From the Outside Looking In

It's has been a while since I have checked in on foreign purchases of US financial assets. It's time now for a number of reasons. There are a few primary "messages" of importance as we listen to what the current data has to say. The International Capital Flow stats for June were released by the US Treasury recently. Only the highlights, we promise. First, over the last twelve months the foreign community has purchased $940 billion of US financial assets. Close to 82% of this number was directly driven by US Treasury purchases. The chart below chronicles the twelve month moving average of foreign purchases of US Treasuries over the last few decades. Of course we've never seen anything like the trajectory of these purchases over the last year that has clearly been vertical in nature. You know how vertical charts end, and it's usually not a pretty sight. Of course the unknown is timing, so that’s a story for tomorrow. So although many in the press highlighted the sale by China of roughly $100 billion in Treasuries over the last year or so, we suggest that contextually that number for now is a rounding error in the greater scheme of ongoing foreign capital flows up to this point.

For a bit of drill, included with the foreign capital flow data is the history of five year US Treasury yields in the above graph. In the past, has the foreign community top ticked Treasury prices (peak purchases as yields bottomed) as their purchasing has accelerated and peaked in prior cycles? The record is mixed. After the peak of foreign Treasury purchasing using the twelve month moving average numbers in 1997, five year UST yields continued to fall and hit a spike low in the aftermath of the LTCM debacle as the Fed collapsed the Funds rate for a time in 1998. After the magnitude of the purchasing peak seen in 2004, the five year Treasury yield continued to climb for two years. Hard to draw hard and fast rules as the motivation for foreign purchasing of Treasuries has been multidimensional in the past (mercantilist driven, attempting to influence currency cross rates, fear, etc.).

But stepping back just a bit, over the last twelve months, again over 80% of foreign purchases of US assets have been centered on Treasury buying; 16% has been purchasing of equities, leaving the remainder as the purchase of corporate and agency debt (or lack of purchasing as is more the correct characterization). Message being? If the foreign community was bullish on the US economy specifically, and by a bit of implication the global economy also, academically they should be loading up on risk oriented assets, not the so-called risk free asset that is Treasuries. So although we know a lot of fear has been unleashed globally over the last few years, this pattern of purchasing is a message about the economic outlook of the foreign investment community.

I believe it reflects their thoughts both about potential economic trajectory and the possibility for deflationary outcomes. You can see above that from 2004 through 2007, foreign purchases of US Treasuries using the 12MMA numbers declined in trend fashion point to point. This was the period of the last US economic expansion and the foreign community rightly purchased risk oriented assets at the expense of Treasury buying. That's not happening at all in the current cycle and stands in noticeable divergence to the prior US economic expansion experience. Very much as is the case with the divergence between UST yields and equities that is more than noticeable at present. It's a message we believe is not getting enough attention.

But from a very near term standpoint, maybe the most important information in the Treasury International Capital flow stats concerns equities. Have a look at the chart below. To the point, the top clip of the chart is the twelve month moving average of foreign purchases of US equities. Clearly there is cyclical rhythm here. In the bottom clip we are looking at the same data with the history of the S&P overlaid. I’m sure you can guess where I’m going with this.

Again, right to the point, at least over the last decade, the foreign community has virtually a perfect track record in top-ticking US equity prices when using the 12 MMA data. And of course the reason I am bringing this up right now is that we may have reached yet another important cycle peak in foreign purchases of US equities. We'll have to see what lies ahead, but as of now the May-June period of this year was the first very meaningful downtick in the 12MMA numbers for foreign purchases of US equities for the current cycle post the May 2009 US equity market bottom. This peak is clearly seen in the clip above. To show you how important this has been over time and why we need to sit up and take notice of this data right now, the following table goes back a few decades and quantitatively recounts what has happened to S&P price only performance in the three, six, nine and twelve month periods after the 12MMA of foreign purchases of US equities has peaked. Have a look.

To be honest, the track record here may really be valid back to 1994 in that the 1998 S&P price advance numbers nine and twelve months later reflect the Long Term Capital Management bailout environment of excess liquidity and huge drops in short term interest rates (this occurred 6 months after the foreign purchasing peak). Factoring this into our thinking and adjusting for the anomaly of the bailout environment, it seems very valid to suggest that the S&P has declined in every one year period post a peak in the 12MMA of foreign purchases of US equities. And here we are again? It's looking that way for now. Unless we have some type of dramatic rally in the US equity markets, the six month S&P price performance for the first six month period post the as of now April peak will be down meaningfully. The three month period is already negative as you can see.

In summation, the character of foreign purchasing of US financial assets over the past year is suggesting the foreign community as a whole is not predicting meaningful economic recovery in the US, and by implication the global economy generally. The one way purchasing of the risk free asset into a so-called recovery period suggests foreign investors see economic slowing and deflation as dominant themes. It's simply the message of actual investor behavior. In like manner, and I suggest this is a very important current period message, history tells us that the foreign community has had a fabulous track record top ticking US equity prices over the last few decades. Peak cycle 12MMA purchasing of US equities by the foreign community has been an important sell signal in the past. Will it be so again in the current cycle? Stay tuned, but it is a clear warning.