Newsletter Q3 2006
July 12, 2006
Central Bankers Rethink Policy
There have been policy shifts among major
central banks around the world since the beginning of the year. The
excessive liquidity practices of the world’s central banks during the last
six years stimulated higher prices in real estate, commodities and many
financial instruments. The world’s central bankers now seem to be
rethinking their strategies and the role of the US dollar in the world’s
financial system.
The People’s Bank of China (PBOC), China’s
central bank, is expected to raise interest rates in an effort to cool the
economy and adopt policies that will achieve a more balanced trade account.
Part of the trade balancing process involves reducing the government’s role
in pegging their currency to the US dollar. China’s central bank recently
stated in its quarterly monetary policy report, “The frequency and strength
of the central bank’s open market currency operations will gradually weaken
and be phased out.”
China now has the highest level of foreign
currency reserves in the world at $875 billion as of the end of March, with
an estimated two-thirds of the total invested in U.S. Treasury securities.
Yu Yongding, a committee member of the PBOC, has advised the Bank that
“China has more than enough foreign-exchange reserves.” He continues,
“China needs to establish a separate body to oversee and invest the reserves
to seek higher returns and to avoid losses in case of a big depreciation in
the U.S. dollar. We need to use some of the reserves to buy other assets
such as gold and strategic reserves such as oil.”
Alexei Kudrin, the Russian Finance Minister,
openly questioned the dollar’s role as preeminent reserve currency at the
annual meetings of the World Bank and International Monetary Fund in April.
“The US dollar’s recent volatility and the US trade deficit cause
significant changes in the international situation and that is why we do not
understand the US dollar at the moment as the universal or absolute reserve
currency. The international community can hardly be satisfied with this
instability. Whether it is the US dollar exchange rate or the US trade
balance, it definitely causes concerns with regard to the dollar’s status as
a reserve currency.”
The Bank of Japan (BOJ) has
“decided in principle” to raise the key interest rate from zero to 0.25% - the
first rate hike in six years. The expected rate increase follows the BOJ’s
removal of excess reserves from the banking system during the first quarter. It
is estimated that the Japanese banking system had 30 trillion yen (approximately
$263 billion) of excess reserves at the beginning of the year. Since 1991,
Japanese corporations had been using their cash flow to reduce debt in response
to falling asset prices. The deflationary effect of corporate debt reduction
was offset with large deficit spending programs by the Government. Japanese
companies are now using their cash flow to expand their businesses instead of
debt reduction, so massive fiscal and monetary stimulus are no longer considered
necessary.
The European Central Bank
(ECB) left it benchmark lending rate unchanged at 2.75% in July but increasingly
hawkish statements have raised expectations of a rate increase in early August.
Jean-Claude Trichet, President of the ECB said, “We’ll continue to do all that’s
necessary to counter inflationary risks and anchor inflationary expectations…and
it seems to be that it’s very well understood by observers.”
Federal Reserve Bank Vice
Chairman Donald Kohn recently spoke with unusual candor at a seminar in London.
“The first thing to keep in mind about global imbalances is their scale. The
U.S. current account deficit is enormous – on the order of $800 billion or 6.5%
of gross domestic product – and it is not likely to shrink substantially in the
immediate future, given the current configuration of economic activity and
prices around the world.”
Regarding government
policies to address the global imbalances, Dr. Kohn’s recommendations included
the following: 1) a permanent correction to the spending imbalances in the
United States involving fiscal discipline and a long-run solution to the
financing problems of entitlement programs; 2) policies to stimulate domestic
demand of trading partners to offset reductions in demand from US imports; and
3) increased exchange rate flexibility in key Asian currencies. Without these
and other types of market flexibility, “rigidities might impede such stabilizing
changes, causing adjustments to break out forcefully in other, more disruptive
ways.”
Dr. Kohn is clear about the
Federal Reserve’s role in the global economic adjustment process. “Continued
strong demand for dollar assets will be critical to keeping that unwinding
smooth and not disruptive. The Federal Reserve can contribute by being sure the
public remains confident that the purchasing power of their dollar assets will
not erode unexpectedly.”
In summary, the major
central banks are adopting more restrictive monetary policies and raising
short-term interest rates. The Federal Reserve must remain competitive by
offering higher interest rates in the US, to ensure “continued strong demand for
dollar assets.”
