Newsletter Q3 2004
July 13, 2004
The Softer Side
of the Economy
Several
economic indicators have been positive in recent months. The U.S. Department of
Labor - Bureau of Labor Statistics has reported the following additions to
nonfarm payroll employment:
June 112,000
May 248,000
April 346,000
March 353,000
Real
GDP increased at an annual rate of 3.9% during the first quarter of 2004, while
corporate profits increased by 32.3% from the first quarter of 2003. Advance
estimates of retail and food service sales for May increased by 8.9% from the
prior year. While the positive economic reports are noteworthy, there is a
softer side to the economic indicators.
Stephen
Roach of Morgan Stanley believes that U.S. job and real wage growth has been
hindered by a “global labor arbitrage” that is being driven by a powerful
combination of offshore outsourcing to low-wage workers and internet-based
cross-border connectivity. The economic expansion is now 31 months old and
private nonfarm payrolls are up only 0.3% from the trough of the last recession
in November 2001. According to Roach, at this stage of the economic cycle, the
normal increase in jobs has been 7.5% from the trough of a recession.
In the
absence of significant job and wage growth, an extended period of easy credit
has provided stimulus to the economy by encouraging consumer spending and
borrowing. Its effects are most obvious in the real estate market. For
example, the California Association of Realtors reported that the statewide
median price of a home had risen by 26% for the twelve months ending in May
2004. Over the last three years, the median price had increased by 81%. As
real estate prices have risen, people have gone to greater lengths to borrow.
Why not? We’ve all heard that real estate prices only go up. Securities backed
by subprime (poor credit rating) mortgages soared from $17 billion in 1995 to
$195 billion in 2003. Unconventional mortgages, like no-money-down loans,
climbed from $1 billion to $80 billion during the same period.
Paul
Kasriel, economist at Northern Trust, provided four graphs with his commentary
on the real estate market. All four graphs ended in December 2003 and showed
post-WWII high ratios for all measures in the last half of 2003. The four
ratios and their last data points for 2003 were:
1. P/E
ratio for owner-occupied residential real estate (market value / imputed rental
services) at 17.25.
2. Market
value of owner-occupied residential real estate / disposable personal income at
180%.
3. Owner-occupied
residential real estate: market value / replacement value at 160%.
4. Owner-occupied
residential real estate leverage: Mortgage debt / market value of real estate at
45%. If the replacement value of real estate is used as the denominator, the
ratio rises to 72%.
Kasriel concludes: “Asset price bubbles deflate
when the ‘gas’ flowing into them – central bank credit – gets restricted. As we
enter a period when the Fed will start to restrict the growth in the credit it
provides the U.S. financial system, it will be interesting to see if it really
is different this time for the housing market or if it is a bubble just as the
stock market was back in 1999.”
Economists expect the Federal Reserve to continue raising the fed funds rate
later this year from the current level of 1.25%. In a poll published by
Barron’s on June 28, the median forecast for the fed funds rate was 2.0% by
12/31/04 and 3.0% by 6/30/05. The median forecast for the 10 year U.S. Treasury
bond was 5.1% by 12/31/04 and 5.3% by 6/30/05. A rise of 2.0% in the fed funds
rate from its trough of 1.0% will still leave it below a neutral stance.
Stephanie Pomboy, who writes a weekly commentary called “MacroMavens,” estimates
that if the Fed were to raise the fed funds rate to a neutral rate (2% more than
the inflation rate), it would have to rise to 5.25%.
The
Federal Reserve appears to prefer a go-slow approach to raising U.S. interest
rates but foreign central banks may not continue filling the U.S. current
account funding gap as they have in the past. In 2003, according to the Bureau
of Economic Analysis, foreign acquisition of assets in the U.S. net of U.S.
acquisitions abroad amounted to $545.8 billion. $248.6 billion of the net
foreign acquisitions were accounted for by foreign central bank purchases. The
central banks of Japan, China, Taiwan and South Korea have been among the most
active acquirers of U.S. Treasury debt to keep their currencies undervalued and
exports strong. However, the accumulation of dollar reserves has fueled money
supply growth and rising inflation in Asia. Asian central banks are now faced
with a choice to reduce inflation: raise interest rates or let their currencies
appreciate. Goldman Sachs Group’s Asia economist Adam Le Mesurier opined, “We
see the return of inflation as the catalyst for Asia to move from fear of
floating to a more flexible exchange rate regime.”
Additions
U.S.
Treasury bills due 8/19/04 were purchased as a short-term alternative to money
market funds. The Treasury bills will mature shortly after the August Federal
Reserve Open Market Committee meeting, when the Fed is expected to raise
short-term rates further.
UT
Starcom, Inc. (UTSI) provides wireless, wire line, optical and switching
solutions based upon internet protocol (IP) to service providers in rapidly
growing telecommunications markets. Product development is driven by three
major telecom trends: the migration from wireline to wireless for voice service;
the move from narrowband to broadband for data transmission; and the evolution
from traditional network switching technology to packet-based networks. In
2003, 86% of revenue came from China and 10% from Japan.
UTSI
sells both handsets and infrastructure equipment for Personal Access Systems
(PAS), which is based upon microcellular stations that are installed on existing
utility poles or buildings rather than large transmission towers. Because of
the low cost structure, PAS operators have a payback period of 2 to 3 years on
equipment with average revenue per subscriber of $7 per month. 58% of the 50
million PAS subscribers in China currently use UTSI handsets. UTSI is expanding
its business in countries other than China. The company expects revenue growth
of 40% to $2.75 billion in 2004, based in part on a large order backlog. UTSI
currently sells for 14.5X the consensus earnings estimate for 2004.
Deletions
Profits
were taken on Sirius Satellite Radio Inc. (SIRI). Although the company has
experienced good subscriber growth, marketing and subscription acquisition
expenses continued to remain higher than expected.
The
Oppenheimer Multi-Sector Fund (OMS) was sold to lower the average duration of
portfolios and improve credit quality.
The
Australia Government bond was sold. While the government’s finances remain
strong, I had some concerns about private debt levels and foreign capital flows
as the Australian real estate market has declined.
Updates
Most
municipal closed-end funds declined in value during the second quarter.
Long-term interest rates increased in April in anticipation of an increase in
short-term rates by the Fed. Municipal closed-end funds are usually leveraged
with preferred shares that pay low short-term rates. The funds now sell at
discounts to net asset value of 12-14% and have tax-exempt yields in the range
of 5.3-6.7%.
Methanex
Corporation (MEOH) expects the 1.7 million ton Atlas methanol plant in Trinidad
to begin production in the second quarter. MEOH has a 63.1% interest in the
joint venture; BP p.l.c. has the remaining interest. The company expects
industry capacity additions in 2004 to be largely offset by further shut-downs
of high cost North American production and continued demand growth.
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.