Newsletter Q1 2004
January 17, 2004
Bubble Trouble? - The Economic Debate Continues
Fed officials are making an effort to
convince people that the current economic recovery is real and without
significant risk. In a speech in San Diego on January 3, Federal Reserve
Chairman Alan Greenspan attributed the ability of the U.S. economy to absorb a
sequence of shocks to “improved structural flexibility” brought about by
globalization and an acceleration of productivity. He also said in a
self-congratulatory statement that “highly aggressive monetary ease was
doubtless also a significant contributor to stability.”
On January 7, the International
Monetary Fund (IMF) issued a report prepared by a team of IMF economists. The
report questioned the wisdom of the Bush administration’s tax cuts and warned
that the large budget deficits pose “significant risks” for the U.S. and the
rest of the world. The IMF warned that the United States’ net financial
obligations to the rest of the world could be equal to 40 percent of its total
economy within a few years – “an unprecedented level of external debt for a
large industrial country.”
On January 13, Chairman Greenspan
countered the IMF’s warning with a speech before the Bundesbank in Berlin .
After acknowledging concerns about the U.S. imbalances, he said that “America’s
capacity for raising cross-border debt…is evidently, in part, a function of
globalization since the apparent increase in our debt-raising capacity appears
to be related to the reduced cost and increasing reach of financial
intermediation.” Greenspan went on to say, “technological advance and the
spread of global financial deregulation has fostered a broadening array of
specialized financial products and institutions. The associated increased
layers of intermediation in our financial systems make it easier to diversify
and manage risk, thereby facilitating an ever-rising ratio of both domestic
liabilities and assets to GDP and gross external liabilities to trade.” In his
concluding remarks, Greenspan said, “Should globalization be allowed to proceed
and thereby create an ever more flexible international financial system, history
suggests that current imbalances will be defused with little disruption.”
Stephen Roach, economist at Morgan
Stanley, has a less sanguine view of the state of the economy. He identifies
some of the same secular trends to which Chairman Greenspan refers, but views
them in a different light. Roach believes that a new macro climate has emerged
over the past decade as a result of the combined forces of low interest rates
engineered by central banks, IT-enabled technological change, and a powerful
global labor arbitrage. As job creation and income generation in the high-wage
US economy are impaired, asset markets have become the “ America ’s internally
generated economic fuel – away from earned income toward the wealth effects
derived from investments in stocks, bonds, and property.”
Evidence of Roach’s “global labor
arbitrage” – offshore outsourcing in goods and services combined with
internet-driven connectivity – is strong in the labor statistics. During the
final five months of 2003, nonfarm businesses added 278,000 new jobs. Three
industry segments that are relatively insulated from international competition –
education, health care, and temporary staffing – accounted for 286,000 new
jobs. In the meantime, the number of jobs declined in manufacturing, retail
trade, and financial and information services. Roach estimates that if this
economic recovery had followed the typical pattern, after 25 months, there would
be 7.7 million more jobs in the U.S.
Roach doesn’t share Chairman
Greenspan’s exuberance regarding the triumph of the new macroeconomic scheme:
Lost in the celebration are the costs
of this recovery as manifested in the form of serious and ever-mounting
structural imbalances — namely, a rock-bottom national saving rate, record
levels of personal indebtedness, a massive budget deficit, and record
current-account and trade gaps. These imbalances are very much an outgrowth of
the new macro climate and the Fed’s post-bubble tactics. Asset-driven economies
are biased toward increased debt and reduced income-based saving; lacking in
domestic saving, the US has no choice other than to import surplus saving from
abroad and run massive external deficits to attract that capital. Moreover, by
keeping short-term interest rates low and signaling that it is inclined to do so
for some time to come, the Fed’s post-equity-bubble damage control tactics have
led to a series of additional asset bubbles — property, refis, bonds, and credit
instruments. The image of the Fed as a “serial bubble blower” is not that
farfetched after all.
