In July 1944, participants
from 44 nations met in Bretton Woods, New Hampshire to adopt the Bretton Woods
Agreements, a formal monetary framework for the settlement of commercial and
financial transactions among nations. A pegged rate currency system was
adopted, where members were required to establish a parity of their national
currencies in terms of gold and to maintain exchange rates within a band unless
the IMF determined that their balance of payments was in fundamental
disequilibrium. The United States agreed to link its currency to gold at a rate
of $35 per ounce and foreign central banks could exchange US dollars for gold at
that rate. At the time, the United States was the economic behemoth of the
world, with a trade surplus, and 65% of the world’s gold reserves. For
practical purposes, the US dollar was considered to be as good as gold.
In the 1960s, Charles de
Gaulle referred to the key role of the United States in the original Bretton
Woods monetary system as an “exorbitant privilege” because, unlike other
countries, the US could simply print more dollars to cover excess imports. Due
to persistent trade deficits and demands by the central banks of France and
other countries for US gold, in August 1971, President Nixon announced that the
US dollar would no longer be convertible into gold. Since then, the world’s
monetary system has not had an anchor of intrinsic value.
Eventually, an implicit
currency arrangement evolved, which is sometimes referred to as Bretton Woods
II. While the “exorbitant privilege” remains in place, its longevity is
questionable. Chris Dialynas, Managing Director at PIMCO, describes Bretton
Woods II as follows:
You can think of it as the Fed producing money
supply that goes through the banking system to consumers, who then consume
underpriced imported goods via the “fixed” exchange rate, a large portion of
which are produced in Asia. Asia takes the money and then purchases U.S. bonds
– in other words, lending it back to the U.S. – and then the cycle repeats
itself over and over again. Asia finances U.S. consumption and the budget
deficit. It all begins with the U.S. government running expansionary policies
that create demand, and with high rates of saving by foreigners who desire to
lend to the U.S. It is the incorrect “fixing” of the exchange rates that is a
necessary element that perpetuates the process.
Some economists dispute the
significance of the expanding current account deficit, which reached $225.6
billion for the third quarter, or 6.8% of GDP. David Malpass, Bear Stearns’s
chief economist, recently wrote an opinion in the Wall Street Journal which
encouraged us to “Embrace the Deficit.” Mr. Malpass’s Hegelian reasoning: “Our
imports grow with our economy and population while our exports grow with foreign
economies, especially those of industrialized countries. Though widely
criticized as an imbalance, the trade deficit and related capital inflow reflect
U.S. growth, not weakness – they link the younger, faster-growing U.S. with
aging, slower-growing economies abroad.” His statement appears to ignore
empirical evidence and predicts the opposite of what the United States trade
experience has been with countries such as China.
Doug Noland of
PrudentBear.com disagrees with Mr. Malpass and believes financial historians
will someday reflect back on the prevailing complacency with the massive current
account deficit with astonishment. He writes that the current account deficit
and associated “credit bubble would be much less perilous if our nation was
expanding debt to finance sound investment” and “wealth-creating capacity,”
which would provide the ability to satisfy our debt obligations with valued
goods and services. Instead, Mr. Noland argues, we are living beyond our means,
“luxuriating in our competitive advantage in issuing AAA securities in exchange
for endless imports.”
Der Spiegel editor Gabor
Steingart has also written about the dangers of U.S. consumption based on
growing debt and reliance upon foreign investors. According to Mr. Steingart,
there is a flip side to this process: 1) public, private and corporate debt
levels exceed any previously known dimensions; 2) some production sectors have
left the country for good, and 3) the US dollar can now be brought to the point
of collapse by external forces.
PIMCO recommends “currency
diversification” based upon the likelihood of a weaker dollar for 2007. They
identify three fundamental reasons for a weaker dollar in the intermediate term:
1) The Fed’s decision to pause its monetary tightening campaign will erode
support for the dollar; 2) Central banks are reducing their share of dollars in
their foreign currency reserves; and 3) Dollar depreciation will tend to
stabilize the U.S. net international liability position as most of our debt is
denominated in US dollars while most US assets held abroad are denominated in
foreign currencies.
