Portfolio manager’s Letter July 2008
From Wall Street Journal July 1,
“Basel, Switzerland. The global economy may be close to a “tipping point” that could see it enter a slowdown so severe that it transforms the current period of rising inflation into a period of falling prices, the Bank for International Settlements said Monday.
In its annual report, the central bank for central banks said the impact of rising food and energy prices on consumers’ incomes, combined with heavy household debts and a pullback in bank lending, may lead to a slowdown in global growth that “could prove to be much greater and longer-lasting than would be required to keep inflation under control. Over time, this could potentially even lead to deflation.”
Currently the buzz in the market is all about stagflation, but what if our credit crisis morphs into a global credit crisis and then into a global credit contraction. Deflation would be a new experience for most of today’s investors, and would come as a great surprise in a world that is busy planning for perpetual inflation. Perhaps it is unlikely but it is certainly not impossible. And it a critical question for the investor because the last thing you need if you are hedging inflation with commodity and energy companies is a nice long period of deflation.
The world that was afloat with cash a year ago is now afloat in bad debts. It would not be correct to blame the FED alone for this mess. In truth the FED has had a lot of help from forces that it has no control over. Two additional forces in the construction of our current bubble are Derivative markets (basically this is Wall Street’s attempt to take control of the money supply), and foreign central banks who choose to subsidize the American Consumer by monetizing their foreign trade surplus. These Foreign banks learned that the quickest way to stimulate their own economy was to pass cash to the Americans.
I suspect that by the time we know if the tipping point has been reached it will be way too late to do anything about it. Too late for the world’s central banks, and too late for investors that have taken positions assuming that any of our current bubbles (commodities, energy, or emerging markets) will become permanent.
After the oil bubble of the seventies Energy companies did not dry up and blow away but they were pretty much dead money for a couple of decades. As for commodities and the emerging markets this is quite a different matter. A pop of these bubbles might not cause as much damage as the pop of the tech bubble, but here would still be a lot of pain.
In the developing economies we are beginning to see cracks in the rose colored glasses. A June story from the Montreal Gazette carried the following details.
“Now China’s cost advantage is being eroded by soaring oil prices, rising wages and an appreciating currency. Canadian companies that outsource their manufacturing to China are already feeling the pinch and some are even bringing production closer to home.
Inflation has already risen 8 per cent this year in China and the government just lowered subsidies on gasoline, resulting in an increase of roughly 20 per cent at the pump. Meanwhile, the Chinese currency has jumped about 17 per cent against the U.S. dollar, making exports more expensive.”
Some reports put the cost of transporting goods from China to the U.S. as having risen by 40% this year. These Rapid increases in the costs of production and transportation in China come just as the U.S. consumer is running out of credit, and could lead to slowdown in the Chinese economy. Just because it is the fastest growing country does not mean that it is immune to economic cycles. Certainly the U.S. never has been. Further evidence appeared in a June 30, story in the Wall Street Journal about Chinese economy.
“The transformation is most apparent in the boomtowns that tied their fortunes to making one product cheaply, from Guangdong province in the south to Honghe’s environs in the Yangtze River Delta. Many of these manufacturing centers have seen hundreds if not thousands of factories and workshops close in recent months, industry executives say. In Shengzhou, a city near Shanghai that claims to make one-third of the world’s neckties, manufacturers are trying to hold a united front to boost prices. Dongguan, in Guangdong, is seeing makers of toys, shoes and brushes close shop.”
It is interesting that even though the US trade deficit remains high, the structure of that deficit has changed. Were as two years ago petroleum imports accounted for about 30% of the trade deficit, today the figure is close to 60% this means that the Jump in oil prices is masking a substantial improvement in the U.S. Trade balance brought on by a lower dollar, and it means that any decline in oil prices will result in a lower trade deficit and a contraction in the international money supply. The inflation bulls tipping point to Money supply growth around the world as evidence inflation will continue.
The the assets European Central Bank have increase by 22% in the last twelve months, M-3 is increasing by 21.4% year over year in India; and 33% in Russia, So all the talk is about the dangers from inflation. Commodity mutual funds and hedge funds are pouring investor’s money into commodity markets.
The question I have is, where is the money coming from? If it is coming from large international banks, hedge funds, and private equity firms how can we expect the results will be any different overseas than they have been in the U.S.? As for the Central Banks it seems likely to me that their generals will end up fighting the last war and remain vigilant against inflation even after that danger has passed.
At this point, it is obvious that the answer to tipping point question has to go in the “way to hard “pile, but the credit crisis has brought monetary growth to a halt in the United States that could spread. It is interesting the Buffett got out of his biggest energy play (PetroChina) last year. Now with the exception of POSCO Berkshire has very little exposure to emerging markets. He still has Conoco Phillips, but other than that has very little exposure to the bubble markets.
In fact, this is one argument that can be made to support the approach of a tipping point is that Buffett has no position in commodity companies and very little exposure to emerging markets and energy. It is likely of course, that Buffett just ignores the tipping point question and is just trying to isolate Berkshire from the risks that are present in the Bubble Markets. I think he would be wise to follow Buffett’s example, and avoid as much as possible energy, commodities; and emerging markets. You have to ask yourself, “Is the potential reward at these prices worth risk inherent in these very inflated markets?”
In this environment I think large cap American stocks are attractive, they have a better operating yield that bonds, and if inflation continuous this yield will increase. On the other hand if the commodity markets crash it helps because it lowers their cost of their raw materials, and the Dollar will rally. So, with these stocks you do not have to know the answer to the tipping point question.
In my opinion the best way to participate in this large cap sector is Berkshire, they already own the best names, and they have all that beautiful leverage from the insurance business.