Competition for Resources – April 2004

April 23, 2004
Dow Jones Average: 10,461
S&P 500: 1,140


Competition for Resources


Over the past four years economic growth has been extremely slow in North America, Europe, and Japan. In emerging markets the story has been quite different, with economic booms taking place in China, India, and other Asian countries. The United States still has the world’s largest economy, supported by one of the most stable banking systems. But the more populous regions of the world are growing at a much faster pace. Just as California grew from a small base to become the most dominant state in the U.S., the center of global economic activity is gradually shifting to Central and East Asia where sixty percent of the world’s population lives.

The level of resource consumption has been dramatically altered by the economic boom in Asia. Afew years ago China was a net exporter of petroleum. The Chinese now import six million barrels of crude oil per day which is more than the Japanese import. Demand from China is the primary reason that oil prices have remained near record levels for more than a year. Other commodities such as copper, nickel, aluminum, and lumber have been similarly affected by Asian demand. Although economic statistics from China are often incomplete and unreliable, reports that are available indicate that in rough terms China is now consuming one half of all cement produced in the world, and one third of worldwide steel production. Dealers in scrap metal are rejoicing as their rusty, old piles of scrap have tripled in value thanks to Chinese demand. Some countries are limiting the amount of scrap metal exported because they fear that there will not be enough left to satisfy domestic needs.

The boom in emerging market economies holds both promise and problems for companies and employees in mature economies. Business opportunities abound as incomes rise in populous countries such as China and India. Many U.S. companies that we track are reporting strong sales to Asia, while business in more mature markets remains weak. Exports to foreign markets certainly leads to employment for some U.S. workers even as others see their jobs outsourced. An increase in global business activity would appear to be a good thing for most corporations, but if it is accompanied by increased competition for natural resources and capital many companies could be squeezed.

Current Strategy

In recent Congressional testimony Federal Reserve Chairman Alan Greenspan said he was no longer worried about deflation. The concerns he voiced a year ago about deflation never seemed plausible to us in light of the rising costs for health care, education, housing, and energy at that time. Now even more goods and services are rising in price. Many economists feel that Greenspan is behind the curve and should be expressing concern about the possibility of an increase in inflation. Chairman Greenspan may not be saying all that he believes. His comment that deflation was no longer a concern, an obvious statement considering that inflation ran at a five percent annual rate in the first quarter of 2004, sent the bond market reeling and interest
rates higher. He is trying to prepare investors for higher interest rates in a gentle way and avoid the panic that would ensue if investors thought he was truly worried about inflation.

Inflation and higher interest rates usually spell trouble for stock market investors. History has shown that when commodity prices and inflation heat up stock values cool off. Commodities reached an all-time inflation adjusted low in 1999 just as stocks were hitting their bubble highs. Since that time the commodity index has been trending higher while the broadly based stock indices have fallen noticeably. Companies often make more money during inflationary times, but investors are not willing to pay as much for those earnings. Inflation brings about higher interest rates and the higher yielding bonds compete with stocks for investor dollars. Some companies earn enough to clear the hurdle presented by higher interest rates, while others fall short of the growth needed to compete with higher yielding bonds. We continue to search for companies that can prosper in a number of economic scenarios and are attractively priced relative to bonds.

The bond market has become increasingly treacherous in recent weeks. Fears of higher inflation and higher interest rates have lowered bond values dramatically. In an attempt to protect our clients’ capital from bond market mayhem, we built bond portfolios over the past few years that consist primarily of short term (six month to four year duration) government paper, and inflation protected longer term bonds. This strategy was designed to produce a return well above money market fund rates while preserving capital from the eroding effects of inflation and higher interest rates. We have achieved that goal and are now poised to buy higher yielding bonds for our clients should rates rise to the five percent area or above.

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