Paul Kasriel, economist at
Northern Trust, recently reviewed the Federal Reserve Bank’s quarterly
flow-of-funds report and provides some explanation for the recent success of the
US stock and bond markets. He found that there has been a slowdown in household
borrowing, although leverage in owner-occupied residential real estate reached a
record high. There has also been a sharp increase in corporate equity
retirement (acquisitions and stock buybacks), funded by profits, in recent
quarters. This has been accompanied by strong growth in funds advanced to the
US by foreign investors. Mr. Kasriel concludes that “this helps explain the
rallies in the bond market and the stock market. With regard to the bond
market, this also helps explain the inversion of the yield curve. The supply of
credit from abroad has continued to grow rapidly as the growth in the U.S.
demand for credit has slowed sharply.”
As we enter 2007, I look
back on my client newsletter from a year ago. At the risk of sounding
repetitive, but entirely consistent, I believe the same strategy is
appropriate. Accordingly, I will maintain a significant allocation to foreign
government bonds and equities, avoid companies that are economically sensitive
or highly leveraged, and may err on the side of caution.
Additions
Positions in the energy
sector were increased in many accounts. The energy sector appears to be
undervalued, based upon long-term projections of global energy supply and
demand. ConocoPhillips (COP), Chevron (CVX), Devon Energy (DVN), and Petrobras
(PBR) continue to sell for less than 10X estimated earnings for 2007. Canadian
Natural Resources (CNQ) sells at a higher P/E multiple of 15.9X estimated
earnings for 2007 because production is expected to increase by 110,000 barrels
per day by the third quarter of 2008, when the first phase of the Horizon Oil
Sands project is completed.
The Western Asset Emerging
Markets Debt Fund (ESD) was purchased for selected accounts during the quarter.
The fund sells at a discount to net asset value of 13.8% and has a dividend
yield of 6.7%. The fund invests in foreign government debt of countries with
emerging financial markets. 91% of ESD’s portfolio holdings are denominated in
US dollars.
Updates
SABESP (SBS) announced on
December 12 that the Brazilian Senate had approved a bill which would establish
rules and regulations for the water and sanitation sectors. The stock price
reacted positively as the bill is designed to encourage additional
infrastructure investment to improve water and sanitation services. SBS
continues to sell at a reasonable P/E ratio of 9.6X estimated earnings.
Ocean Power Technologies (OPWT
in US pink sheets, OPT in London) has filed a registration statement with the
Securities and Exchange Commission to raise $100 million from a public offering
of the company’s common stock in the United States. OPT will apply to list the
shares sold in the offering on NASDAQ. The Company plans to continue to list
its common stock on the London Stock Exchange. Proceeds of the offering will be
used to fund the following: 1) wave power station projects, 2) research and
development to increase system output, 3) expansion of sales and marketing
capabilities, and 4) improvement of field service capabilities.
Shareholders of the
Alliance World Dollar Government Fund II Inc. (AWF) approved a proposal to
eliminate a policy that requires at least 65% of its total assets to be invested
in US$-denominated debt securities issued or guaranteed by foreign governments.
The change will facilitate new investment policies approved by the Board to
invest in debt of both governments and corporations, foreign or domestic,
denominated in a variety of currencies. The fund will also be changing its name
to the AllianceBernstein Global High Income Fund, Inc.
First Trust/Aberdeen Global
Opportunity Income Fund (FAM) is now selling at a small discount to net asset
value. Some positions have been reduced and the proceeds will be used for the
purchase of other closed-end income funds that are selling at larger discounts
to net asset value.
If you have any questions
regarding your accounts, please contact me. I wish all of you a happy and
prosperous new year!
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.