June 2012

……………..Thoughts and Comments

Market and Economic Updates

Well, another quarter of extreme volatility has come and gone, this time to the downside instead of the upside.  Nine of the ten sectors (excluding utilities) were down for the quarter with the energy, information technology and precious metals sectors leading the pack.

Economies around the world are showing signs of slowing:

1)    Industrial production and exports have slowed throughout the world.

2)    Manufacturing activity in the Eurozone continued its decline in June, with even the region’s biggest economy, Germany, contracting at its fastest pace in three years.

3)    Manufacturing and exports slowed in China, which just reported its lowest growth of GDP since 2009 (up 7.6%).

4)    South Korean and Taiwanese manufacturing industries contracted.

5)    Taiwan, the center of the technology production, just reported exports to Europe, China and the US down by 12%, 3% and 14% respectively.

6)    A number of high tech companies, the most recent being Red Hat, have warned that they are seeing a slow down in demand and headwinds from a stronger dollar.

Shipping, which is an excellent gauge of exports, is going through a serious contraction, with Europe’s 3rd largest ship financer getting out of the business. Two of the other major players, Lloyds and Soc Gen, have both already quit the business. According the the China State Shipping Corporation, 50% of the ship builders in China could be bankrupt in the next 2-3 years.

Don’t Worry – the Government Will Fix it!

So what have been governments’ responses to the slowing economies?  To do the same thing they have been doing and hoping that this time it works.  Einstein had a word for this: “insanity.”

The Fed’s response to weakening economic indicators was to announce the extension of their Operation Twist. The problem is that Operation Twist didn’t work and won’t work this time either.  According to Bloomberg, more Treasury bond holders are holding the debt instead of selling it – a sign that they think the economy will weaken.  This means the Fed will buy securities at even more expensive prices and won’t accomplish anything economically other than to reduce the value of the U.S. dollar.

I would really love someone at the Fed explain to me how they are going to sell all of these long maturities later, when the economy is stronger, without a huge loss.  If the economy is stronger, interest rates will rise, which means that they will sell their bonds for losses unless they intend to hold them until maturity, which means that they have permanently expanded their holdings, which means they have decided to permanently expand the money supply.

At the same time that the Fed is printing funny money, Congress is coming up with ways to spend it all.  In order to do this, they are raising taxes. We have all heard and/or read about the fact that the Bush tax cuts expire at the end of 2012.  But what no one seems to be talking about is that the new healthcare laws, now with the approval stamp from the Supreme Court, will raise the tax on unearned income (dividends and interest on savings) by 3.8%.  In addition, the Medicare payroll tax for those earning above $200,000 ($250,000 for a family) goes up.

Starting in 2013 and then in 2014, a number of new taxes or fees impact businesses outside the healthcare industry as well. The bottom line is that costs will rise, which is likely to lead to price increases, which will keep pressure on consumer spending and which will leave businesses with less incentive to hire.

Also in the next two years, states will find that their costs on an expanded Medicare System have skyrocketed as the federal government changes from paying 100% of the expanded coverage to 20% (the states will be responsible for paying for the rest).

Our “leaders” are intent on turning us all into government-dependent slaves.

But don’t worry, because the Europeans are even further along and have their heads stuck into the ground at least as deeply as the American policy makers. In fact France’s President Hollande has promised to move things in reverse by reducing the retirement age back to 60 from 62 and making it economically unfeasible for companies to lay off workers.

Europe is Finally Addressing Their Economic Problems – and Other Fables

While you were sleeping, the governments of European Union members have been hashing out ways to provide funding to help the banks and reduce the stress on the various governments’ debts.  They are so close, if they can just agree on a few final points.  Well, that is what the newspapers keep telling us.

The problem is that Europe has not changed its stripes. European culture is much less focused on making lots of money like us nasty Americans, and more focused on relaxation.  What they haven’t figured out is how to have everyone relaxing all the time and yet make sure everyone has enough money to live on.  As Margaret Thatcher once said: “the problem with Socialism is that eventually you run out of other people’s money.”  The proof of this is in a European Union Court of Justice ruling a few weeks ago on an eight-year-old lawsuit based in Spain.

The following is from the Court of Justice of the European Union press release on the ruling.

