[back to Newsletter Archive]

Newsletter Q1 1999
December 31, 1998

The Euro and its Implications for U.S. Financial Markets

The introduction of a European common currency, the euro, will be a significant financial event of 1999.  The first group of eleven participating countries includes Germany, France, Belgium, Luxembourg, Netherlands, Austria, Finland, Ireland, Portugal, Spain, and Italy.  Other countries such as Great Britain, Sweden, Greece, and Denmark may join by 2002.  On January 1, 1999, firms in the Euro-11 countries will be allowed, though not required, to keep their books and conduct business in euros.  Banks will be required to handle accounts in either euros or their national currencies.  Euro currency notes and coins will eventually start circulating in 2002.

The euro is expected to have several benefits for participating countries.  A common currency will reduce transaction costs on trade between Euro-11 countries, as businesses will be handling one currency rather than many.  Transparency of pricing should promote competition, as it will be easier for consumers to compare prices throughout the euro zone.

The euro introduction is also expected to benefit European capital markets.  The elimination of currency risk for investors among the Euro-11 countries will encourage investments across borders.  A broader capital market is expected to improve the allocation of capital among countries and lower the cost of capital to companies.  Further progress needs to be made, however, to reduce differences in taxes, regulation, disclosure requirements, accounting, and trading rules.

The introduction of the euro has significant implications for the U.S. currency and financial markets.  The dollar has been the reserve currency of choice for the world's foreign central banks.  In 1997, 57% of the world's reserves were in dollars.  To some extent, this is a reflection of international trade practices.  Roughly half of world trade is invoiced in dollars, while nearly all commodities are priced in dollars.  The euro will soon become an alternative reserve currency with critical mass.

A comparison of some key statistics (see table below) between the Euro-11 countries and the United States shows a significant contrast.  The Euro-11 countries collectively have a large current account surplus and significant reserves held by their monetary authorities.  The United States, on the other hand, has a large current account deficit and reserves of $64 billion, which is small relative to the current account deficit.  The current account measures trade, services, and transfer payments. 

The ability of the United States to maintain a large current account deficit while avoiding a decline in the value of the dollar depends upon the willingness of foreign central banks and private investors to provide capital in amounts large enough to offset the current account deficit and U.S. investments in foreign countries.  In recent years, the U.S. has had progressively larger current account deficits and progressively larger net capital inflows to offset those current account deficits.  In 1997, the U.S. had a net capital inflow of $263 billion, primarily from private investors.  Given the introduction of a major alternative currency that is fundamentally stronger, large current account and capital flow imbalances are not likely to be sustainable.

	Euro-11	United States	Japan
Current Account Surplus (Deficit) ($B)	99.5	(201.5)	117.3
Reserves Excluding Gold ($B)	408.2	64.6	211.2
Gold Reserves (M troy ounces)	319.7	261.6	24.2
Broad Money Growth vs. year ago	5.0%	10.8%	3.9%

Sources: The Economist and IMF International Financial Statistics

How much money will shift to the euro and how fast will the adjustment process develop?  Nobody knows but the adjustment process may proceed faster than many people expect.  The central banks of China and Switzerland have announced their intention to shift a portion of their foreign currency reserves from dollars to euros.  Other central banks and private investors are expected to do the same.  According to LDC Bond Watch, Japanese financial institutions are moving to change the mix of their foreign investments from the current 70% dollar/30% European to a 50%/50% split.  Consequently, a weak U.S. dollar appears likely in early 1999.

In anticipation of the significant changes in the international financial system, I have been increasing the percentage of foreign fixed income securities during the past months, using several closed-end funds and one mutual fund.  Although interest rates are low in Europe, their fixed income securities remain attractive due to expected currency gains and modest declines in interest rates.  I also remain cautious towards U.S. equity markets due to a combination of high valuation levels and probable capital transfers from the United States to Europe.

^ back to top 

Updates

Carl Icahn recently made a tender offer of $10.50 for depositary units of American Real Estate Partners (ACP).  The depositary (limited partnership) units have a book value of $16.45, of which $9.22 is in the form of cash or U.S. Treasury bills.  The partnership continues to generate significant cash flow and earnings.  Earnings for 1998 should be around $1.40 per unit.  I continue to prefer the convertible preferred units (ACP.PR) to the ordinary units at current prices.  The preferred will probably be converted by the partnership at the earliest possible date - March 31, 2000.  Carl Icahn owns 86.5% of the preferred units and delaying the reinstatement of a cash distribution to the limited partners will allow him to obtain more depositary units at the time of conversion.  If the preferred units are converted in 2000, the value should rise by 51% from the current price of $7.31 over a period of 15 months.  The conversion of the preferred units should act as a catalyst for the realization of the full value of the partnership's depositary units.

Qualcomm's (QCOM) price has recently drifted a little lower due to the ongoing standards battle and I have increased some positions.  The International Telecom Union (ITU) has not yet made a decision on a third generation wireless standard.  The European Telecommunications Standards Institute has endorsed W-CDMA, a third generation standard developed by Ericsson and Nokia.  There is also legislation in the European parliament that would require all wireless carriers on the continent to use w-CDMA.  W-CDMA incorporates aspects of QCOM's CDMA (code division multiple access) but is incompatible with existing CDMA networks and involves higher installation and operating costs.  In response, Qualcomm issued a statement in October stating that it will not license its intellectual property rights for any competing versions of third generation technologies that incorporate elements of CDMA.  The ITU has declared that it will not endorse any standard that has intellectual property rights in dispute.  Qualcomm's proposed standard, CDMA2000, will accommodate both dominant network standards that are in use today and some operators have issued statements in support of a compatible standard.  As George Gilder has pointed out, if superior technology prevails over political considerations, QCOM will win.

In a recent press release, Ira Brodsky of Datacom Research Company pointed out that the wireless data communications market greatly expands the universe of potential users for CDMA.  Every auto, gas pump, ATM machine, vending machine, and security system is a potential CDMA user.  In the meantime, QCOM sells for 19.8X the consensus estimate for the current fiscal year (9/30/99) and 15.2X the following year's estimate.

The Bermuda-based reinsurance companies, La Salle Re Limited (LSH) and IPC Holdings, Ltd. (IPCRF), continue to sell at low valuations.  1998 has been a year of unusually high insured catastrophic events.  In the United States, for example, insurers' catastrophe losses for the first nine months are more than three times the total for all of 1997.  Consequently, earning for LSH were $3.06 for the fiscal year ending 9/30/98, compared to $5.55 a year ago.  IPCRF is expected to earn $2.98 for 1998, compared to $4.01 a year ago.  A series of loss events will impact short-term financial results but normalized earnings for the companies over a longer period of time should justify higher prices for their stock.

If you have any questions regarding your accounts, please do not hesitate to call me. I wish all of you a Happy New Year!

Sincerely,
Robert G. Kahl,
CFA, CPA, MBA

[back to Newsletter Archive]