Market Overview: In the fourth quarter of 2012, the MSCI World Index increased +2.49% while in the U.S. the S&P 500 decreased -0.38%. In Europe, the German DAX increased +5.49% and the French CAC 40 index increased +8.53% during the quarter. The Nikkei 225 index increased +17.19% during the period. Crude oil decreased -0.40% to $91.82 a barrel, and the price of gold decreased -5.66% to $1,673.16 an ounce at quarter-end. The U.S. dollar rose +11.30% against the yen and it weakened -2.53% against the euro. On the first trading day of 2013, U.S. markets rallied in response to the last-minute deal that prevented the country from going over the fiscal cliff. However, this settlement was a low-quality compromise that could exacerbate one of the core structural problems in the U.S.—the U.S. savings shortfall. We feel this shortfall has both domestic and global consequences since the dollar is the world's reserve currency.
To date, current U.S. policy makers have been almost exclusively focused on targeting inflation and smoothing local economic activity. This has led to very accommodative fiscal and monetary policies. These accommodative policies are, in essence, trying to stimulate consumption and investment at a time when we already have a shortage of relative savings. When central bankers try to produce more investment through easy monetary and fiscal policy, the current account deficit widens and that savings shortfall manifests itself somewhere in the economy.
Historically, as we saw during the technology and real estate bubbles, the savings shortfall typically surfaces in the private sector. However, in the current environment, it is the private sector that is deleveraging and repairing its balance sheet. As a result, the shortfall has grown in the government sector. The Federal Reserve is adopting unconventional asset purchases in an attempt to grow the nominal economy and money supply faster than the size of the deficit as a percentage of GDP. Such actions could exacerbate the structural current account deficit and related fiscal deficits.
Additionally, a boom in investment that is not fueled by domestic savings can lead to a buildup of capacity that isn't supported by a corresponding long-term demand. If the U.S. government had not eased fiscal policy, demand would have fallen much more dramatically after the credit crisis. The fact that the government kept spending meant that corporate margins stayed at reasonable levels. This created the illusion of a healthy economy, but there is no free lunch and the U.S. government's balance sheet is deteriorating.
China has been viewed as a stronger economy at a time when the U.S. is faltering under debt. In reality the two countries' economic situations are two sides of the same coin.
Similar to the U.S., China has built capacity to meet demand for goods and services that would not have existed if the exchange rate was not kept artificially low. The manufacturing infrastructure in China has come under pressure as the real effective exchange rate normalizes. An exchange rate can normalize in one of two ways: by rates moving towards fair value or because the cost of labor changes at a rate different from other countries.
In the case of China, with their exchange rate pegged to the U.S. Dollar with only a modest managed appreciation over the past few years, the potential for normalization would appear to come from wage inflation. China built extensive amounts of manufacturing capacity to support demand from the U.S., but those factories are becoming less profitable as workers push for higher salaries. At the same time, the U.S. is benefitting from more moderate wage trends and the bounty of shale oil and gas. China's wage inflation should logically be the means to bring the effective exchange rate back in balance. However, just as the U.S. has been fighting deflation through fiscal and monetary stimulus, China has been fighting inflationary pressures. Instead of letting money seep back into the economy, they've been accumulating vast amounts of reserves. This huge pool of reserves would seem like a windfall benefit for China. But it is not as beneficial as one would think, since China holds these reserves in U.S. Dollars that are of declining real value and creditworthiness.
The policy backdrop in both the United States and China has prolonged a return to savings and investment equilibrium. With the Federal Reserve committed to printing money and the Chinese government determined to accumulate reserves, it's hard to earn a real, rather than a nominal, return on investments.
Other issues that concern us include the potential for volatility in energy prices, which could loom larger than monetary policy going forward. Demographics are also a long term worry. An aging population is aggravating the fiscal challenge in the U.S. that has arisen as one result of monetary imbalances.
These domestic and geopolitical fault lines cause us to believe that, despite market confidence, there are underlying issues that may lead to choppy moments ahead.
Portfolio Review
We have often described our cash position as a residual of our disciplined investment approach. We have also described it as offering deferred purchasing power and providing the option to capitalize during periods of market volatility. In this discussion of cash as deferred purchasing power, it is critical to look at not just the return of cash today, but the return you could earn on a well-timed investment in a good quality business purchased during market distress.
You can hold an investment for a decade at a market return, or you can hold cash for three or four years and then buy a depressed equity which may then appreciate more than the market over the long term. It's our belief that, provided you're disciplined, cash has a very material option value. It's an option on deployment in distress. A willingness to hold cash and be patient also helps reinforce our absolute underwriting standards.
The top contributors to performance over the quarter were Fanuc Corp. (FANUY, Financial) (+0.20%), HeidelbergCement AG (HBGRF, Financial) (+0.19%), Mitsubishi Estate Co. Ltd. (MITEY, Financial) (+0.19%), Bouygues S.A. (BOUYF, Financial) (+0.16%) and Berkeley Group Holdings PLC (BKGFY, Financial) (+0.16%).