“The Court points out that, according to settled case-law3, entitlement to paid annual leave must be regarded as a particularly important principle of EU social law, a principle expressly enshrined in the EU Charter of Fundamental Rights. The right to paid annual leave cannot be interpreted restrictively.

The Court also points out that the purpose of entitlement to paid annual leave is to enable the worker to rest and enjoy a period of relaxation and leisure. The purpose of entitlement to sick leave is different, since it enables a worker to recover from an illness that has caused him to be unfit for work.

Bearing in mind the purpose of paid annual leave, the Court has already held that a worker who is unfit for work before the commencement of a period of paid annual leave is entitled to take that leave at another time which does not coincide with the period of sick leave4.

In its judgment today, the Court states that the point at which the temporary incapacity arose is irrelevant. Consequently, a worker is entitled to take paid annual leave which coincides with a period of sick leave at a later point in time, irrespective of the point at which the incapacity for work arose. It would be arbitrary and contrary to the purpose of entitlement to paid annual leave to grant workers the right to paid leave only if they are already unfit for work when the period of paid annual leave commences.

In that context, the Court points out that the new period of annual leave (corresponding to the duration of the overlap between the period of leave initially scheduled and the period of sick leave to which the worker is entitled after he has recovered) may be scheduled, if necessary, outside the corresponding reference period for annual leave.”

Apparently Europe is trying to remove all risk of living from the living; a cool trick if you can continue to print money long enough.

Apparently Europe is trying to remove all risk of living from the living; a cool trick if you can continue to print money long enough.  The problem with this solution is noted succinctly by Michael Pettis in his latest blog.

“(W)hat the market needs is not for investors to start trusting policymakers more.  Rather it needs actions that reverse the downward spiral in which countries like Spain find themselves, in which each sector of the economy – from workers to creditors to businessmen to middle class savers to policymakers themselves – are rationally and in self-defense acting in ways that increase the country’s debt, reduce growth, and exacerbate balance sheet fragility.

Unfortunately there isn’t much that can be done in a big enough or credible enough way to reverse the downward spiral, and this is why I don’t pay too much attention any more to the proposals and counterproposals that are on offer in Europe.  I think it is probably too late for that, but certainly by continuing to behave as if this is all about trust, or lack of trust (or, for the more conspiratorially minded, about underhanded actions by speculators hoping to bring the system down), policymakers are building in their own disappointment and extending the crisis.

At this point the only thing that can save the euro is a combination of moves in which the European banks are guaranteed by a credible institution and in which Germany takes steps to stimulate its economy quickly and dramatically.  Until Germany is willing to boost domestic spending enough to run a deficit that allows Spain to run a surplus, it is impossible for Spain to repay its debt. This is just basic balance-of-payments arithmetic.”

For those of you who do not know of him, Michael is a respected economist and analyst who has been living in China for some time.  I read his blog religiously and encourage those with an interest in understanding Chinese and world economies to read it as well (MPettis.com).

What To Do?

We have continued to reduce stock holdings and focus more on those which we believe have the ability to weather the economic storm and actually even have positive surprises.  At the same time, we have increased our fixed income position.  While yields are low, interest rates are not rising any time soon and they will protect better than stocks in a recession.

We have sold GE and DuPont, as we think that earnings are going to be under pressure due to a rising dollar and weakening economies.

We have continued to add to the fixed income side of the portfolio, which should provide some protection from these issues.  We have an average duration that is less than two years but have mixed the holding between very short (3 month) and a smattering of intermediate (7 year) corporates.  The spread between corporates and government securities is much too high and as we see no chance of the Fed raising rates any time soon these spreads should tighten (see Chart 1).

Chart 1: 5yr Treasury and 5yr Corporate Note Spreads

Special Thanks to Bill Archibald and Fidelity Capital Markets for providing the data for Chart 1.


We still hold gold, as the world is creating inflation through all of the money printing, and while gold stocks had a terrible second quarter, gold companies made plenty of money.  These stocks are undervalued but it may take a while before the markets recognize their value.

Defensive postures make the most sense at least until the election in the U.S. in November.  After that we will see just how bad next year will be.  In the meantime, discretion is the better part of valor.

Next month we will discuss specific positions and start reviewing their earnings.

Alan E. Rosenfield                                                                                                                     Managing Director


July 2012



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