Traditional money supply figures
published by the Federal Reserve fail to capture the ongoing expansion of credit
that is taking place outside of the banking system. It is estimated that
approximately two-thirds of the increase in U.S. credit is now created outside
of the banking system. As of 12/29/03 , seasonally adjusted M2 had increased by
3.6% from one year ago. Fannie Mae, the largest government sponsored
enterprise, increased its book of business by 21.6% as of October 2003 versus
the prior year. When investors swap their savings accounts that pay negligible
interest rates for mortgage-backed securities sold by Fannie Mae, the money
supply declines but the amount of credit outstanding remains the same. It is no
coincidence that the expansion of credit available for residential real estate
has been accompanied by a similar rise in the price of residential real estate.
The European Central Bank has no
plans to intervene in the currency markets as it believes that efforts to sell
the euro against the dollar would be futile without the cooperation of the U.S.
government. Asian central banks, however, have attempted to forestall the
inevitable. According to Christopher Wood of CLSA, Asian central banks have
accounted for 58 percent of U.S. Treasury bond and agency purchases by
foreigners in the past 12 months and have accumulated foreign reserves of $1.8
trillion. The extent of intervention is now enormous.
Japan ’s
Ministry of Finance announced in mid-December that it would raise the ceiling on
the amount it could borrow for currency intervention to 100 trillion and 140
trillion yen for the fiscal years ending on March 31, 2004 and March 31, 2005 ,
respectively. These numbers represent 18.6% and 26.0% of Japan ’s 2002 GDP. In
the first half of January 2004, Japan committed an estimated $60 billion to
foreign exchange intervention. This represents a much higher rate than the $175
billion commitment for all of 2003.
Marshall Auerback, market strategist
for David Tice & Associates, offers another opinion that is contrary to Chairman
Greenspan’s:
In contrast to Mr. Greenspan’s
musings, a more accurate characterization of current reality is that an
unsustainable boom in consumer spending fuelled by credit has simply replaced
the unsustainable bubble in corporate expenditure of the late 1990s that was
driven by corporate debt. In view of these continued imbalances, we view the
bear market as merely interrupted, rather than eradicated; at some point in the
near future it will return. But when this latest bubble pops appears to us to
be very much a case of Asian central bank discretion, rather than “brilliantly
conducted” Fed policy.
Additions
SK Telecom Co. (SKM) is South Korea
’s leading mobile communication service operator. SKM has over 18 million
cellular subscribers, representing a 54% share of the market. SKM has been a
technology leader, introducing the world’s first CDMA cellular service in
January 1996. It was also the first commercial operator to market with its 3rd
generation CDMA2000 1X service in October 2000 and CDMA2000 1x EV-DO service in
January 2002. The 1x EV-DO service provides a maximum data transmission speed
of 2.4 Mbps. SKM has a joint venture with China Unicom to establish a wireless
internet service in China . It also has an investment license from the
Vietnamese government to establish a CDMA network. SKM sells for 9.6X estimated
earnings for 2004.
Deletions
Mymetics Corp (MYMX), the spinoff
from MFC Bancorp, was sold. MYMX has not made much progress towards
commercialization of their intellectual property and I was unable to contact a
company representative regarding the company’s prospects.
Updates
Positions in Fresh Del Monte Produce
(FDP) were increased for many accounts. The company continues to report good
results and the balance sheet has strengthened. The price has declined slightly
along with earnings estimates in recent months. FDP now sells for 6.6X
estimated earnings for 2004.
Positions in Stillwater Mining Co. (SWC)
were reduced. The price of the stock has risen considerably since the purchase
date, while earnings estimates have remained about the same. Platinum prices
continued to rise during the fourth quarter while palladium prices have remained
flat.
Sirius Satellite Radio (SIRI) added
over 100,000 subscribers during the fourth quarter of 2003 to end the year at
261,061 subscribers. The price of the stock rose recently after favorable
comments by analysts regarding holiday sales of satellite radios. Analysts
expect SIRI to add 700,000 to 800,000 subscribers during 2004. Kit Spring , an
analyst with Stifel Nicolaus & Co., expects SIRI and its competitor, XM
Satellite Radio, to share 25 million subscribers by the end of the decade.
In September, the Argentine
Government offered to write down the value of defaulted debt by 75% and replace
it with new low-interest bonds without paying any interest in arrears. On
December 3, the Argentine Bondholders’ Committee made a counter-offer to
write-off 35% of the nominal value of defaulted debt, but interest in arrears
would be paid to bondholders. The negotiations continue.
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.