June 16, 2004

June 16, 2004

Interest rates

Interest rates and pronouncements by Fed officials are the primary thing most market participants are talking about these days. We know higher rates are on the horizon. How fast will the U.S. raise rates? This has big implications for the world economic picture.

Inflation in the U.S. will determine how fast rates rise. I believe inflation will be slightly above plan and be unsettling to the markets. Add this to the problems in Iraq and Saudi Arabia and investors have good reason to keep their list of short sales up to date.

Inflation is not good for stock or bond markets. As inflation rises, bond markets take a substantial hit. A rise in inflation by a few percent (say 2 or 3%) can send long-term bond prices down 20% or more with no difficulty. Thus, we are keeping all of our bond maturities short, and mostly denominated in British Pounds, where interest rates are much higher than in the U.S. Two-year British government bonds denominated in Pounds pay 4.5%, which is about 66% higher than the 2.7% that two-year U.S. government treasuries pay.

Equally dangerous is the fact that historically (as recently restated by Merrill Lynch’s chief economist), P/E ratios for common stocks shrink about two and a half multiple points during periods of rising inflation. Inflation may help corporate profits a little bit, but when one’s stocks P/E ratio falls from 17 to 14.5, the stock price falls by 15%. This is not fun, and for this reason we are very concerned about higher inflation.

Historically, the beneficiaries of inflation have been companies that produce commodities, especially oil and precious metals. In the current situation, the rise in inflation may be in great part due to the rise in the prices of energy. Thus, energy stocks will be an important way to invest in coming years.

My experience during the big rise in inflation in the 70’s was that energy stocks, precious metals stocks and small consumer growth companies that were able to capitalize on changes in market demand went up a lot, while big companies who were unable to adapt quickly did poorly.

It is easy to see that inflation in the 70’s changed the way the consumer reacted to costs. It created a bit of a hoarding and a “buy today, because prices will go up tomorrow” psychology. It is precisely this psychology that the Fed is working so hard to keep under control at this time. Hence, all the pronouncements about how inflation is under control, and the emphasis by bond market participants on the core CPI (which does not contain food and energy). Anyone who ignores the cost of food and energy is self-deluded.

The simple fact is that inflation is worse than people are admitting, and this makes it somewhat frightening. What happens when the public awakens to this reality and begins to adopt an inflationary psychology? Inflationary psychology creates substantial economic dislocations as people hoard and buy today. To avoid these dislocations the Fed is trying to talk about interest rate increases to keep inflation psychology to a minimum. Let us hope that they are successful in slowing down inflation and keeping the psychology under control.

Unfortunately, world economic demand, especially in India and China, is partially what is stoking the inflationary fires. Until world economic demand moderates it is doubtful that inflation will moderate. The other major cause of inflation is the extremely accommodative monetary policies that have been promulgated by the majority of industrialized countries for the last several years. I do not see these policies changing soon.


I recently received a couple of emails from friends about China and its impact on the U.S. I think both China and India are having a big impact on the world, and the world on them. Today, even India, which used to have the lowest correlation imaginable with the U.S. market, now has a high correlation with the U.S. economy and market.

China’s economic growth is tied to their banking system, which is their one big problem. It is also why we have not made real commitments to Chinese stocks for a number of months. While it may be very rational from a Chinese political point of view, the Chinese banking system is wildly irrational by western standards.

Banks that are far from Beijing are under the control of local politicians, not the politicians in Beijing. These banks are sources of patronage and income to the local politicians, who are understandably protective of their ability to give loans at ridiculously low rates of interest to ridiculously unqualified borrowers. The bank’s money is also often used to bail out past mistakes with new loans. Obviously, this is not a situation that the top political forces in Beijing think should continue, so there is a tug of war for power between the central planners and the local political “fixers”.

Eventually, the Beijing element will win. Beijing can after all, remove and even arrest the bankers and politicians. They can arrest the managements of the corrupt and inefficient companies that have been borrowing but not repaying.

