|As of February 27, 2008|
|Index||YTD % Change||Market Value|
|Dow Jones Industrials||-3.77%||12,694.28|
As reflected in the S&P 500 earnings, the corporate beneficiaries of global growth have been doing well, and we do not anticipate this will change any time soon. Our analysis of last quarter’s earnings has reinforced our view that the global emerging economies and their infrastructure needs will remain the major drivers of economic growth. We expect this global growth to be in the range of $1.5 trillion. Very specific sectors of the S&P 500 are prime beneficiaries of this growth and according to our research are demonstrably undervalued based on earnings, cash flow and asset valuations.
It is for this reason that Federal Reserve Chairman Ben Bernanke has been so aggressive in reducing interest rates and injecting liquidity into the system. The 150 basis point reduction in the discount rate and the federal funds rate since September 2007 has occurred over an extraordinarily short period of time. Originally it was felt that the Federal Reserve was acting too slowly, but the rapid shift in policy has made up for lost time. The Federal Reserve, however, is in a difficult position. They are being forced to lower interest rates to moderate the economic downturn at a time when the inflation rate is still rising. Adding to Chairman Bernanke’s dilemma is the fact that finally the Chinese currency is appreciating at a more rapid rate versus the dollar, something that the U.S. government had been encouraging China to do prior to today’s problems. But as a result of this, the cost of imported goods from China is rising and will now add further to our inflation rate. The U. S. inflation rate, because of rising energy, raw materials and agricultural costs has just taken its biggest jump since 1981. Still, the Federal Reserve appears to have little choice but to reduce interest rates once again and to continue to inject needed liquidity into the system, which will tend to further weaken the U.S. dollar.
Notwithstanding the inflation pressures that are building, there is a high probability that interest rates will be reduced further by the Federal Reserve from today’s 3% to 2.5% and possibly lower over time. It would not surprise us to see a 2% interest rate structure emerge this year. Additional credit market problems continue to eat away at the banking system’s capital, which reduces their ability to lend money and puts pressure on the Federal Reserve to reduce interest rates still further. Under former Federal Reserve Chairman Greenspan, rates were dropped to 1% in reaction to the technology and dot-com implosion and stock market decline in the early 2000’s. We believe that today’s economic problems are significantly more difficult and much more extensive, requiring the Federal Reserve to repair bank capital as quickly as possible.
The European Central Bank, whose priority is fighting inflation, has also had to contend with similar financial problems and has injected vast amounts of liquidity into their banking system. Nevertheless, their currency, the Euro, has been rising versus the dollar, hurting their exports and causing their economies to slow. Notwithstanding this, the European Central Bank, unlike their U.S. counterpart, appears to be unwilling to lower interest rates for fear of stimulating inflation.
The enormous amounts of monetary creation since last August have put upward pressure on the prices of tangible assets such as raw materials, energy, agricultural products and precious metals. In addition, the secular trend of demand for all of these products continues to rise as global infrastructure needs and rising living standards for 3.5 billion people continue apace. Under these conditions, the disequilibrium caused by rising demand and supply shortages should continue for an extended period of time. It cannot be determined how much prices need to rise in order to re-establish equilibrium, or to put it another way, what prices need to exist in order to bring supply and demand into balance. However, it is our view that this condition could last for many years. We are describing a secular trend, not a cyclical one, where growing demand and supply imbalances are expected to continue as global living standards rise.
Agricultural Products and Food Inflation
Agriculture officials last month forecast that U.S. wheat stocks will be shrinking to their lowest levels in 60 years. The U.S. is the largest exporter of wheat, and we have already made commitments to sell more than 90% of what we normally export in a year. It should therefore be no surprise that wheat prices have reached record levels. In addition, both Russia and Kazakhstan have indicated they would raise export tariffs significantly to keep their domestically produced grain at home. It is very possible that we will be overcommitted and will have to import wheat at higher prices to meet the remaining part of our contract obligations.
Over 37% of the United States is in severe to extreme drought conditions and according to the Federal U.S. Drought Monitor at least 57% of the West and 76% of the Southeast are suffering from moderate to exceptional drought conditions. Clearly, this will also continue to put upward pressure on grain prices. Not only is wheat in short supply, but rice, which is a staple food for half the world, has also seen significant price pressures because of shortages. We expect a protracted period of food price inflation to affect the U.S. economy. To make matters worse, Saudi Arabia has announced that they will cease wheat production by the year 2016 due to significant water shortages. As a consequence of these higher prices, U.S. farm income is expected to hit a record $92 billion this year, up from $88.7 billion in 2007. This will have an impact on demand for farm-related products, including fertilizer, seed and farm equipment.
While the dollar has depreciated against all major currencies over the past several years, it has also depreciated against both hard and soft assets. Just last week, iron ore prices were raised 65% by the major producers, which follows double digit price increases over the past several years. The prices for industrial commodities, as indicated in our last Outlook, have risen sharply in terms of dollars. This has been a function of considerable demand increases for industrial commodities in Asian economies, particularly China. The growth of the emerging economies should continue for many years and investment opportunities resulting from this will remain significant. One would be hard pressed to find any materials in any category not rising in price as a consequence of global growth and U.S. dollar weakness.
Restricted supplies of electric power in South Africa, China and Chile (among other regions) suggest many years of power shortages. Severe power problems and the need to cope with these shortages suggest that emerging markets’ infrastructure spending could total trillions of dollars over the next ten years. It is estimated that over $21 trillion in infrastructure spending is needed to serve a population of 3.5 billion people who are demanding higher living standards in developing countries.