In early April, former Federal Reserve Chairman Paul Volcker described the Fed’s
dilemma: “The world has been staging a run on the greenback, with damaging
results if it continues…Concerns about recession are rife, and the Fed will be
tempted to subordinate the fundamental need to maintain a reliable currency to
the impulse to shore up a flagging economy. The danger is that you lose both
battles, as in the 1970’s, and wind up with stagflation.”
Federal Reserve Chairman
Ben Bernanke acknowledged concerns about the US currency and inflation, and
appeared to signal a change in Fed policy during his June 3 speech at the
International Monetary Conference in Barcelona. “We are attentive to the
implications of changes in the value of the dollar for inflation and inflation
expectations….The Fed’s commitment to price stability and maximum employment
will be key factors insuring that the dollar remains a strong and stable
currency.”
The European Central Bank (ECB)
has been more concerned about inflation than the Fed and promptly followed
Bernanke’s statement with one of their own to signal higher interest rates. On
June 5, ECB President Jean-Claude Trichet said, “We could decide to move our
rates a small amount in our next meeting in order to secure the solid anchoring
of inflation expectations.” Axel Weber, President of the Bundesbank, expressed
his agreement for emphasis. “The ECB is not split. We have sent a clear
message to the markets about what to expect in the near future. We have to let
deeds follow words.” In response, interest rates promptly moved higher in both
European and US financial markets and stock prices dropped sharply.
The Fed then leaked word
that Bernanke’s statements about fighting inflation should not be taken too
seriously. Robert Novak, syndicated columnist, wrote on June 16: “Speculation
that the Fed is about to begin inflation-fighting interest rate increases
appears to be dead wrong. Bernanke disagrees more with the European position
than is reflected by his public statements.”
Gary Dorsch, editor of the
Global Money Trends newsletter, believes that the Fed will be “under heavy
pressure to match a second ECB rate hike to 4.50%, to defend the value of the
dollar.” In essence, the ECB has taken the lead from the Fed and is now setting
the pace for monetary policy in the world, in an attempt to keep inflation under
control.
The Mortgage Bankers
Association reported that 8.8% of home loans were past due or in foreclosure at
the end of the first quarter. California and Florida accounted for nearly a
third of the problems loans. Default rates were highest for adjustable-rate
mortgages. As real estate prices decline, some borrowers may choose to walk
away from their mortgages even if they have the capacity to continue making
payments. According to Mark Zandi of Moody’s Economy.com, an estimated 10.6
million homeowners will have zero or negative equity by the end of June. This
represents 21% of first mortgages.
While Congress considers
how to help mortgage lenders with a bailout, Standard & Poor’s issued a
cautionary report. S&P estimates that the potential cost of a government
bailout of two government-sponsored private corporations, Fannie Mae and Freddie
Mac, would be in the range of $420 billion to $1.1 trillion. S&P believes that
the fiscal burden of such a bailout could be large enough to jeopardize the AAA
credit rating of the US Government.
The higher cost of energy
has also been providing resistance to an economic recovery. Congress held
hearings in an effort to scapegoat speculators rather than develop a credible
energy policy. Charles Maxwell, a prominent energy analyst, sees no chance of a
timely political response that will do anything to head off the oil crisis he
sees developing starting in 2010, when the world will no longer be able to use
the drawdown of inventories to meet growing demand. He expects the global
production of all liquids (including tar sands oil, condensates and biodiesel)
to peak by 2015 and the resulting financial crisis to last at least 10 years as
the world deals with price-induced rationing. Maxwell believes it will take US
pump prices of $12-15 per gallon to get Americans to give up some of their
“precious freedom of mobility.”
Another sign of the
changing US economic condition was Der Spiegel’s recent report that the
International Monetary Fund had “informed” the Federal Reserve of plans for a
general examination of the US financial system, called a Financial Sector
Assessment Program. According to Der Spiegel, President Bush has refused to
allow the IMF to conduct its assessment for seven years and only gave consent on
the condition that the examination could not begin until his last year of office
and could not be completed until after he left office. Fed Chairman Bernanke
may wish that he was out of office himself by the time the IMF releases its
report.
The economic prognosis for
the world economy and particularly the US economy remains poor. The economic
adjustment process that must occur suggests that the light is at the end of a
very long tunnel. I will continue to hedge against a declining US dollar with
foreign government bonds and stocks, with an emphasis on companies that provide
essential services such as energy and telecommunications.
Additions
American Strategic Income
Portfolio (ASP) was purchased for retirement accounts. ASP invests primarily in
whole-loan mortgages on commercial properties and multifamily housing. They
also own some preferred stocks and U.S. agency mortgage-backed securities. The
fund sold at an 11-12% discount to net asset value at the time of purchase. It
currently has a dividend yield of 7.6%, is leveraged to some extent (28% of
assets), and has a relatively short duration of 3.6 years.
A Canadian Government bond
with a two year maturity was purchased for selected accounts in late June to
replace another Canadian Government bond that had recently matured.
Deletions
The AllianceBernstein
Global High Income Fund (AWF) was sold as the discount to net asset value
declined to less than 2%. The proceeds will be used as a source of cash to
purchase other closed-end funds selling at larger discounts.
IShares Silver Trust (SLV)
was sold at a small loss. Due to the short-term price volatility, I decided
that I would no longer use SLV as a money market substitute.
AFP Provida SA (PVD) was
sold. The Chilean pension fund administrator is required to maintain a 1%
reserve in the five funds that they manage. If the returns of any of the funds
drops below the minimum required return, the reserve is used to enhance the
returns and PVD must make additional contributions to maintain the reserves. In
the first quarter of 2008, PVD had higher expenses due to negative returns on
some of the funds and higher expenses for life and disability insurance which
PVD must provide for its participants. Consequently, earnings estimates have
declined and further downward revisions are possible.
Updates
The Board of Directors of
TeliaSonera (TLSNF) rejected a non-binding indicative offer by France Telecom
because the offer “significantly undervalues” the company’s potential. France
Telecom had further discussions with TeliaSonera but was “unable to reach
agreement” and dropped its takeover bid altogether. The price of TLSNF recently
declined due to the abandonment of the bid by France Telecom. TLSNF currently
sells for 10X 2008 estimated earnings.
The Australian subsidiary
of Ocean Power Technologies, Inc. (OPTT) announced a joint development agreement
with Griffin Wave Power Ltd. for a wave power station off the coast of Western
Australia. Initial plans are for a wave power station capable of producing up
to 10 MW, with a potential expansion to 100 MW.
Ashford Hospitality Trust (AHT)
announced that it had closed the sale of the Hilton Dallas Lincoln Centre for
$72.25 million. The company has completed $289 million in asset sales in the
first six months of the year and has used the proceeds to reduce debt. AHT
currently sells for 3.4X estimated funds from operations and has a dividend
yield of 18.8%.
Huaneng Power International
Inc. (HNP) has declined in price due to higher coal prices and reduced earnings
estimates. HNP currently sells for 16.4X 2008 or 13.9X 2009 estimated
earnings. Jim Rogers, a retired hedge fund manager, continues to like China as
he expects the Chinese currency to quadruple in value over the next decade, a
forecast that is consistent with purchasing power parity estimates. China now
has $1.8 trillion in foreign currency reserves due to its trade surplus and
investment flows.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.