginning to dawn on those fleeing to safety that they are heading in the wrong direction. After all, how much safety can there be in an asset where supply is exploding and demand is based solely on the false perception of safety? When perception catches up with reality, supply will overwhelm demand, and the price will collapse. In this case, price refers to the exchange rate of the dollar verses other currencies, or its value in terms of gold.

In addition, it is slowly becoming more evident that the global economy can function without American consumption. In March, auto sales in China surged another 10% to over 1 million units for the first time ever. In contrast, sales in the U.S. slid to just over 850,000 in March, 37% below last year's level. This marks the third consecutive month that Chinese car sales exceeded those in the U.S. As I have long forecast, the world is still producing cars, it's just that fewer of them are being purchased by overly indebted Americans, while more are being bought by an emerging class of Chinese car buyers.

Meanwhile, the February U.S. trade deficit narrowed to "only" $26 billion, a nine year low. Significantly, the improvement is not due to a surge in exports, but a collapse in imports. At first blush, one might conclude that a smaller trade deficit is bullish for the dollar, but the move is hardly sufficient to create any additional buoyancy for the greenback. A reduced trade deficit is welcome, but our account balance must actually move strongly into surplus if we have any chance of actually resolving the imbalances that brought our economy into crisis.

While a $26 billion trade deficit may seem small when compared to the $60 billion level that had become routine during the height of the bubble, the number is still large in absolute terms. A trade deficit of any size means that we are still injecting dollars into a global economy that is already saturated with an excess supply. Once our foreign creditors come to their senses, not only will they be unwilling to finance our somewhat smaller monthly deficits, but they will be unwilling to continue warehousing the trillions of dollars already in their possession as a result of funding our past deficits.

Ironically, just as the United States government ramps up its issuance of debt, smaller U.S. trade deficits mean that our trading partners now have fewer dollars to recycle into our bond markets. As the budget deficit explodes to nearly $2 trillion annually, slackening demand for Treasuries from abroad could be devastating. With smaller trade surpluses to recycle, nations like China will have diminished need to buy our debt. The argument supporting the "vendor financing" system that had developed between the United States and China always rested on their need to lend us money so we can keep buying their products. But if we are now using their money to finance government stimulus programs (including spending on education, health care, green energy, and corporate bailouts), this dog no longer hunts.

With these negatives building for the dollar, alternatives are emerging. Now that stock and commodity prices have stabilized investors are looking to other assets that offer higher yields and better long-term prospects. While most of the attention has been focused on the recent rally in U.S. stocks, few have noticed that foreign stocks are doing even better. The 20% rise in the S&P from its March low merely returns the index to its Oct 2008 low. In contrast, Hong Kong's Hang Seng index is now 40% above its October 2008 lows. In short, while U.S. stocks have merely treaded water, Hong Kong shares have surged 40%. Far from being dead, de-coupling is clearly alive and well. My advice is to take your seat on this train before most investors realize that it's left the station.

By Peter Schiff, President and Chief Global Strategist of Euro Pacific Capital