July 6, 2012

Dear Client,

For the first 6 months of 2012 our average account appreciated +2.35%.

All eyes remain on Europe and it is an unsettling sight.  The Union appears to consistently have eight policies, one for every day of the week and a spare for alternate weekends.  As we write this the issue that seemed to be put to bed last weekend, that the Spanish government would not have to be on the hook directly for the bailout of its banks, is back in play.  Yields and fears are up accordingly.  A step back, though, might produce a clearer picture.  As this week’s Der Spiegel magazine puts it, “The history of monetary integration has been a series of broken taboos.”

Angela Merkel has billed herself as the world’s leading Austerian, an iron Chancellor, a lady not to be turned.  She would turn the south of Europe into a sponging house if she could, or so we are told.  Yet last Friday at 4 in the morning she did a U-turn, acquiescing to something preciously close to a Eurobond to rescue Spain and Italy, with oversight to come later, if ever.  What came 12 hours after that is most interesting, and little heralded.  The German lower house of Parliament approved her concessions, with scarcely any debate, by 493 to 106.  That vote by itself tells you something vital to all of our futures.  From the beginning, German posturing has been the rival of Kabuki theater.

Everyone knows that with half their economy made up of exports, the Germans won’t sell a car or truck intra-Europe if this downturn isn’t halted, and there goes the end of Wirthshaftswunder
1 .  Far more immediately, it would also mean the rather instant demise of the German banking system, and here we must rely on the estimable “Grant’s Interest Rate Observer” to tell the tale.  In the June 1st issue, Grant’s reveals the inner workings of the “Trans-European Automated Real-Time Gross Settlement Express Transfer System.”  In German, that’s a jaw breaker, but it has been given the slang expression “Target 2”, and that word “transfer” is the one to keep your eye on.  Turns out a Greek doesn’t buy a Mercedes the way any normal person would think he would.  He doesn’t just fork over a 50,000 Euro brick of cash and drive off.  No.  He writes a check from his bank which gets cashed at the Greek Central Bank, which then incurs a debit to the European Central Bank.  The ECB in turn credits the Bundesbank with 50,000 Euros, they in turn contact Mercedes’ banker, and the car company makes payroll.  Prior to 2007, there were enough German tourists in the Greek Isles frolicking up a storm that these trades netted out to about zero.  Then came the financial crisis.  From then to now the peripheral nations of Europe have racked up a huge bill with the European Central Bank, as they have taken in far more than they have exported, and they have left the Bundesbank with a 700 billion Euro credit with the ECB, which has no one but dodgy borrowers to go after in case something goes amiss.  Did we tell you that the Bundesbank’s dodgy Target 2 assets have been growing at a 112% annual rate as of last month?  Let’s put 700 billion Euros in perspective.  Germany has 81 million people, about one quarter of America’s population.  At current exchange rates, this staggering debt would amount to $3.500 trillion, about twice our annual deficit.  And to sin by repeating ourselves, it’s growing at over 100% per annum.  They can posture all they like; they cannot throw people out of the Euro.  The Bundesbank is already staring at its huge loss.  It’s the rest of the world that hasn’t seen it yet.  German two year notes yield less than zero today, a truly astonishing turn of events for us since we owned German bonds twenty years ago when they yielded more than 9%, and it was a difficult purchase at the time.  It is as though the world has fled back to the certainties of 1992, and not noticed other balance sheets have been published since then.  Fear often makes people do strange things, but rarely ever wise ones.  The German authorities know the devastation a loss of this size would do.  They are hunting for a face saving way to inflate their way out of it.

In ignoring the risk of inflation investors are also ignoring the reality of arithmetic.  There is no way to lower the debt to GDP burden of the peripheral Eurozone countries except by making nominal GDP grow faster than the interest rates they pay.  At an all in cost of say debt at 3% and 4% for Italy and Spain respectively, that means nominal growth of about 5% and 7% to put any dent in the problem.  All the technocrats know this.  What remains to be decided is how to get there, and how much of that growth is to be real, and how much inflation.  That more than half of it will be inflation seems to us about the easiest call we’ve ever made.

Meanwhile in the U.S. we have growth, painfully slow but real nonetheless.  In our portfolio, on the other hand, we have growth that is bounding along nicely.  That it goes unappreciated is a little vexing, but we’ve known worse moments.  It is decidedly, odd though, that in a world with so little real growth, growing companies sell at almost exactly the same capitalization rates as dormant ones.  Shouldn’t there be a scarcity value premium?  Well, there isn’t.  Apple, Google, Qualcomm, Tupperware, Walmart and McDonalds all sell at multiples within a point or two of market multiples, and all are turning in results as though the worldwide economy were doing handstands, rather than its persistent sleep walking.  That the best of the best sell at such pedestrian prices in the face of near zero interest rates puts the lie to the efficient market theorem once again.

No where does American exceptionalism shine brighter than in the energy sphere.  For thirty years and more the Oil and Gas Journal has been a bummer of a read.  Each week its opening pages led with American oil production, and each week it was lower than the previous year’s level.  Until about 18 months ago.  From there to now has been an eye opener.  The same horizontal drilling and rock fracturing techniques that have been such a godsend to natural gas production has been loosed on oil.   For the year to date oil production in America is up 7.2%, and the growth is accelerating.  For the month production is up 11.2% year over year.  Natural gas liquid production is up 15% year over year.  Combined with phenomenal coal exports and some soon to be natural gas exports, we might be looking at an America self sufficient in energy in a handful of years.  With Canadian and Mexican efforts thrown in, our continent may be going from pauper to oil sheikdom in record short time.  That this has touched off so little joy is bewildering, all the more so in that it is one of the few healthy ways society might ward off some of the inflation likely to come.

When people are feeling this downbeat they can ignore all sorts of good news.  But America not having to pay vast yearly treasure for its energy needs to pay some of the worst people in the world means prosperity in the Dakotas and Pennsylvania, Colorado and the mid-West.  Eventually Wall Street and Broad will find out about it.  They always do.
1 Economic Miracle

Sincerely yours,

Edwin A. Levy

Michael J. Harkin