October 9, 2012

Dear Client,

At September 30th our average account had appreciated approximately +9.92% for the year.

In the middle of last month in response to desultory growth, Federal Reserve Chairman Benjamin Bernanke announced Quantitative Easing III, a program most notable for its claims to “unlimited” size.  By the calculation of Martin Feldstein in the Financial Times last week, “unlimited” might come to $1.5 trillion of new money created in three years.  To put such a sum in perspective, the Fed’s assets totaled all of $825 billion at the beginning of the financial crisis in late 2007.  America’s leading economic light, Professor Paul Krugman of Princeton, says that not only is there nothing alarming about this, but that those of us who express concern are like bullies who would scare small children around a campfire for our own amusement.  Inflation is dead, now and forever, says the twice a week New York Times Columnist.  His assertion will look odd to you if you have been in a grocery store lately, but it grows positively loopy if you’re currently paying for a Princeton undergraduate.  Nothing on that campus is going up at a 2% annual rate, least of all tuition.  Which might remind all of us how often in politics things look different if you are signing the front of the check or the back.

What got us to shake our heads even harder at QE3 was the simultaneous announcement that 0% interest rates at the short term would be extended through mid-2015.  Beyond bridling at the clairvoyance that this would require from an institution that was wholly impercipient through the worst of the crisis, it also goes a year and a half beyond the term of Chairman Bernanke, set to expire January 31, 2014.  Bernanke was confirmed by the Senate last time by the smallest majority ever, and aren’t the country’s savers, who will have gone without interest for about 7 ½  years by the end of this program, ever to be heard from, ever to have their rights restored?

In thinking about what comes after QE3, consider this.  It currently costs America comparatively little to service our debt , a little over $200 billion a year, because interest rates are so low.  But that number will leap by something on the order of $500 billion the next time interest rates revert to anything like historical low norms.  And it will be worsened still more by the losses that the Fed will have on its mortgage and long bond holdings.  The Fed and the Treasury came to an agreement that those losses would not be borne by the Fed, but would instead flow through Treasury’s current year deficit.  This was reported in January 2011 by Grant’s Interest Rate Observer, and to our knowledge no place else.  It is a disturbing agreement, partly because it has the whiff of someone preparing to leave the scene of an accident.  But even more, it means the next Fed Chairman, if he only normalizes monetary policy, will be handing the political system an incredible bill, wholly unexpected, about the size of the Simpson-Bowles fix all by itself.  And we did not have the courage to implement that fix a year ago.  Paul Volker is 6`7”; the next fellow is going to have to be a lot bigger when inflation has to be tamed again.

Our inflation worries were illustrated on the cover of this week’s der Spiegel, with a melting Euro under the headline, “Careful, the slow expropriation of the Germans!”  The Germans have a point in thinking their worries are worse than ours.  We are, after all, rapidly becoming an energy sheikdom;  they’re not.  We also have a technology sector that increasingly dominates the world, and the last SAP product launching was on no one’s radar.  The German public longs to extricate itself from their sinking European brethren, and has been misled by its political class, who know the impossibility of such a thing.  But the German press does make the very salient point that it is absurd to argue that you are taking very valuable messages out of a market that you are very vigorously rigging.  In time you will have fooled only yourself, a point Professor Krugman never seems to grasp as he twice a week urges more stimulus.

Meanwhile, despite lackluster growth and downbeat consumer confidence our portfolio continues to thrive.  Walmart and American Express produced a marriage announcement yesterday, in which they propose to have a bank together.  Walmart has been thwarted in its banking ambitions for a decade and more, so this might be a big deal.  They are also worldwide leaders, and thoroughly All-American.  Think back a decade ago, when American dominance in technology seemed to be threatened by Finnish, French, German, Japanese and even Canadian competitors.  Where are they now?  Then think back about where Apple and Qualcomm, Google and EMC, Akamai and Cognizant were then, and are now.  And they showed dominant growth through the second worst economic crisis in history.

Inflation is a threat to every investor, and indeed to every member of society.  But it can be lived through, and we can prosper despite it.  We know, because we have defeated inflation before, which is about the only sentence a money manager can write in which age is not a hindrance.


Edwin A. Levy

Michael J. Harkins