This is a quarterly update of economic conditions and investment strategy.
Third quarter, 2007 GDP increased at an annual rate of 4.9%, up from a 3.8% rate in the prior quarter. These results were aided by robust exports and continued consumer spending. The third quarter data have limited predictive utility because they do not fully reflect the housing and credit market difficulties.
Erosion in balance sheets of financial institutions continues as the sub-prime debacle works through the financial system. The sequence of events has been: recognition of poor risk management and losses; employment cuts including changes in leadership; and efforts to restore balance sheets through capital raising and dividend cuts. In a notable reversal of fortunes, financial institutions in the U.S. and Western Europe are securing investment capital from China, Singapore, and the Middle East. At this point, it is not clear how much deeper and wider the problems extend. We believe that at least two more quarters are needed for full disclosure.
Fourth quarter GDP is likely to show the impact of seven consecutive quarters of housing weakness. Despite last quarter’s additional half-point Fed interest rate reduction, along with targeted actions to restore lending activity, a general U.S slowdown, if not contraction, is underway. While policy actions may mitigate the impact, housing prices need to fall further before the residential market can clear and trade normally. Also, credit availability at reasonable rates is crucial to the resumption of healthy economic growth. Next to gauge are U.S. employment data and credit card delinquencies. We will report on these in the quarters ahead.
Central bankers in the U.S. and Europe, while cutting interest rates and offering additional measures to assist banks, also caution about inflation risks. With gold prices up 30% and grain prices up 36% in 2007, oil near $100 per barrel, and recent CPI increasing at a 4.3% annual rate, inflation is in the picture. As noted below, portfolio adjustments have been and will be made to accommodate inflationary expectations.
Our goal is to provide clients with favorable absolute returns over full market cycles, usually defined as rolling three to five year periods. In doing so, we typically own a mix of stocks, bonds, “hard” assets (such as precious and base metals and real estate), and other assets or asset classes that provide favorable risk/reward characteristics.
For 2007, our returns exceeded comparison benchmarks by a significant margin; for the sixth consecutive year, we were well ahead of the S&P 500. Positives included continued focus on energy, water, and other natural resources; exposure to gold; a new emphasis on companies profiting from robust grain prices; and owning securities that benefited from the falling U.S. dollar. We were further assisted by lightened exposure to real estate and other financials, avoidance of companies heavily exposed to the sub-prime fiasco, and the absence of mortgage and other asset-backed securities in our bond portfolios.
Portfolios profited substantially from the dollar’s weakness. For example, a number of our Canadian holdings were purchased when the Canadian dollar was approximately 70 cents U.S. and European securities at about $1.10 to the Euro. With the Canadian dollar having appreciated one-third over the past three years, we doubt the dollar has another 33% to fall, with a similar prognosis for the Euro and the British Pound. Asian currencies are a different story. Currency considerations are generally less important than company investment merits but must be fully considered at times of extreme over evaluation (Euro, Pound) and under valuation (some Asian currencies.)
We continue to believe that while $100 oil is grabbing the headlines, water is the more challenging issue for global economies. Sustained droughts in Australia have impacted wheat crops, wine production, and residential water allocations. The Western U.S. is again experiencing fierce water allocation issues. China, too, has challenging water problems. The U.N. projects that food production will need to increase 67% by the year 2030 in order to meet increased demand from population trends and dietary changes. Agriculture is the largest user of fresh water supplies. In the developing world, providing basic water infrastructure and sanitation will require, by some estimates, over $100 billion of capital spending. Also, energy, including nuclear power, is a tremendous user of water. Our investment focus has been on companies, in the U.S. and overseas, that provide expertise in water systems design, construction, and ongoing management. We are also very interested in seed companies working on water efficient crop production.
Because of its importance, we cannot omit energy from our year-end report. Energy prices will decline for a short period if we experience a world-wide slow down, but we believe that we are in the early phase of a 10-20 year period of accelerating oil price increases. We believe this is likely even if full throttle is given to alternative energies and to programs that curtail energy use. Moreover, we expect that new technologies will only accelerate oil reservoir recoveries, not materially increase the amount of oil retrieved. Consequently, we overweight energy securities in politically safe areas.
Finally, investment candidates overall, and bond portfolios more specifically, are increasingly evaluated for returns in a more inflationary climate. Bond portfolios remain of short duration, and, for taxdeferred accounts, bonds indexed to inflation are attractive. Stocks are judged, in part, on companies’ ability to pass through higher costs and on the risk to their profits from inflationary pressures.
We invite questions and comments, and we appreciate your ongoing confidence.
With best wishes for the New Year,
Phil Tucker, Bill Lauer, Eric Kraus, Tom Frank, Ed Dobranetski, Sneha Mansukhani, John Edwards, Terry McCubbin, Kathleen McGill