May 22, 2003

May 22, 2003

The famous baseball pitcher, Satchel Paige is renowned for the quote, “Don’t look back – something may be gaining on you.” Our comments today are focused on this theme. We believe that something is gaining on us. What is it? The answer is deflation. However, contrary to Mr. Paige’s advice, we are looking back, as well as forward, to learn from history, and to clearly analyze coming events so that we may make a plan to profitably deal with any economic eventuality.

The subject of deflation can be somewhat pessimistic, so let us first discuss some good news. So far we are doing well in 2003. Our Euro and Canadian dollar bonds have been rising versus the U.S. dollar. Our foreign stocks, especially foreign cell phone service providers and Internet service providers, have also been rising fast. Gold is rising although rising costs are keeping gold mining shares from realizing the same degree of appreciation as the metal itself. The domestic stocks we bought are also rising as the U.S. experiences an uptick in economic activity after the Iraqi war.

The second element of good news is that we believe we are better prepared for the possibility of a deflation than are many other investors. We have experience in varied economic environments and the tools to deal with and profit from a deflationary cycle. We do not welcome deflation, but we are aware of the unique risks and opportunities it creates.

Potential for Deflation: A Problem for the U.S. and the World

In recent letters I have been saying that in the U.S., there was a risk of deflation similar to that currently being experienced by Japan and Germany, but that deflation was only a possibility. I put the odds at 1 in 4 that we would have deflation here. Recent economic news has changed my mind and increased my pessimism. Of course there is no guarantee that we will have deflation, but it is a concern of ours.

We are not alone in this concern. Recently, Federal Reserve Bank of Dallas President Robert McTeer said to Dow Jones News that the economy needs to grow “well over 4%” for some time to bring down unemployment and reduce any threat of deflation. In the first quarter the U.S. economy grew at 1.6%. Very few economists believe the economy can grow at 4% for a prolonged period with the large debt and tax burdens we face. McTeer went on to say; “there is maybe one chance in four of deflation”.

Mr. McTeer is a senior Federal Reserve official and, as such, must be cautious and circumspect in his pronouncements. If he says one chance in four, it is possible that he believes it is more likely to be one chance in three, or even one chance in two.

Our further concern was piqued when we heard Fed Chairman Alan Greenspan speaking before Congress yesterday saying, ” We have reached a point at which … the probability of an unwelcome substantial fall in inflation over the next few quarters, though minor, exceeds that of a pickup in inflation.”

At GIM we see the possibility of deflation as one chance in two. I consider it a toss up whether we will successfully inflate or see deflation here in the U.S. As we have written in several previous letters, both Japan and Germany are currently in a deflationary environment.

Deflation is not salutary for the economy, for the future of our economic system or for the standard of living of the world. It may lead to far more severe economic, political and social consequences than have yet occurred in Japan or Germany.

Causes of Deflation

Rather than list the many different causes of deflation, we will focus on three important causes:

Firstly, the weak and irresponsible banking systems in parts of the developed world, especially Japan and Germany, are a problem. Unwillingness to write off bad debt and liquefy the markets allows overpriced assets (buildings and factories) to stay on the books at absurd valuations creates weaker banks and excess industrial and commercial capacity.

Secondly, bad political management (for fear of political consequences) allows these bad banking practices to continue and expand unchecked.

Thirdly, the rise of lower cost producers who destroy profitability in existing businesses can cause deflationary pressures. China has grown into the low cost producer of manufactured goods and India is becoming the world’s low cost producer of software. This marginalizes and eventually can destroy the emerging economies that had been growing by manufacturing, distributing and assembling for the developed countries. This is bad news for Mexico, Korea, Thailand and several Eastern European countries.

The Chinese have the will and ambition, and are developing the infrastructure, to become the worlds’ dominant manufacturer. Taiwan, Japan, and the U.S. will provide the technology. The companies doing the outsourcing will provide the capital.

Will Deflation Lead to Depression? What Can Be Done to Thwart Deflation?

