Newsletter Q2 2003
April 15, 2003
Recycling
Dollars
American
consumers have been a major source of demand growth in the global economy.
The
United States
imports substantially more goods and
services than it exports, which created a huge current account deficit of $503
billion in 2002. Trading partners
have continued to invest dollars earned on exports back into dollar-denominated
assets. At yearend 2002, foreign
investors held 31.5% of outstanding U.S. Treasuries, 20.8% of corporate bonds,
12.3% of agency securities, and 11.5% of corporate equities.
Asian central banks have been major buyers of U.S. Treasuries because
they do not want their currency to appreciate against the dollar, which would
reduce demand for their export-driven industries.
Analysts
estimate that more than 80% of the world’s savings is funneled to the
United States
. Direct
foreign investments, such as the purchase of real estate or businesses, have
declined in recent years. Most
foreign investment is now in the form of marketable securities that can be sold
quickly and converted to another currency. Rather
than increasing productive capacity, much of the increase in debt of the
American economy is mortgage related. We
may not be sending goods to our foreign trading partners but we are building
bigger houses.
How
long will foreign countries be willing to accept IOUs from Americans in return
for the goods and services they produce? U.S.
Treasury Secretary John Snow says that they receive complaints at the Treasury
Department about our current account deficit from “our friends around the
world. And our response is, ‘Yea.
You know why? Because you
don’t buy enough from us.’” And
we thought the previous Treasury Secretary was diplomatically challenged.
Some
economists are encouraging Asian central banks to let their currencies
strengthen against the dollar. Christopher
Wood, regional strategist at CLSA Emerging Markets in
Hong Kong
comments: “This would have the
benefit of improving the purchasing power of
Asia
’s high-saving consumers in line with
the long-term fundamentals, which are that
Asia
, not the
U.S.
consumer, will be the next driver of
global growth.”
Jane
D’Arista, economist for the
Financial
Markets
Center
, once again provides some of the most
cogent remarks on the subject:
Keeping the economy humming with
savings borrowed from abroad may have seemed like a good policy choice in the
1990s….But regardless of its merits and flaws, retaining that policy has
become increasingly difficult. Towering
levels of external and domestic debt, persisting overhangs of excess capacity,
and faltering economic performance have now left the
U.S.
more vulnerable to a shift in
foreign-investor sentiment – and a potential fall in the exchange rate –
than it has been at any time since the dollar’s collapse at the end of the
1970s. Moreover, these same
conditions have made it more difficult for monetary policymakers to halt a
decline in the dollar by raising interest rates as they did in the earlier
crisis.
I agree with Jane D’Arista’s assessment and will continue to hold foreign
government debt, foreign equities and gold mining stocks as a hedge against a
lower dollar.
Additions
Canadian
and Australian government bonds have been purchased for most accounts.
The governments of both
Canada
and
Australia
currently have budget surpluses and
AAA credit ratings from S&P. The
bonds should benefit from the continuing decline of the U.S. dollar.
Aegon
N.V. (AEG) is the holding company of one of the world’s largest insurance
groups. AEG’s primary focus is
life insurance, pensions, and related savings and investment products.
Headquartered in the
Netherlands
, the company earned 62% of its net
income from
North America
in 2002.
AEG currently sells for 7.1X estimated earnings for 2003.
MFS
Charter Income Trust (MCR) was purchased for some accounts.
MCR is a multi-sector closed-end bond fund that invests in U.S.
Government securities, foreign government securities, and high-yield corporate
bonds. MCR has a dividend yield of
6.2% and sells at a 9% discount to net asset value.
For
some accounts, Argentina Government bonds were purchased at a deep discount to
par value. After instituting a
moratorium on debt payments,
Argentina
shifted to a floating exchange rate in
January 2002. Interim President
Eduardo Duhalde also decreed that dollar deposits and loans should be converted
to pesos. The result was financial
turmoil. In spite of its problems,
the economy of
Argentina
has regained its footing and its
currency has appreciated steadily since July of last year. Argentina
now has a trade surplus and industrial production in February was 12% higher
than the previous year. According to
Standard & Poor, government debt as a percentage of GDP is 58% (vs. 50% in
the
U.S.
), while private sector debt is 21% of
GDP (vs. 145% in the
U.S.
).
Interim President Duhalde has deferred any major economic proposals to
the next president, to be determined by an election this month.
There is now a strong consensus to restore investor confidence.
The nature of the government’s economic proposal, including some
renegotiation of sovereign debt, should be forthcoming with the next few months.
IRSA
Inversiones y Representaciones S.A. (IRS) is
Argentina
’s largest and most diversified real
estate company with interests in office buildings, shopping centers, hotels, and
property developments. Most of the
company’s lease contracts were originally denominated in U.S. dollars.
The Argentine government created a windfall for tenants when it
mandatorily converted U.S. dollar monetary obligations to pesos.
As a result, revenues from properties have declined by 50-60% and
operating income for the company is now at a breakeven level. However,
revenues should increase substantially as leases are rewritten upon expiration.
Deletions
Aberdeen
Asia-Pacific Income Fund (FAX) was sold at a profit.
The fund currently has about 14% of the portfolio in South Korean bonds.
The discount to net asset value could widen if the disagreement between
the
United States
and
North Korea
becomes more contentious.
Positions
in U.S. Treasury zero coupon securities were reduced.
The
U.S.
government’s lack of fiscal
discipline and large current account deficit raise the probability of a
devaluation of the U.S. dollar and higher interest rates.
Large
Scale Biology Corp. (LSBC) was sold at a loss.
The lack of any significant contracts accompanied by cash payments has
been disappointing and the company will most likely need to seek additional
financing.
ICN Pharmaceuticals (ICN) was sold. Several
companies now have plans to produce generic versions of ribavirin, a major
source of revenue for ICN. Schering-Plough,
ICN’s licensee, has signed an agreement with Three River Pharmaceuticals and
is negotiating with two other generic companies.
The strength of ICN’s patent protection is now in doubt.
Electronic
Data Systems (EDS) was sold at a small profit.
Moody’s downgraded the company’s debt for a second time in three
months as the company has experienced lower demand for its services.
Among other comments, Moody’s expressed concern about the risk of
contracts with several major airlines.
Updates
Holly
Corporation (HOC) signed a merger agreement with Frontier Oil Corp. (FTO),
subject to shareholder approval by both companies.
HOC shareholders will receive one share of FTO, $11.11 in cash, and a
non-transferable interest in potential future recoveries from litigation with
the U.S. Government for past sales of jet fuel.
I plan to hold HOC until completion of the merger, as the
non-transferable interest may be worth several dollars per share.
Sears
Roebuck (S) announced that it intends to sell its credit card division, which
generates about 55% of annual profits. Sears
hopes to sell the division for $7 billion in cash, which is nearly equivalent to
the current market value of the entire company.
If
you have any questions regarding your accounts, please do not hesitate to call
me.
Sincerely,
Robert
G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.