Delphi’s bankruptcy is a big deal. It is emblematic of a new set of pressures bearing down on the US. The global rebalancing framework that I continue to embrace suggests that the world’s growth and asset return dynamic has only just begun a major tilt away from the US and dollar-based assets. If that’s the case, America will have little to offer in a low-return world for risk-averse and yield-hungry investors. Could Delphi be the long awaited wake-up call that drives this realisation home?
Hindsight is always a great luxury. This would certainly have been the year for global investors to have avoided dollar-denominated assets. While the dollar itself has held up surprisingly well, US stocks and bonds have not. Year to date, the S&P 500 is down 1.3% versus a 9.5% increase for the All-Country World ex-US Index (in US dollars).
Returns in Japan, Europe, and most emerging markets have been terrific. But despite all the euphoria over sustained upside earnings surprises in the US, equity returns have been hammered by a wrenching compression of multiples. US sovereign bonds have also underperformed most of their global counterparts: year-to-date returns of 1.7% on 10-year Treasuries have fallen far short of above 9% returns for German bunds and emerging market debt. Only Japanese government bonds have lagged those in the US – hardly surprising in light of the nascent recovery in the Japanese economy.
The single most important question for global asset allocation is whether this year’s under-performance of dollar-based assets is just an anomaly, or the beginning of a multi-year trend. For what it’s worth, I suspect it’s the latter. The metrics I continue to use suggest that there has been only scant progress on the road to global rebalancing.
The disparity between the world’s current account surpluses and deficits continues to widen, likely to hit a record of nearly 5% of world GDP in 2006. America’s massive external deficit of 6.4% of GDP in the first half of 2005 – on track to account for 70% of all the world’s deficits this year – seems set to go from bad to worse over the next year, as the US saving shortfall is exacerbated by energy-related pressures on households and Katrina-related pressures on the Federal government.
And the US consumption share remains at a record 71% of GDP, well in excess of shares in Europe (58%), Japan (55%), and China (42%). The world may have woken up to the imperatives of rebalancing. So far, however, there is very little to show in the morning after.
The good news is that the laggards of the world are on the mend. Restructuring and reforms are leading the way in the surplus-saving economies of Japan and Europe. Yet it is very different in America. Suffering its greatest shortfall of domestic saving in modern history – a net national saving rate that has averaged just 1.5% of GDP since early 2002 – the US lacks the internal wherewithal to support investment in public goods such as infrastructure, homeland security, and a safety net for the underclass. When saving-short America needs funding, it turns to the rest of the world to provide the capital. Global lenders have been delighted to do so – and, so far, have offered the flows at extremely generous financing terms insofar as the dollar and real interest rates are concerned.
The Delphi Chapter 11 filing needs to be seen in this context. It is yet another contingent liability for the US shoestring economy. First of all, this is a major bankruptcy in the US, in and of itself – the 13th largest in terms of assets and the largest auto-related filing in history. But the real twist comes in the form of potential spillover effects to GM. As part of the 1999 spin-off, GM agreed to guarantee pensions, post-retirement healthcare, and life insurance for certain Delphi UAW workers – guarantees that our fixed income team believe amount to around $3.8bn. For a nation that long boasted, “What’s good for GM is good for America,” this is hardly a development to take lightly.
The Delphi bankruptcy raises two key questions – the first about credit spreads. Liquidity-driven markets remain more than willing to treat Delphi as a largely idiosyncratic risk that does not pose broader credit problems for Corporate America. GM ripple effects may well draw that presumption into question – especially for credit markets, where spreads remain historically tight.
A second concern pertains to the funding of legacy costs. This is a big deal for the US. The Pension Benefit Guaranty Corporation puts the funding gap at $450bn for single-employer plans and another $150bn for multi-employer plans – to say nothing of approximately $1.5 trillion for state and local government plans. Like all contingent liabilities, America and its creditors have long viewed this as a distant obligation. Delphi challenges that complacency, as do recent bankruptcy filings for Delta and Northwest Airlines. That, in turn, raises the risks of added fiscal funding strains on the US government. For saving-short America, those risks will only increase an already daunting current-account financing problem.
I do not want to blow the Delphi bankruptcy out of proportion. But unlike the failures of WorldCom and Enron that were traceable to accounting scandals, Delphi’s Chapter 11 filing reflects the pressures of global competition, bloated labour costs, and the enormous legacy costs of increasingly onerous retirement benefits. In that important respect, Delphi’s failure could well be yet another important milestone on the road to US restructuring – especially insofar as its impacts on American workers are concerned.
But there’s an important twist in 2005: America has long stood alone in embracing the “creative destruction” of corporate restructuring. The US penchant for shredding social contracts and forcing bad companies out of business is widely viewed as a unique aspect of “flexibility” that other nations were reluctant to embrace. America was the unquestioned front-runner in the global restructuring sweepstakes.
That was then. Today, the restructuring playing field has many more players than was the case in the 1980s and 1990s. That’s certainly been the case in Japan over the past several years and now appears to be so in Germany. The balance between headcount reductions and job creation is key in discerning the macro impacts of ongoing micro shifts in corporate performance.
The first phase of restructuring is usually dominated by plant closings, outsourcing, and net job destruction – a distinct negative for personal income generation and consumption. In the second phase, the balance shifts toward renewal, expansion, and net job creation – conditions that foster a healing of consumer confidence and income generation, which eventually sets the stage for a pickup in private consumption.
After a decade of restructuring, Japan may well be on the cusp of entering the healing phase. In Germany, corporate restructuring remains in the painful first phase – although the gap between job reductions and creation has been narrowing this year. That’s usually a good leading indicator of a shift to the healing phase.
The point is that the US no longer has the restructuring story to itself – a distinct shift from the climate of the past 20 years. Moreover, Delphi’s bankruptcy underscores the heavy lifting that still lies ahead for Corporate America and the US workforce. That, in turn, draws into question the relative restructuring premium that has benefited dollar-denominated assets over this period.
Moreover, there is good reason to believe that the US model will now have to face some new and important challenges of its own – not just the pension time bomb symbolised by Delphi but also the downside of another asset bubble, shifting political winds, new leadership at the Fed, and the inevitable current account adjustment. This spells unrelenting pressure on US-centric global growth and asset allocation.
Alas, liquidity-driven markets always seem to have a knack of creating a false sense of confidence that long outlasts underlying fundamentals. Most still believe that this year’s under-performance of dollar-denominated assets is an aberration that is about to be reversed. My guess is that dollar-overweight investors are now moving into the final phase of denial. In my view, the biggest anomalies in world financial markets remain the US dollar, US bonds, spreads on risky assets (emerging-market debt and high-yield corporates), and energy prices. And who wouldn’t like gold in this climate?
Yes, I, too, am getting sick and tired of droning on endlessly about the coming rebalancing of an unbalanced world. The wait is always most painful at the end. Remember the early months of 2000? George Eliot put it best in Silas Marner: “The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.”
By Stephen Roach, Morgan Stanley economist as published on the Global Economic Foru