Additions
Aluminum Corp. of China
Ltd. (ACH) was purchased shortly after the end of the second quarter for many
accounts. ACH currently accounts for 76% of alumina production in China. The
Aluminum Association forecasts substantial growth in Chinese aluminum demand
over the next decade, from 7 million tons to 16 million tons per year. ACH
currently sells for 5.5X 2006 estimated earnings and has a dividend yield of
3.6%.
The Macquarie Global
Infrastructure Total Return Fund (MGU) was added to additional accounts during
the quarter. MGU invests in basic services such as pipelines, electric and gas
distribution, toll roads, and airports. MGU recently increased its quarterly
distribution to $0.40 per quarter (yield of 7.0%) and the fund sells at an 8%
discount to net asset value.
Foreign government bonds of
Australia, Canada, and Germany were added during the quarter for many accounts.
The American Century International Bond Fund was also used for selected
accounts to increase foreign currency exposure.
U.S. Treasury bills due in
6 months were purchased at the end of the quarter for many accounts. The yield
on the 6 month T-bill continues to exceed those of longer term bonds. Further
increases in short-term rates by the Federal Reserve are possible.
Deletions
A Canadian Government bond
due in 2013 was swapped early in the second quarter for a Canadian Government
bond due in December 2007. The probability of higher interest rates in Canada
has increased and the average maturity of Canadian bond holdings has been
reduced.
The StreetTracks Gold Trust
(GLD) was sold. There could be further deleveraging by hedge funds and gold has
been a popular holding for them.
Fresh Del Monte Produce
(FDP) was sold. The first quarter earnings report was disappointing and
earnings estimates were revised downward.
Positions in Methanex Corp.
(MEOH) were reduced during the quarter. The outlook for capacity additions and
closures remains favorable for the industry. Product prices, which are a
function of global industrial production and energy costs, declined slightly at
the end of the second quarter. Proceeds from the partial reductions will be
used to diversify portfolios further.
The Nuveen Preferred and
Convertible Income Fund 2 (JQC) was sold. The closed-end fund has a
distribution rate that exceeds its net income and the discount to net asset
value had declined since it was purchased.
Positions in First
Trust/Aberdeen Global Income Opportunity Fund (FAM) were reduced and proceeds
were used as a source of funds for the purchase of an Australian Government
bond. FAM has increased the allocation of U.S. dollar denominated bonds within
its portfolio and I would prefer to maintain exposure to other currencies.
Updates
Prices of energy companies
such as Chevron (CVX), Devon (DVN), Canadian Natural Resources (CNQ), and
Petrobras (PBR) declined in May, although the price of oil did not change
substantially. Many of these companies continue to sell at a low price/earnings
ratios and substantial discounts to the present value of their reserves.
In June, Sonic
Environmental Solutions Inc. (SEVSF) announced that Larry Rodricks was joining
the company as Vice President of Remediation Services. Mr. Rodricks was a Vice
President with CH2M Hill, a large environmental consulting company, and has over
20 years of experience in the Canadian environment industry. Mr. Rodricks said,
“I consider Sonic to have the best solution in the market today for chlorinated
contaminated soil such as PCBs, pesticides, dioxins, furans, and TCE. The
Company provides the most cost-effective alternative to thermal treatment….I
plan to aggressively expand Sonic’s operations in Canada by securing contracts
through an established network of private and government clients.”
In 2004, The Canadian
Federal Government and the Province of Nova Scotia proposed a 10-year, $400
million plan to clean up the Sydney Tar Ponds site, which is contaminated with
PCBs and other toxins. After much public opposition to the incineration of PCB,
Cape Breton University submitted a treatability study report in May that
recommended Sonic’s technology as the only viable alternative to incineration.
South Korea Telecom (SKM)
agreed to invest $1 billion in China Unicom (CHU) convertible bonds and work
together on the Chinese company’s CDMA cell phone business. At the end of May,
China Unicom had 134 million subscribers in China. SKM may convert the bonds to
899.75 China Unicom shares, or 6.67% of the post-conversion shares outstanding.
The Putnam Tax Free Health
Care Fund (PMH) received a shareholder proposal to request that the trustees
convert the fund to an open-end fund or otherwise enable shareholders to realize
the net asset value of their shares. If the proxy proposal is successful, the
current 14% discount to net asset value is likely to be eliminated.
If you have any questions
regarding your accounts, please contact us.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.