April 14, 2011
David R. Kotok



Situated on the southern coast of Sicily, the city of Agrigento embraces the ruins of the ancient city of Akragas, established 2500 years ago by Greek colonists. The geography of the area allowed Akragas to become a prominent, well-defended city during the Golden Age. According to our local archaeological guide, Luigi Napoli, its population of 150-250,000 was fourth largest in the ancient world, behind Athens, Siracusa, and Corinth, respectively. Through to the Middle Ages, the city survived many wars and many occupiers.

What is most remarkable is the archaeological site, the Valle dei Templi. This acropolis has seven structures, constructed of yellow sandstone and in the Doric style. Undoubtedly the best preserved is the Temple of Concordia, or Harmony. It stands without reconstruction, just as it has for over two millennia. It is a testament to the grandeur of the ancient world. Built on a rock formation, the temple remains intact, as an underground layer of clay functions as a shock absorber, protecting it from earthquakes. In addition to this natural defense, the edifice was converted into a Catholic church dedicated to Saints Peter and Paul during the medieval period, continuing its conservation. Today, we can appreciate its beauty and history as it lies entire before us.

One can observe in Agrigento the play of history from pre-Hellenistic times, when local tribes were the occupants, through to the present day, as discussed in our last commentary. As did the ancients, we create monuments and documents that will become remnants and memories. We do so, only for scholars to pour over them in the attempt to interpret their meanings, decades, centuries, and even millennia after their creation.

And so, in that spirit, our economics discussions continue here.

Today we focused on an issue involving currencies and the current status of oil markets. The issue derives from the fact that oil producers tend to allocate their reserves against an index or other proportion, and plan accordingly in the deployment of their reserves. Since the producers are mostly Middle Eastern or North African, those reserves tend to have some political bias. In some cases, it is against the dollar and in favor of other currencies and assets. The same thing happens with Asian reserves, which tend to lean in favor of the dollar in greater proportion. The difference between the two creates an interrelationship among currencies, their exchange rates, and various levels of economic activity and price change throughout the world.

Picture the condition of a sovereign-wealth-fund manager in the Persian Gulf. The price of oil goes up by 30 dollars a barrel, and in come unexpected additional billions of dollars. On receipt, they raise the allocation of US dollars beyond the typical benchmark index. The portfolio manager then has to sell some of the dollars and redeploy them into another currency, such as the euro, yen, pound, or others. The effect of the sale is to weaken the dollar and strengthen the euro; but because commodity prices are all priced in dollars, the secondary effect raises commodity prices of other items like industrial metals, precious metals, or food.

Market participants then see the weakening dollar, the rising price of oil in USD terms, and the rising price of commodities in USD terms, and the cycle intensifies. Does this mean inflation in the general price level? What is the transmission mechanism that takes a food price or gasoline price and converts it to a rising level of all prices, or most prices, or more than half of all prices? Here is where the concept gets difficult.

In Europe, the authorities of the European Central Bank incorporate food and energy into their inflation measures. In the United States we do not; we use something called core inflation. We determine that food and energy prices are the result of shocks that are beyond the control of the Federal Reserve and, therefore, are not reflective of central bank policy. The European Central Bank sees it quite differently.

The ECB has raised its policy interest rate. It is worrying about inflation, looking at the energy price shock, and watching the price of Brent crude. It is seeing the rising prices of food, and tolerating the risks of sovereign debt restructuring, other sovereign debt issues, a banking system that still needs repair, and possible economic weakness in some regions.

The Federal Reserve, led by Chairman Bernanke, Vice-Chairman Yellen, and NY Fed President Dudley, has staked out a different position. They are looking at core inflation. They are worried about the large negative output gap reflected in the high unemployment rate, and they are leaving policy interest rates at present levels. Such are the differences between the two central banks.

What will happen next? Well, the economies of the world as a whole seem to be slowing. The IMF has confirmed this, and the outlook is for no improvement for the rest of this year. In fact, many forecasters are ratcheting down their calculations, as the energy price shock; turmoil in the Middle East and North Africa; risk developing in Sub-Saharan Africa; Japan, now reaching a nuclear structure of Chernobyl proportions, with supply-chain issues that are truly global – all come together on top of high unemployment and structural financial weakness to lead us to a rising risk of a global double-dip or slowdown before the end of 2011.

Do we know what the outcome will be? We certainly do not. Is there any way to predict a second recession, a repeat of the 1937 experience that prolonged the Great Depression, which would further weaken housing, sending home prices lower, triggering more foreclosures and essentially creating a replay of the horror movie we have seen the last few years? The answer is: we don’t know.

What do we know? We know that when measured against other options, some debt instruments have extraordinary returns. For example, it makes no sense that a very-high-grade tax-free bond, secured mostly by federally backed mortgages issued by a state housing authority, should yield a higher interest rate than a duration-matched treasury security, which is also an obligation of the United States of America. This is not a credit difference. Both instruments rely on the promise of the US government to complete their payment obligations. Yet the tax-free instrument yields more than the taxable instrument. Why?

We know that stocks reflect a combination of very high profitability in certain business sectors and the likelihood that there will not be rising wage pressures. Why do stock markets behave the way they do? Is the risk or fear of slowdown so acute as to render the forecasts of profitability false? We don’t know.

We also know that high energy prices result in high profits and expanded business in the oil and natural gas sector, which supports its infrastructural, exploration, drilling, and services activities. Thus, an energy weighting seems appropriate in a stock portfolio.

What else do we know? We know that the health-care sector has been under extreme pressure for years and appears to be very cheap by any historical standard. We also know that it’s a place where money flows when markets want to become defensive. We see this in the relative outperformance of the health-care sector in very recent market activity.

We know that the structural problems in Japan will require that country’s central bank to engage in huge additional financial assistance to the government as it rebuilds. So there will be another round of quantitative easing, QE7, 8 or 9, or whatever we want to call it. We also know that Japanese savers will finance it. Because of this, Japanese interest rates are likely to remain very, very low, even as the Bank of Japan participates in an expansion of its balance sheet, facilitating large additional fiscal stimulus to resuscitate and repair the Japanese economy.

What we finally come to realize is that the relative values of currencies around the world are driven by disparate and remarkable forces. In Washington, we see some attempts to resolve the political impasse, albeit questionable attempts, in the eyes of the world.

We do not expect an inflation explosion in the near term. We see weakness in economic terms continuing to unfold this year. That means very low interest rates will persist for a while longer. Thus, certain stock market sectors and certain bond market structures remain attractive.

We remain nearly fully invested worldwide, with allocations to particular sectors like energy, and we remain invested in bond market sectors where we find spreads to treasuries very, very attractive. We also favor certain barbell portfolio structures that attempt to capture values at either end of the yield curve and move away from the middle, which we believe is distorted by the focus of the Federal Reserve’s current QE2.

The sun is setting over the hills of Agrigento. April decorates Sicilian gardens with flowers in warm hues of pink, purple, and yellow. The serene, balmy air blows through the picturesque olive trees, and the slight haze over the Mediterranean renders this landscape seductively sweet.

There are serious concerns that hover just beyond our sight, so this calm and tranquil setting must be taken in with at least a pound and a half of caponata and a glass of delicious Nero d’Avola.


David R. Kotok, Chairman and Chief Investment Officer

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