September 29, 2003

September 29, 2003

There are many new developments taking place in the world of currencies, stock markets and metals as a result of the G-7 meeting which took place last weekend in Dubai, and other events, so we are writing this short note to keep you informed of our opinions.

The US economic situation and the situation of the developed world are moving inexorably toward inflation. Running huge long-term trade and budget deficits eventually leads to a lack of confidence in the countries that run them, developed economies like the US and most European nations included. While I do not see inflation as a problem in 2003 or 2004, we do expect the rate of inflation, and the direction of inflation, to be moving higher at an accelerating rate in the not too distant future. The main drivers of inflation will be higher commodity prices, especially energy and metals. Oil, metals and other commodities are rising because of rapid money supply growth and tax policies designed to foster growth in all major industrial economies.

The primary forces for deflation are lower manufacturing costs in the developed world and the transition of jobs to China, India and other areas from the developed countries. Given the amount of fiscal stimulus and accommodative monetary policy by the world’s central banks, deflation should be thwarted.

Our old acquaintances at OPEC are at it again. They can’t be called friends. The day after President Bush spoke at the UN defending US actions in Iraq, OPEC announced a production cutback of 900,000 barrels a day to reduce supply in response to expected oil flows from Iraq. Remember the oil weapon? Is it being unsheathed? We need only look at who the members of OPEC are to get that answer. The Saudis, other Middle Eastern countries, Indonesia, which has a strong anti-western minority, and Venezuela, which is under the direction of Hugo Chavez (who is making Fidel Castro look like a moderate, pro business head of state by comparison) are OPEC’s members. The reality is this; oil has been, is being, and will be, used to further the political and social goals of OPEC.

Russia is now the world’s largest oil producer, surpassing Saudi Arabia. Their recent side agreements with the Saudis regarding oil production were mentioned in our last letter. We are very nervous about these alliances and we believe that the two nations will jointly work to raise global oil prices.

The situation in the US is critical. The country imports a huge percentage of the world’s oil to maintain a high (and energy inefficient) standard of living. This oil problem is well known and was the precursor to the oil price rises of the 1970’s. At that time, natural gas and coal were plentiful in North America and shortages could be met using the large US coal reserves or by building pipelines to get to Canadian gas.

In the last few years all of this has changed. Coal has been reduced as an alternative to gas and heating oil due to public outcry over coal’s polluting effects, acid rain, etc. Natural gas production has been in decline. The stores and reserves appear to be dwindling and even the new seismic and drilling technologies have not been able to increase supply. Informed observers are stating that LNG (liquid natural gas) will be imported into the US in the next few years. One method to benefit from the LNG opportunity is to invest in the companies that supply the equipment and terminals to turn the gas into liquid for transportation, and then return it to a gaseous form. We think that it may be a little too early to get involved in these stocks. The fact remains that LNG will be imported as a possible deterrent to spending large amounts of money on risky new wells. The combination of a reticence to spend big to make new discoveries and increasing demand argue for higher natural gas prices for the next few years.

If we get unseasonable weather, prices could be much higher. Commercial interests have built up large short positions in gas expecting lower gas prices in coming months. It is our opinion that natural gas prices will move higher in the coming months. We continue to be strongly impressed with natural gas stocks and we own two outstanding US companies in this area, Ultra Petroleum and Chesapeake Energy.

The Euro, the Yen and other currencies are rising and the US dollar is falling again. This will probably continue until the Euro gets to about 130 cents US for each Euro. The US continues to earn global enmity for its foreign affairs approach. Read this week’s Economist to see why the WTO (World Trade Organization) talks in Cancun, Mexico collapsed. The WTO story is the cover story. While it is clear that other countries have done some stupid things, the US position on agricultural price supports has been far from helpful. We believe that the WTO is useful and that free trade is a far better alternative than the historical pattern of restrictions and subsidies.

The US Balance of Payments, Trade and Budget deficits are once again coming into focus and the world demand for dollars is ebbing. It seems that anything is more desirable than the US dollar, especially gold. All the major currencies have unattractive attributes, but they are still able to appreciate versus the dollar, and thus gold will continue to be accumulated by the informed and the intelligent. We own gold shares and for our limited partnerships we hold Euro forwards. We plan to add to these positions when prices pull back.

Precious Metals
We anticipate that gold will rise to about $425 US in the next several weeks. After that it would be normal for gold to move sideways or slightly lower for a few weeks. Silver should also gradually rise. There are many current and future factors fueling our optimism in precious metals. We will be enumerating them in more detail in our upcoming letters. Our largest precious metals positions are Newmont Mining, Tan Range Exploration and Hecla Mining.

The move into China by global investors continues unabated. There is no reason to expect the trend to change soon. The key in China is to stay with legitimate companies where the interests of the management are congruent with the interests of the shareholders. I avoid most A shares and H shares and stick to those Chinese shares listed in the US or that have American Depository Shares that trade in the US as it means there is increased regulatory oversight of their behavior. We recently sold some Chinese shares we owned like and for very nice profits. We plan to re enter them when they decline to our buy range. Our remaining positions in Chinese stocks and PetroChina still make China the largest single country commitment in our portfolios.

The free cash flow being generated by Japanese companies as a percentage of GDP is reaching all time highs. The corporate community in Japan is receiving some constructive help with national policy issues, the reform-minded Prime Minister Koizumi has been re-established as the spokesman of his party for the next 3 years. Never has a reformer had such strong popular support, with 65% of the public approving of him. Even his party, which has been responsible for many of Japan’s problems, enjoys over 50% popularity on Koizumi’s coattails.

From a long-term perspective, Japan is now cheap. We are wary that the stronger Yen could eventually hurt the Japanese economy, but we can rest assured that there will be considerable intervention from the Japanese authorities to stop the Yen from rising too quickly. The fact that 52% of Japanese exports are to China and other non-Japan Asian countries helps the yen as it demonstrates that Japan has become a key supplier to the Asian/Chinese outsourcing boom.

We have recently taken profits in the Japanese IShares Index Funds on the Japanese market, and still own the Japan OTC Equity Fund and shares of Sumitomo Mitsui Financial Group, a large banking company.

Other Markets
We continue to be favorably impressed with events in Taiwan and India although we are concerned about developments in Korea. We hold positions in the first two countries and have sold our position in Korea. The Taiwanese and Indian economies continue to benefit from the trend by US and European companies to outsource the manufacturing of technology products and software to lower cost Asian suppliers.

US Stocks
We see the current correction as normal. It is being driven by profit taking, and by the issuance of a lot of secondary offerings and new issues by companies who have not been able to raise equity capital for years. The issuance of lots of stock eats up available capital and takes some of the wind out of the market’s sails.

We have done research on a number of technology and medical companies and will be looking to purchase them on weakness. We do not plan to disclose their names until we have purchased them however.

We look forward to hearing from you and discussing any issues or points you that you find interesting.