Rumors of the Economy’s Death

October 3, 2007

Dear Investor:

The last quarter marked the return of risk and reminded investors of the power of volatility—a word that is somehow used to describe stocks only when they are going down.

The true victims of the quarter were mortgage lenders and certainly trading hedge funds, many of whom went bust. According to Reuters, a partial list reads as follows: the Bear Stearns Funds (down more than 90%), Sowood Capital (down roughly 50%), Tykhe Portfolio Ltd. Class C (down 26.5%), Basis Capital (down around 80%), the Maquarie Bank Funds (down about 25%) and Basis Capital Alpha Fund (filed for bankruptcy). For more on the topic, see our Huffington Post blog:

The economy is now at a crossroads, with recession threatening and the credit markets in disarray. To the domestic news watcher, the story looks grim: subprime defaults, layoffs, record oil prices and the worst real estate collapse in 20 years—perhaps ever.

The unpublicized side of the story is the tremendous global boom that is carrying China, India, Russia and Eastern Europe into unmatched prosperity. The falling dollar is making our exports attractive to euro and yen-rich buyers. For the first time ever, a true middle class is gaining traction in China and becoming a large consumer of our goods and services. The Wall Street Journal reports that U.S. exports rose 2.7% to a record $137.68 billion in July and added a half a point to GDP growth. Our trade deficit is enormous. This, however, is increasingly due to our voracious consumption and not to the rest of the world’s lack thereof. Over time, a weak dollar and continued emerging market growth should bring the trade account back toward balance.

The flip side is that inflation will likely return as China ceases its disinflationary effect. The Chinese consumer will grow richer and more acquisitive and this will boost prices worldwide. The cost of production in China will increase dramatically as wage pressures grow. This will
defuse the dangerous protectionist rhetoric here at home but will also spur costs. The same weak dollar that boosts exports should also stoke inflation and cause bond yields to rise.

In the past quarter, our rotation to large-caps finally paid off as the mega-cap multinationals led the way. Our large positions in cash and bonds also were helpful as we were able to take advantage of the volatility to invest after market tumbles. Less successful were our underweight positions on energy, a sector we cut too early, causing us to miss out on continued gains. We still feel, though, that a looming recession puts energy in a precarious short-term position and that our decision will ultimately be vindicated. What looks interesting is the troubled high-yield bond sector. As the economy slows, there could be some selective buying opportunities amongst the fallen.

Our view is cautious but not cataclysmic. We believe the economy will slow sharply without collapse. To paraphrase Mark Twain, the rumors of its death have been greatly exaggerated.