It is not hard to imagine that it is very difficult for foreigners to make money competing in an economy where loans are made, not on rational criteria, but in order to collect bribes, stoke political favoritism, or to increase regional pride. For example, regional pride and corruption bring you the following. Too many steel mills are being built in China. The rational analysis of market demand and return on capital is not a big part of the Chinese investment process. For example, many plants are being built in areas with little access to iron ore, or coal and with expensive transportation options. With no access to ship transportation, the only transportation available to them is by railroad. All import of raw material and export of finished goods must be achieved by railroad. Railroads in China are over crowded and in short supply.

The logic for building the plant in spite of these obvious problems is that an industrial area will be built nearby. Maybe even a big industrial area, or perhaps even a city will be built. This creates a strong source of temporary demand. The key word is temporary.

Ten years from now, when the industrial area has been built and the local infrastructure has been completed, what will they do with the plant? Will you have earned enough return on it to tear it down and start over? It is very unlikely that the mill will be able to repay its loans, which may have many more years until maturity.

Because of failure to consider the longer term return on capital, they will have built a white elephant. In this case, it is a steel mill with low demand for its products and little likelihood of being converted to another use. Steel mills are difficult to convert into schools, hospitals, apartment buildings or even doorstops. [An attempt at a joke]

Another way of saying this is that the Chinese government will have to waste money bailing out the banks whose loan portfolios are stuffed with bad loans. Many banks will not be able to make a high enough return for a long enough period to repay the loans and the Chinese people will have to pay in the form of bank bailouts, or as in the above example, a bailout of the steel company.


India has other problems, but a wildly out of control banking system is not one of them. Their banking system is conservative and charges very high interest rates. Yes, it is true that the new government may require banks to make some non-productive loans for social purposes, but these should be a small percentage of total loans.

In our opinion, India, with its more rational lending policies, is a better place for western companies to do business than China. Yes, India is filled with corruption and red tape-loving bureaucrats who consider slowing down progress a mark of personal success. However, India is not a country where one can borrow money at low rates to open a new plant to compete with your plant a block away. In India, your competitors can’t borrow money for any economically stupid project at absurdly low rates of interest. Indian bankers are very cautious and thrifty about lending for new manufacturing facilities and you must run the gauntlet of the government bureaucrats to get a permit. This means you must plan and wait quite a while to start a new plant. The good news is that your competitors also have to wait. Thus, if you are the first to gain market share selling a product to the Indian masses you may have strong profits for a long time. Foreign companies know this. For example, several Japanese motorcycle and automobile manufacturers makers have been building a base in India for years.

This is a long-winded way of saying that the Indian market is a more attractive place to invest than China and that Indian banks may be a good place to invest at some time in the future. However, there is too much political uncertainty to make big commitments to India at the present time.


Currencies are closely tied to interest rates. After U.S. interest rates raise some, we expect the U.S. dollar to decline. We own, and will continue to buy, British Pounds, selling U.S. dollars to do it. In our opinion, with the U.S. running huge budget deficits for the foreseeable future, the dollar will have a very hard time rising over the long-term.


Interest rates are a risk to both the bond and stock markets. Currencies, especially the British Pound, appear to be a good way to hold cash balances.

Small companies that can grow fast and develop new market niches make attractive investment opportunities. We are still finding these kinds of attractive, low P/E growth companies in the U.S. and in certain markets abroad.

Oil and natural gas stocks continue to look attractive to us. We have held some energy companies for quite a while and we plan to hold them for the long run. It takes perspicacity or “stick-to-it-ive-ness” to continue to hold energy stocks when the media is constantly quoting experts saying that oil prices are going to fall to under than $30 per barrel. These experts, may I remind you, were the same ones saying that oil would be at $25 dollars by now. Today oil is over $38 per barrel. While we can see oil falling by a few dollars a barrel as the late summer approaches, we doubt that it will go to $25 anytime soon. Therefore we continue to hold our positions in energy.