David Rosenberg, economist
at Merrill Lynch, recently wrote that two powerful secular forces sustained
spending, output, employment and profits during the last two decades: the baby
boomer generation and the 20-year secular credit expansion. Now that the median
baby boomer is approaching 50 years of age, he says we can no longer “expect to
see the demographic cushion to consumer spending that helped ease the blow in
each of the recessions dating back to the 1970s.” The demographic forces that
led to higher consumer spending were also accompanied by higher household debt
levels. From the mid-1960s to the mid-1980s, the household debt to income ratio
was relatively stable at 70%. At the end of 2007, that ratio reached an
all-time high of 140%.
At the end of his economic
commentary, Rosenberg listed some of the headlines from major newspapers to
illustrate the shift in consumer behavior:
“Frugality Trumps Brand Loyalty,” WSJ, 11/6/08.
“The Latest Style: Self-Denial,” WSJ, 11/6/08.
“The Bright Side: Deep Discounts from Retailers,” WSJ, 11/13/08.
“In a Down Economy, Spam Sales are Up,” NY Times, 11/15/08
“The New Frugality is Likely More Than a Fad,” Philadelphia Inquirer, 11/28/08.
“Many Boomers Fearful of Retirement Expenses,” WSJ, 11/18/08.
“Happy Holidays! But Don’t Expect Too Much from Santa Claus,” WSJ 12/6/08.
Households are now
attempting to raise their savings rates and reduce consumption. The US economy
is in the process of reducing capacity in a number of sectors such as finance,
housing, retail stores, and automobile manufacturing. Businesses are also
reducing investment to adjust to the new economic reality. Government efforts
to expand credit have been ineffective as households are attempting to reduce
debt and lenders have been dealing with a steady rise in nonperforming loans.
In an attempt to offset
lower consumption and investment, the Federal Government is developing plans for
significant infrastructure spending. The most recent infrastructure/economic
stimulus proposal is for $775 billion over two years. Because total government
expenditures account for approximately 33% of GDP, increased spending by the
government on infrastructure over several years is unlikely to fully offset the
decline in consumption and private sector investment. Negative GDP growth,
which started in the third quarter of 2008, and higher unemployment are likely
to continue for several quarters as the private sector finds a more sustainable
level.
The Federal budget deficit
totaled $401.6 billion for the first two months of the current fiscal year that
started on October 1. Estimates for the full fiscal year range from $1.2
trillion (Congressional Budget Office estimate without an economic stimulus
package) to $2 trillion. The full extent of financial bailouts is not reflected
on the US Government financial statements because some are off-balance sheet
operations by the Federal Reserve.
Professor Willem Buiter of
the London School of Economics offers his opinion about the future implications
of the US economic stimulus package being contemplated:
The US Federal government has taken on massive
additional contingent liabilities through its bail out/underwriting of the US
financial system (and possibly other bits of the US economic system that are too
politically connected to fail). Together with the foreseeable increase in
actual Federal government liabilities because of vastly increased future Federal
deficits, this implies the need for a future private to public sector resource
transfer that is most unlikely to be politically feasible without recourse to
inflation. The only alternative is default on the Federal debt. There is
little doubt, in my view, that the Federal authorities will choose the inflation
and currency depreciation route over the default route.
Persistent large budget
deficits increase the probability of a future default. US Treasury securities
have often been called “risk-free” but the credit default swap market says
otherwise. It now costs 0.59% to insure US Treasury securities against default
for one year, compared to 0.01% a year ago. Although McDonalds Corp. debt has a
credit rating of A, it costs less to insure its debt against default than
AAA-rated US Treasury debt.
During the fourth quarter,
many closed-end funds sold at historically large discounts to net asset value.
These discounts have since diminished and the prices have recovered to some
extent. The safe-haven status of US Treasury debt appears to be over-rated at
this point. The credit spreads on tax-exempt debt and corporate debt remain
relatively attractive after factoring in a high default rate.
Some common stock purchases
were made as the market declined because I thought that a depression scenario
had already been factored into the prices. In hindsight, some of these
purchases were premature, as prices declined further. The selling was often
indiscriminate and affected companies which have continued to demonstrate good
operating results. Cash levels remain high in the portfolios as I expect a
continuation of negative economic new during the first half of 2009. Preference
for any stock purchases will be given to companies that offer high dividend
yields and provide basic services.
Additions
Some tax-exempt closed-end
funds were purchased during the quarter for taxable accounts: Nuveen Florida
Quality Income Municipal Fund (NUF), Nuveen Premier Municipal Income Fund (NPF)
and Federated Premier Intermediate Municipal Income Fund (FPT). The funds use
some leverage by borrowing at low short-term rates and have an average credit
rating of AA or AAA. They were purchased at discounts to net asset value of
19-23%. Current tax-exempt yields for the funds exceed 6%.
