Review and Outlook
December 22, 2011
To my Clients, Friends & Observers:
The International Monetary Fund was established to help rebuild the world’s economy after WW2. Most of its attention thereafter has been to developing nations in Africa, Asia and the former East Bloc. Now, 65 years after WW2, the IMF is redirecting aid back to Europe.
The Federal Reserve Bank has committed to lending the European Central Bank (ECB) U.S. funds at an interest lower rate than that available to U.S. banks (.58% vs .75% at the discount window). Ironically, the collateral for these loans include the dubious mortgage backed securities that helped create the crisis in the first place – valued at whatever the borrowers say they are worth. As yet U.S taxpayers are not directly exposed. The Fed holds $2.2 billion of these loans.
The ultimate solution to the European Union is dissolution. All the current dialogue is political posturing. Inevitably, revenues must meet expenses, in democratic republics, Latin dictatorships and communist oligarchies. Germany is not going to commit any further capital to enable its spendthrift neighbors with which it is culturally incongruous. German exports have been helped by the Euro but not enough to justify a further German recapitalization of the rest of Europe. Germany has barely completed rebuilding East Germany. It’s notable that in October, 2010 Germany made its last reparations payment from the Versailles Treaty of 1919, $94 million. The total paid over 96 years would equal $400 billion in today’s dollars.
To read the press you’d think China was on the brink of depression. Growth has slowed to 9% from 12%. Expect to see 8-9% in’12. Its stock market has dropped over 25%.
Europe will be in recession in 2012. U.S. GDP should grow 1 ½ to 2%. Risk of a U.S. recession is far less likely. Average global growth should approximate 3 ½%. A drop in oil prices would be a huge catalyst. Historically oil prices have always trended lower over time. For the first time in my life oil/gasoline prices are not determined by U.S. consumption and production, they are being determined in China. This is big.
Companies we own or have owned that are exposed to Europe: Illinois Tool Works, Exxon Mobil, and Ford. We have sold ITW. Exxon exposure to Europe is immaterial even at 29% of revenues. Ford could be impacted, particularly as the Euro weakens but we own Ford debt, not equity.
U.S. banks are too interconnected with European banks. Morgan Stanley, JP Morgan, Citigroup and Bank of America are exposed collectively to $230 trillion in credit default swaps. This is what should be regulated, in fact, banned. Instead, innocent bystanders and productive concerns like farmers and commodity hedgers are subjected to Dodd-Frank, which is so complicated that it cannot even be enacted for another year yet. It was supposed to be in full effect by May of this year. When it finally is, it will take further years of litigation to determine what exactly it is regulating. I attended a Global Derivatives Conference in New York in September and the keynote speaker addressed Dodd Frank compliance. It is a counter-productive nightmare.
It used to be that bank presidents started out as corporate lenders. Why? Because that’s where banks made their money, lending shrewdly, at good rates. A loan officer had to be a capable financial analyst as well as a good judge of character. Banks used to lend money to make money. Now they are mollycoddled by the Fed Reserve which guarantees them a 3% margin to do nothing but hold deposits. A bank is supposed to be a safe depository for a citizen’s money. Money is supposed to be a store of value. When we deposit funds in a bank we are lending the bank money to invest productively and safely. The bank owes the depositor a return on his/her loan. It is just another assault on common sensibilities that Bank of America, among others, charge their depositors for allowing them to use their money.
A company that lends shrewdly as above is Triangle Capital Corporation, a business development company that finances mid-sized businesses with debt and equity. Most impressive is the quality of its management and lending officers. We have begun to build a position in TCAP. It is reasonably valued and yields a significant dividend that appears sustainable.
Stock market volume has noticeably decreased. Trading volume is off by about 10% the past month, year over year. Fewer companies are issuing equity. More companies are considering going or staying private. The cost of debt capital is always cheaper than equity, and debt is historically very cheap. The cost of equity is getting costlier (see Sarbanes-Oxley and Dodd-Frank). Demographically, the same numbers that are affecting the housing market are also affecting the securities markets, i.e., aging baby boomers.
Little to no inflation and possible deflation is the long-term trend we are about to realize. Read “little appreciation.” My fixed income discipline requires very short durations, averaging two years presently.
Dennis M. O’Connor