Dear Client,
We have never written quarterly letters because we doubted enough could go on within 90 days to make it worthwhile. The quarter gone by has put a dent in that notion as the capital markets bounced from pillar to post.
The extraordinary American victory in the Persian Gulf War was, of course, the catalyst for that change. It is hard to believe now that just two months ago there were many television pundits and Congressmen predicting outright defeat or victory so expensive as to make it rival defeat. Our stunning success was sure to engender a burst of enthusiasm for all things American, and it has.
Victory has also had a profound and little noted financial effect, however. We wrote in January, “Wars have always cost potfulls of money which governments have proved ill-prepared to spend”, never envisioning that Washington would hit on a method to fight the war at a profit. However, our allies pledged $54 billion in aid, $40 billion in cash, in January before the lopsided war score was known. No less an authority than Charles Bowsher, impartisan head of the Congressional budget office, estimates the total war costs at no more than $35 billion, and quite possibly less. Since the weaponry involved was purchased some years ago and would not have been replaced, it is fair to think of this $40 billion as almost purely a splendid one time gain, tribute from the allies. Since the full cash payments are due by today, this windfall over two months is the equivalent of roughly a $200 billion swing in our current account, from deficit to surplus. It has played hob with the currency markets, since the funds were all pledged by governments in their local currencies, Deutschemarks and yen for instance, and then had to be exchanged for dollars in currency markets wholly unprepared for this.
We certainly wish we had seen this coming, as we have given back the appreciation we’ve made in the bonds and more from the effects of the roiled currency markets. It would also be churlish in the extreme if we didn’t take our hats off to the fellows in the Treasury department who thought this up; we can’t think of any historic parallel. However, we can still turn this to our advantage, as the sell off in Deutschemarks has encouraged every kind of wild rumor, including most prominently that the Russians are coming. More precisely, that turmoil in the Soviet Union will lead to vast numbers of new immigrants besieging German social services.
Since the Warsaw Pact effectively policed the Western European nation’s borders for many years by shooting anyone who wanted to illegally immigrate, the Nato allies have gotten completely out of the habit of sponsoring their own effective border patrols. Before the Western Europeans get completely bent out of shape on this issue, they might be advised to take a trip to the American border just south of San Diego. There they will find approximately 80 million people desperate to come to the United States and a thoroughly harassed border patrol that somehow manages to keep a reasonable semblance of order. This condition has lasted many years and has not done California any noticeable harm, and we are confident that after the Europeans get used to the new burden they will find the same thing.
Euphoria over American military might and the odd nature of the war reimbursement have combined to drive Deutschemark bonds to levels of extraordinary value. We think this is transitory. If we remember that the Germans have an inflation rate easily three points less than America’s, and the bonds now yield about 8.5% in DM, this is the dollar equivalent of an 11.5% convertible bond in a high quality issuer. That doesn’t come along everyday.
The stock market has celebrated victory in its own robust fashion. The rapid descent we were salivating over in early January has turned to euphoria in March. The market’s problem now is that splendid little wars in far off places are not a regular part of American foreign policy, and the other people’s money that has funded this rally is soon to dry up. Considering the extraordinary valuation stocks have been given, if hopes for the economy are now dashed they will be dashed from a great height. On this score we are not sanguine. The now popular idea that people have stopped buying cars because they were too busy watching CNN is laughably out of touch with middle class reality. Except for the extraordinarily rich nobody goes out and buys a car because there’s nothing good on the tube that night. Buyers are stymied because they are “upside down”, to use the industry argot. This is what happens when you buy an American car that has a four year economic life with a seven year car loan. You owe more than the car is worth every day until the loan is paid, making trade-ins virtually impossible. There are great swatches of the economy similarly hog-tied by the leverage excesses of the 1980’s. It makes it difficult for us to see how the historically exceptional values now put on stocks can pan out well for the buyers.
Overall, we end the quarter down about 3%. Since just about everything that could go wrong for us did go wrong, we think both the law of averages and great value are on our side for the rest of the year.
Sincerely,
Edwin A. Levy
Michael J. Harkins