American Strategic Income
Portfolio III (CSP) is a closed-end fund that invests primarily in mortgages on
apartments and other commercial properties. CSP also owns some preferred stock
of real estate investment trusts. CSP currently sells at a discount to net
asset value (estimated by the fund) of 20% and has a yield of 9.2%.
Genco Shipping & Trading
Ltd. (GNK) has a modern fleet of 30 vessels to transport dry bulk cargoes such
as iron ore, coal, grain, and steel products. In November, GNK cancelled the
acquisition of 6 new ships and relinquished $53 million of related deposits.
Although spot shipping rates have dropped approximately 90% from record highs in
the summer, GNK has time charters at fixed rates for approximately two-thirds of
its 2009 capacity. Spot shipping rates are expected to rise from the current
depressed levels as trade credit is restored and iron ore inventories are
depleted in China. GNK currently sells for 3.5X the consensus earnings estimate
for 2009. GNK paid a quarterly dividend of $1.00 per share in November but the
dividend may be reduced in 2009.
Tortoise North American
Energy Corp. (TYN) and Tortoise Capital Resources Corp. (TTO) were purchased for
accounts. Both are closed-end funds that invest primarily in oil and gas
pipeline companies, which typically charge a fee based upon the volume of oil or
gas transported. TTO has some investments that are not publicly traded and the
net asset value is estimated on a quarterly basis. Most of the investments in
both funds are master limited partnerships which issue K-1 schedules but
ownership thru the closed-end funds avoids any complex tax reporting
requirements and shareholders should receive 1099 forms instead of K-1s. At the
time of purchase, the yields on TYN and TTO exceeded 15% and 20%, respectively.
The Nuveen Multi-Currency
Short-Term Government Income Fund (JGT) was purchased. As of 9/30/08, 59% of
the assets were invested in Federal Home Loan Bank debt securities and the
remainder was invested in sovereign debt of other countries. The fund is not
leveraged. JGT currently sells at a 16% discount to net asset value and has a
yield of 12.7%.
Deletions
The American Century
International Bond Fund (BEGBX) and German Government bonds were sold in October
to reduce the foreign currency allocation temporarily. The Norwegian Government
bond positions were reduced at the end of the quarter. A portion of the
proceeds from the sales were invested in JGT, which was purchased at a large
discount to net asset value.
The Van Kampen Bond Fund (VBF)
and MFS Intermediate Income Trust (MIN) were sold to provide a source of funds
for the purchase of other closed-end funds that sell at larger discounts to net
asset value.
Chevron Corp. (CVX) was sold
and some positions in Canadian Natural Resources were reduced in order to reduce
the large energy sector allocation of the portfolios. I currently have a
preference for companies that offer higher dividend yields such as the Canadian
income trusts and energy pipeline companies.
Sinovac Biotech Ltd. (SVA)
was sold. Revenue for the third quarter of 2008 declined in comparison to the
prior year, which management attributed to a shift from private market sales to
the government sector. The shift in market emphasis will most likely result in
lower profit margins and was inconsistent with prior statements by management.
ASA Limited (ASA) was sold
due to the persistent decline in net asset value of the fund after it was
purchased.
Updates
Gramercy Capital Corp (GKK)
elected not to pay any dividends to common or preferred shareholders for the
fourth quarter and will retain capital for working capital purposes. The
company had paid enough dividends in the prior quarters to meet it minimum
distribution requirements to maintain REIT status. During the second half of
2008, GKK has purchased its own debt in the secondary market at a deep discount
to its face value.
Trina Solar Limited (TSL)
reported net revenues of $290 million for the third quarter of 2008, an increase
of 252% over the prior year. Earnings per ADR of $1.28 for the quarter
increased 313% over the prior year. Piper Jaffray analyst Jesse Pichel expects
negative growth of -2.5% in worldwide solar installations for 2009 due to the
new limitation on tax subsidies in Spain which has been a major market. TSL and
other solar companies are reconsidering their expansion plans. In mid-November,
TSL had an order backlog equal to 90% of its year-end production capacity. TSL
currently sells for 4.2X the consensus earnings estimate for 2009.
Positions in Idearc senior
notes were increased during the quarter. Idearc, which publishes the Verizon
Yellow Pages directories, had $304 million in cash as of 9/30/08 and drew down
$247 million on its letter of credit at the end of October to increase its cash
balance further. For the first 9 months of 2008, Idearc had operating income of
$897 million before interest expense of $491 million. The company hired
financial advisors to evaluate a financial restructuring and has imposed a
“quiet period” until the evaluation is complete. At recent price levels, the
purchase of senior notes in the secondary market represents a bargain for the
company. The purchase and early retirement of the senior notes would allow the
company to reduce interest expense and strengthen the balance sheet.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.