Newcrest Mining Ltd. (NM, Financial) (-0.30%), gold bullion (-0.29%), Shimano Inc. (-0.16%), Microsoft Corp. (MSFT, Financial) (-0.15%) and Ono Pharmaceutical Co. Ltd (OPHLY, Financial) (-0.15%) were the largest detractors from performance over the quarter. We do not take a directional view on gold and we recognize that its price will fluctuate based on the strength of the human made financial architecture—but we believe that gold continues to be a real monetary alternative and as such provides us with a potential hedge against extreme outcomes. We appreciate your confidence and thank you for your support.
To date, current U.S. policy makers have been almost exclusively focused on targeting inflation and smoothing local economic activity. This has led to very accommodative fiscal and monetary policies. These accommodative policies are, in essence, trying to stimulate consumption and investment at a time when we already have a shortage of relative savings. When central bankers try to produce more investment through easy monetary and fiscal policy, the current account deficit widens and that savings shortfall manifests itself somewhere in the economy.
Historically, as we saw during the technology and real estate bubbles, the savings shortfall typically surfaces in the private sector. However, in the current environment, it is the private sector that is deleveraging and repairing its balance sheet. As a result, the shortfall has grown in the government sector. The Federal Reserve is adopting unconventional asset purchases in an attempt to grow the nominal economy and money supply faster than the size of the deficit as a percentage of GDP. Such actions could exacerbate the structural current account deficit and related fiscal deficits.
Additionally, a boom in investment that is not fueled by domestic savings can lead to a buildup of capacity that isn't supported by a corresponding long-term demand. If the U.S. government had not eased fiscal policy, demand would have fallen much more dramatically after the credit crisis. The fact that the government kept spending meant that corporate margins stayed at reasonable levels. This created the illusion of a healthy economy, but there is no free lunch and the U.S. government's balance sheet is deteriorating.
China has been viewed as a stronger economy at a time when the U.S. is faltering under debt. In reality the two countries' economic situations are two sides of the same coin.
Similar to the U.S., China has built capacity to meet demand for goods and services that would not have existed if the exchange rate was not kept artificially low. The manufacturing infrastructure in China has come under pressure as the real effective exchange rate normalizes. An exchange rate can normalize in one of two ways: by rates moving towards fair value or because the cost of labor changes at a rate different from other countries.
In the case of China, with their exchange rate pegged to the U.S. Dollar with only a modest managed appreciation over the past few years, the potential for normalization would appear to come from wage inflation. China built extensive amounts of manufacturing capacity to support demand from the U.S., but those factories are becoming less profitable as workers push for higher salaries. At the same time, the U.S. is benefitting from more moderate wage trends and the bounty of shale oil and gas. China's wage inflation should logically be the means to bring the effective exchange rate back in balance. However, just as the U.S. has been fighting deflation through fiscal and monetary stimulus, China has been fighting inflationary pressures. Instead of letting money seep back into the economy, they've been accumulating vast amounts of reserves. This huge pool of reserves would seem like a windfall benefit for China. But it is not as beneficial as one would think, since China holds these reserves in U.S. Dollars that are of declining real value and creditworthiness.
The policy backdrop in both the United States and China has prolonged a return to savings and investment equilibrium. With the Federal Reserve committed to printing money and the Chinese government determined to accumulate reserves, it's hard to earn a real, rather than a nominal, return on investments.
Other issues that concern us include the potential for volatility in energy prices, which could loom larger than monetary policy going forward. Demographics are also a long term worry. An aging population is aggravating the fiscal challenge in the U.S. that has arisen as one result of monetary imbalances.
These domestic and geopolitical fault lines cause us to believe that, despite market confidence, there are underlying issues that may lead to choppy moments ahead.
Portfolio Review
We have often described our cash position as a residual of our disciplined investment approach. We have also described it as offering deferred purchasing power and providing the option to capitalize during periods of market volatility. In this discussion of cash as deferred purchasing power, it is critical to look at not just the return of cash today, but the return you could earn on a well-timed investment in a good quality business purchased during market distress.
You can hold an investment for a decade at a market return, or you can hold cash for three or four years and then buy a depressed equity which may then appreciate more than the market over the long term. It's our belief that, provided you're disciplined, cash has a very material option value. It's an option on deployment in distress. A willingness to hold cash and be patient also helps reinforce our absolute underwriting standards.
The top contributors to performance over the quarter were Fanuc Corp. (FANUY, Financial) (+0.20%), HeidelbergCement AG (HBGRF, Financial) (+0.19%), Mitsubishi Estate Co. Ltd. (MITEY, Financial) (+0.19%), Bouygues S.A. (BOUYF, Financial) (+0.16%) and Berkeley Group Holdings PLC (BKGFY, Financial) (+0.16%).
Newcrest Mining Ltd. (NM, Financial) (-0.30%), gold bullion (-0.29%), Shimano Inc. (-0.16%), Microsoft Corp. (MSFT, Financial) (-0.15%) and Ono Pharmaceutical Co. Ltd (OPHLY, Financial) (-0.15%) were the largest detractors from performance over the quarter. We do not take a directional view on gold and we recognize that its price will fluctuate based on the strength of the human made financial architecture—but we believe that gold continues to be a real monetary alternative and as such provides us with a potential hedge against extreme outcomes. We appreciate your confidence and thank you for your support.
