Newsletter Q1 2005
December 31, 2004
The Dollar
Question
At a
December 15 meeting with Italian Prime Minister Berlusconi, President Bush
insisted, “The policy of my government is a strong dollar policy.” Some might
wonder which dollar he was talking about as the decline of the U.S. dollar has
received more attention in recent months. The inevitable reduction of the U.S.
current account deficit may have a significant impact on asset returns in 2005.
As
Marshall Auerback has pointed out, in spite of the U.S. dollar decline, “the US
has managed no trade improvement because the greenback keeps falling against the
wrong currencies. Most of emerging Asia either directly pegs (e.g. China,
Malaysia, and Hong Kong) or manages its currency closely against the greenback.
And these are the countries which continue to run the biggest trade surpluses
with the US.” China has announced that it is gradually moving towards greater
exchange rate flexibility but would not do so under heavy external pressure.
The
prescription to correct the current account deficit could involve a combination
of bitter pills to swallow: higher interest rates to increase domestic savings
and reduce consumption, reduction of the U.S. Government’s budget deficit,
higher gasoline taxes to reduce crude oil imports, and a further decline in the
dollar to improve price competitiveness of U.S. goods and services in global
markets. This combination of bitter pills has negative implications for the
U.S. capital markets, the real estate market, and the global economy. U.S.
policy makers have been reluctant to administer such medicine as long as 80% of
the world’s savings continues to flow to the United States.
According to the International Monetary Fund, during the four years from 1999 to
2003, foreign exchange reserves at central banks worldwide increased by 69%. At
the end of 2003, dollar reserves accounted for 70 percent of the total while
euro reserve holdings represented 20 percent. Since 2001, the annual rate of
foreign direct investment (by private investors) in the U.S. has decreased by
about $250 billion while foreign central banks have increased their purchases of
U.S. Government and Agency securities by a similar amount to make up the
difference. The central banks of the world may have reached their limits in
support of the dollar. Dollar reserve holdings are higher than global trade
flows would warrant and the euro has now established itself as a viable
alternative.
In
recent months, much of the commentary about the dollar’s decline has become
increasingly blunt with little equivocation. Many of the commentators seem to
be urging U.S. policy makers to act more decisively. A sample follows:
The
Economist, December 4, 2004 editorial:
The dollar is not
what it used to be. Over the past three years it has fallen by 35% against the
euro and by 24% against the yen. But its latest slide is merely a symptom of a
worse malaise: the global financial system is under great strain. America has
habits that are inappropriate, to say the least, for the guardian of the world’s
main reserve currency: rampant government borrowing, furious consumer spending
and a current-account deficit big enough to have bankrupted any other country
some time ago. This makes a dollar devaluation inevitable, not least because it
becomes a seemingly attractive option for the leaders of a heavily indebted
America. Policymakers now seem to be talking the dollar down. Yet this is a
dangerous game. Why would anybody want to invest in a currency that will almost
certainly depreciate?
Joseph
Quinlan, chief market strategist of Bank of America Capital Management:
The message from the
foreign exchange markets seems to be simply this: The free ride for the rogue
nation is over. No more guns and butter, or wads of foreign cash for a nation
deeply enmeshed in the Middle East, heavily indebted at home and seemingly
disengaged, some might say, from the rest of the world.
Sung
Won Sohn, chief economist of Wells Fargo Bank:
My worry is that we
could see the dollar not only falling further but also we run the risk of a
plunge in the value of the dollar at some point as it becomes more and more
difficult to attract foreign investors. I say the dollar depreciation is not
enough because studies have shown that about 70 percent of our deficit comes
from overconsumption in the United States and that includes obviously budget
deficits, low savings rates, and I don’t expect them to change overnight.
Stephen
Roach, chief economist of Morgan Stanley:
We all hope for a
well-managed revaluation of the dollar and a measured rebalancing of the world
economy. But the margin for error is so slim since the imbalances are so huge.
Masatsugu Asakawa, top official at the Japanese Finance Ministry who manages the
largest portfolio ($720 billion) of U.S. government securities in the world:
We’ve heard the
rumors in the last few days that the Chinese guys, the Indian guys, the South
African guys are diverting from dollars. We have no plan at all to divert from
our dollar-denominated assets…. Imagine that tomorrow people hear, ‘Hey, Japan
has decided to divert from U.S. dollars to euros.’ That would create a hugely
undesirable impact on the U.S. Treasury market, and we have no intention at all
to make an unfortunate impact on the U.S. Treasury market.
A
black-market currency trader named Ampon in Bangkok, Thailand:
No, I’m not buying
dollars these days.
Additions
Converium Holdings Ltd. (CHR) is a Swiss reinsurance company. For the second
quarter, CHR reported a large loss of $660 million, partly due to additional
reserves resulting from a detailed review of its U.S. casualty business, which
had been experiencing higher than expected underwriting losses. As a result of
the review, CHR announced that it would not underwrite any new business in the
U.S. and would raise additional capital of $420 million through a rights
offering which allowed shareholders to buy additional shares at a discount to
the market price. The price of the stock declined due to the dilutive effect of
the additional shares to be issued and diminution of demand from existing
shareholders who had no incentive to buy in the open market prior to the rights
offering. Subsequent to the rights offering, shares were purchased at
approximately 58% of pro forma book value. Eventually, I expect CHR to sell at
a price in line with other reinsurance companies, most of which sell at premium
to book value.
StreetTracks Gold Trust (GLD) is an exchange-traded fund that attempts to track
the price of gold. The fund holds gold and a portion of its holdings may be
sold as needed to pay expenses of the fund, which are expected to be 0.3% of
assets per annum. The fund had its IPO on November 18 and now has over $1.5
billion in assets. I believe that GLD represents an attractive alternative to
the U.S. currency at this time.
Deletions
ITLA
Capital Corporation (ITLA) was sold at a profit. Analysts expect ITLA’s
earnings to decline in 2005. Household International (HI) will probably
discontinue its arrangement with ITLA to process tax refund anticipation loans
because HI was acquired by HSBC. ITLA continues to be well-managed but the
current valuation level does not provide as much upside potential as in the
past.
Updates
The
Board of Canadian Natural Resources Ltd. (CNQ) has not yet approved the Horizon
oil sands project in Alberta. The Board is expected to approve the project
within one to three months, which should add 6 billion barrels to CNQ’s reported
reserves. The lack of Board approval has helped operating managers negotiate
better terms on construction contracts.
In
October, Harmony Gold Mining Co. Ltd. (HMY) initiated a hostile takeover of Gold
Fields Ltd. (GFI), another South African mining company. HMY management
believes that it can cut expenses after the acquisition of GFI by one billion
rand due to management restructuring, reduction of procurement costs, and
combining the mining hospitals of the two companies. The HMY offer was
contingent upon the elimination of the proposed transaction between Gold Fields
and IAMGOLD, which was rejected by GFI shareholders in December. HMY and GFI
are now discussing “alternative transactions” that could change the hostile
takeover offer into a friendly deal. Although the price of gold has continued
to rise in U.S. dollar terms, earnings estimates for HMY have declined because
the South African rand and HMY’s rand-denominated operating expenses have
increased at a faster rate.
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
Sabino
Investment Management, L.L.C.