Deflation can lead to depression, but not always. Deflation could lead to depression if the U.S., through monetary and fiscal policy, does not act quickly. The U.S. will need support from the other major economic blocks, especially Europe and Japan in this program. The developed economies must jointly increase monetary aggregates and do so rapidly, decisively, and with an eye to creating inflationary consequences. This has actually been going on for some time now, and thus far, has been less than effectual.

War is expensive. It creates uncertainty and a “save and wait for clarity” psychology in consumers and investors. We believe the war in Iraq has added to our economic difficulties. It was expensive and draining, and will create continuing expenses. I also question whether we will ever control Iraq’s oil supply.

Interest rates must be reduced further. This will lead to falling value for the U.S. dollar. Fiscal policy must also be coordinated to cut income taxes and incentivize investment through mechanisms that will act to encourage entrepreneurial risk taking, the commercialization of new technologies, and the formation of new companies. These policies have been begun in a modest way and have been somewhat successful, but thus far, not successful enough.

The Federal Reserve has lowered short-term interest rates in an appropriate manner. More must be done. The Fed needs to do more at the long end of the yield curve. Long-term interest rates must also come down so that banks are forced to lend rather than buy bonds for their portfolios. If the Fed buys long-term bonds and drives down the rates investors earn on their long-term bonds, those investors will invest in more capital producing, entrepreneurial endeavors including common stocks. This will also make it easier at a later date for the Treasury to sell long-term bonds to fund the deficit.

The President has requested a tax cut. This is a good idea, but the tax cut which has been approved is not properly structured. This is partly due to Congress’ political and pork barrel changes, and partly due to the President’s desire to curry favor with middle class voters. We believe the tax cut should be more focused on investment and incentivize risk-taking and the development of new technologies.

What Will GIM Do To Deal with a Potential Deflation?

At GIM, we are closely monitoring economic developments to alert ourselves to the onset of continuing deflationary pressures. We are exploring many possible opportunities to take advantage of in case deflation takes hold. For example:

Add to bond positions in safe, high quality issues such as U.S. Government Treasuries.
Expand our commitment to short the U.S. dollar, long Euros and Canadian dollars, albeit only for a while. The new U.S. Treasury Secretary, Snow, has let the dollar fall in value in order to sell the large quantity of U.S. bonds which must be sold. Why lower the dollar to sell bonds? Once the dollar falls another 10 -12% the U.S. authorities can say, “The dollar is undervalued; if you buy our bonds, you will make money both on the interest income and on the long-term dollar appreciation.” Snow has couched his dollar-lowering strategy in the traditional double-speak. Out one side of his mouth he says, “We have a strong dollar policy.” Out of the other he says, “Intervention (to support currencies) doesn’t work”, and, “A lower dollar will eventually help U.S. exports”. Most recently, he has abandoned any pretense of supporting a strong dollar, and his double-talk has become comical.
Later, sell short the currencies of countries hurt by China’s pressure on industry such as Korea, Thailand, Mexico, and Eastern Europe.
Buy more gold. Gold will benefit from deflation. As deflation gradually establishes itself, gold will move higher in dollar terms. In phase one, gold will rise as the dollar falls. Investors will hedge their dollar exposure in gold bullion. In phase two, gold will rise as people buy it for its’ store of value versus depreciating real assets such as real estate and commodities. Phase three (if this develops, and there is no guarantee that it will): as deflation leads to depression, gold will fall in absolute terms but rise in value versus real estate, other levered assets, company shares and some commodities.
Short real estate equities. Deflation equals lower rents. Lower rents lead to lowered revenues, with expenses falling more slowly than revenues.
Short offshore manufacturers other than China.
Short banks and brokerages. Over-leverage and the extensive employment of derivatives (and the counter party risks that come with them) will be tough to deal with.
Short heavily levered and capital consuming companies in all industries.
Buy companies that benefit from deflation, such as gold producers and Chinese manufacturers.

As you can see, there are opportunities available, even in the event of something as unpleasant as deflation.

I’m sorry that this is not a more upbeat letter, but by continued monitoring of the situation and a plan to implement should deflation take hold and should that deflation begin to depress economic activity, we will be able to preserve and grow capital.

Please feel free to call us with your suggestions, criticisms and questions.