End of the great American affair

IT HAS been a torrid romance lasting almost 10 years. Some thought that the longer it continued the more it looked like madness, an amour fou which would end in pain and grief when the greedy search for excitement in the arms of a feckless and unstable partner came face to face with financial reality.

Whatever their motivations, the infatuation of foreign investors with the US dollar has seen them pump almost $2 trillion (£1.37 trillion) into US assets since 1992, becoming in the process owners of 11% of all US shares, 21% of US corporate bonds and more than 40% of privately-held US Treasury bonds. But now the affair is over.

The 5% fall in the dollar against the euro since the beginning of the year is just one sign that US markets have lost their pulling power. Another is the fact that two years after hitting their highs share prices on Wall Street are languishing even though the economy is perking up.

As custodians, State Street Bank and JP Morgan Chase hold, on behalf of clients, investments worth $6.5 trillion and $6.3 trillion respectively. They see where their customers are putting their money on a day-by-day basis. 'Enthusiasm for US dollar denominated investment has waned,' said JP Morgan strategist Larry Kantor.

Official figures, which are not as up-to-date, tell the same tale. Steven Roach, of Morgan Stanley, said foreign direct investment in the US was only $158bn in 2001 compared with almost $300bn in 1999 and 2000 when companies such as Daimler-Chrysler, Vivendi and Deutsche Telekom were making their ill-fated multi-billion dollar US takeovers.

Foreign investment in US equities also plummeted last year. Steve Triantafilidis, of reinsurance group Swiss Re in Zurich, said that since 11 September even US investors are cautiously diversifying out of domestic equities and moving into foreign markets.

Avinash Persaud of State Street Bank sees the collapse of energy trader Enron and the associated doubts about the quality of US accounting as a trigger for the retreat. Foreign investment in US corporate bonds, at record levels last year, also slumped in the first two months of the year.

There are doubts, too, about funds still flowing into US assets. Morgan Stanley said that in February 40% of US inflows came from Asia, excluding Japan. 'We remain sceptical of this region's ability to remain a stable provider of capital given its own needs,' it said.

But it is stable inflows America desperately needs. The US must import more than $1.5bn a day of capital to finance its massive, and rising, $400bn current account deficit. US Treasury Secretary Paul O'Neill insists it is foreigners' enthusiasm to own US assets that has driven up the dollar and pushed the nation into external deficit.

This was probably true in the 1990s. The end of the Cold War, a government in budget surplus, low oil prices, low inflation and low interest rates combined to create an optimism that recalled the America of pre-Vietnam days.

With an apparent stepchange in productivity levels, the US emerged as the undisputed leader in new economy technology and corporate profits boomed.

UBS Warburg's chief economist George Magnus says the related stampede into dollar assets coincided with the bursting of the Japanese bubble economy and Europe's unification hangover - the long period of slow growth as the Continent prepared for the euro. But now, he says, the notion that the long-term outlook for the US economy is vastly superior to Euroland and Japan is in doubt.

As its budget moves back into the red, America's 'twin' current account and budget deficits have reappeared. Interest rates will have to rise from emergency lows even though households and companies are overburdened with debt.

Corporate America is sitting on billions of dollars worth of underused assets and unsold goods and billions more of underfunded pension liabilities waiting to decimate profit and loss accounts when they are forced to make more realistic assumptions about future rates of return on underlying investments.

And with the US recovery starting from a relatively low level of unemployment, wage growth is likely to be strong. So shareholders will get a smaller slice of the national pie. Given global overcapacity, too, the overall picture is that the US is staring at a recovery that will not deliver the usual, extended, post-recession profits bonanza.

Critically, said Magnus, all this coincides with growing transatlantic political tensions as Europe increasingly questions the political hegemony of the 'pax Americana'. The implications of these trends for the global economy are enormous. Waning demand for US assets is already driving the dollar down. On the plus side, this will eventually help to reduce the US current account deficit and rebalance the economy. The big question is how quickly and disruptive the correction will be.

Longer term, Roach said: 'The coming US current account adjustment speaks of a new recipe for sustained global growth - the world can no longer afford to be dependent on the American engine as the dominant source of economic expansion.'