Nov ’05  Bonds - Domestic demand for greater inflation protection, Fed moves to combat inflation and burgeonng real estate financing are forcing yields inexorably higher, despite plentiful investment flows into the dollar from Eastern trading partners anxious to protect their exchange rates and Europeans seeking higher returns than offered in their home countries.  Foreigners continue to buy, even though the dollar is now at new highs compared to early 2004.  The long-predicted collapse of the dollar will be delayed so long as interest rates are rising.  Total treasury debt is now $8 trillion, about evenly held by various government agencies and private investors.  Foreign ownership of the privately held portion has increased from 40% to 53% over the past two years.  Absent an increase in the U.S. savings rate, currently zero, it is conceivable that all privately held Treasury debt will eventually be in foreign hands.  As the dollar moves higher, which looks like a good bet on technical grounds, foreign goods become cheaper, putting the trade balance ever further into the red.  We think it is fair to credit Mr. Greenspan with engineering serial bubbles in stocks, real estate and the trade balance, while Congress was a more than willing accomplice in producing massive fiscal deficits and tagging Bush with the legacy, so far, of being the most spendthrift president in history.  Mr. Bernanke is the unlucky heir to this mess, the resolution of which is far from clear.  The bright side is that soon investors will be receiving a more traditional nominal fixed-income return.  Whether it turns out to be a higher inflation-adjusted real return remains to be seen.

 

 Equities - Being now in a seasonally favorable period for an advance in stock prices, the next month or so will likely be more pleasant than the last two.  The picture changes early in ‘06, in our opinion. Consumer spending has long been considered to be about 66% of GDP.  Recent figures indicate a larger proportion, over 70%, caused by a decline in the savings rate and record drawdowns of home equity.  Consumer real estate loans will total $240 billion this year, the largest part of an estimated increase in total disposable income of $460 billion.  Being awash in debt and paying a record 14% of disposable income for debt service, consumers are ill prepared to maintain high levels of spending, much less cope with rising energy costs, an increase in mortgage interest rates, a rise in minimum credit card payments and the lurking threat of falling house prices.  The employment picture and chances of rising wages are hardly enough to counter a potentially ominous situation. Consumer sentiment fell to a 13-year low in October.  Ironically, record corporate profits (largely confined to the energy sector) and flush company balance sheets have failed to bolster corporate pension funds.  Two-thirds of S&P 500 companies have pension fund assets which fail to cover their liabilities.  Shoring up these funds and being required to fully expense stock options next year will be a drag on earnings.  Likely further dollar strength will reduce the value of multinational profits earned abroad.  Congress seems to finally be getting the message on reducing government spending.  Miniscule reductions presently proposed could swell.  The Pentagon has announced cuts in big-ticket hardware items and programs.  Can the market climb this wall of worry?  It will become progressively harder.  And impossible if consumer spending caves.

 

William Wright