April 23, 2004
Dow Jones Average: 10,461
S&P 500: 1,140
Competition for Resources
Over the past four years economic growth has been extremely
slow in North America, Europe, and Japan. In emerging markets the
story has been quite different, with economic booms taking place in
China, India, and other Asian countries. The United States still has
the world's largest economy, supported by one of the most stable banking
systems. But the more populous regions of the world are growing at
a much faster pace. Just as California grew from a small base to become
the most dominant state in the U.S., the center of global economic
activity is gradually shifting to Central and East Asia where sixty
percent of the world's population lives.
The level of resource consumption has been dramatically
altered by the economic boom in Asia. Afew years ago China was a net
exporter of petroleum. The Chinese now import six million barrels
of crude oil per day which is more than the Japanese import. Demand
from China is the primary reason that oil prices have remained near
record levels for more than a year. Other commodities such as copper,
nickel, aluminum, and lumber have been similarly affected by Asian
demand. Although economic statistics from China are often incomplete
and unreliable, reports that are available indicate that in rough
terms China is now consuming one half of all cement produced in the
world, and one third of worldwide steel production. Dealers in scrap
metal are rejoicing as their rusty, old piles of scrap have tripled
in value thanks to Chinese demand. Some countries are limiting the
amount of scrap metal exported because they fear that there will not
be enough left to satisfy domestic needs.
The boom in emerging market economies holds both promise
and problems for companies and employees in mature economies. Business
opportunities abound as incomes rise in populous countries such as
China and India. Many U.S. companies that we track are reporting strong
sales to Asia, while business in more mature markets remains weak.
Exports to foreign markets certainly leads to employment for some
U.S. workers even as others see their jobs outsourced. An increase
in global business activity would appear to be a good thing for most
corporations, but if it is accompanied by increased competition for
natural resources and capital many companies could be squeezed.
Current Strategy
In recent Congressional testimony Federal Reserve Chairman
Alan Greenspan said he was no longer worried about deflation. The
concerns he voiced a year ago about deflation never seemed plausible
to us in light of the rising costs for health care, education, housing,
and energy at that time. Now even more goods and services are rising
in price. Many economists feel that Greenspan is behind the curve
and should be expressing concern about the possibility of an increase
in inflation. Chairman Greenspan may not be saying all that he believes.
His comment that deflation was no longer a concern, an obvious statement
considering that inflation ran at a five percent annual rate in the
first quarter of 2004, sent the bond market reeling and interest
rates higher. He is trying to prepare investors for higher interest
rates in a gentle way and avoid the panic that would ensue if investors
thought he was truly worried about inflation.
Inflation and higher interest rates usually spell trouble
for stock market investors. History has shown that when commodity
prices and inflation heat up stock values cool off. Commodities reached
an all-time inflation adjusted low in 1999 just as stocks were hitting
their dot.com bubble highs. Since that time the commodity index has
been trending higher while the broadly based stock indices have fallen
noticeably. Companies often make more money during inflationary times,
but investors are not willing to pay as much for those earnings. Inflation
brings about higher interest rates and the higher yielding bonds compete
with stocks for investor dollars. Some companies earn enough to clear
the hurdle presented by higher interest rates, while others fall short
of the growth needed to compete with higher yielding bonds. We continue
to search for companies that can prosper in a number of economic scenarios
and are attractively priced relative to bonds.
The bond market has become increasingly treacherous
in recent weeks. Fears of higher inflation and higher interest rates
have lowered bond values dramatically. In an attempt to protect our
clients’ capital from bond market mayhem, we built bond portfolios
over the past few years that consist primarily of short term (six
month to four year duration) government paper, and inflation protected
longer term bonds. This strategy was designed to produce a return
well above money market fund rates while preserving capital from the
eroding effects of inflation and higher interest rates. We have achieved
that goal and are now poised to buy higher yielding bonds for our
clients should rates rise to the five percent area or above
