A.R. Schmeidler & Co., Inc.

The prevailing view at the start of the year was that the world was in the midst of a gradual economic recovery. Our view was that deleveraging in the developed world and industrialization and growth in the developing economies would remain the defining features for investment security selection and portfolio management. As a result, portfolios have been and continue to be focused on:

These themes represent what we believe to be major and enduring secular trends. Moreover, current conditions have been further complicated by the tragic events in Japan and the popular uprisings in the Middle East, which are reinforcing and augmenting the attractiveness of the investment opportunities described above. For government leaders and central bankers, the dramatic changes that have occurred in the world in the past two months in Japan and the Middle East, when combined with the prevailing global disequilibrium, require a rethinking of many of the current policy initiatives in the areas of energy, currencies, deficits (trade/government), employment, infrastructure, taxation, legacy obligations and inflation/deflation. The recent coordinated currency intervention by the G7 central banks was designed to weaken the Japanese Yen to prevent it from becoming a drag on Japanese exports during its time of greatest vulnerability. Prior to the crisis, the Japanese government was already struggling to weaken its currency in order to strengthen its exports and stimulate its economy after a two decade-long recession. The linkages and interdependencies of the global economy are shown to be dynamic and reflexive as one country’s actions lead to responses by others.

The devastating effects of the earthquake and tsunami in Japan will be felt for many years and its economic impact will be far-reaching touching diverse areas including infrastructure, energy, global manufacturing, and agriculture. Japan, the third largest economy with a current GDP of approximately $5 trillion, is burdened by the highest debt-to-GDP ratio of any developed nation. The costs to rebuild could exceed $300 billion, or 6% of its GDP, as new towns and cities will have to be built. Moreover, the pattern of energy consumption has been forced to move away from the use of nuclear power towards fossil fuels (oil, gas, coal, and liquid natural gas), solar, and wind power. Japan was the third largest owner of nuclear reactors with 54 operating representing 29% of its electricity generation. Up to now, Japan imported 4.4 million barrels of oil per day but now it will be required to import more refined product as nine refineries representing 1 million barrels per day of production are now offline.

In addition, Japan has long held a position as one of the top-two exporters in the world and is a major element in the supply chain for just-in-time inventory management of global corporations. The economic impact of the recent disaster has potential negative implications for multinational corporations as supply disruptions have left many companies scrambling to replace critical components for manufacturing. Moreover, nuclear fallout may become a greater consideration in the export and consumption of agricultural and marine products.

Since Japan is totally dependent on the outside world for resources, and as it needs to finance the purchase of these resources, the potential and actual repatriation of overseas assets has led to a further appreciation of its currency. A higher Yen value would tend to reduce global demand for Japanese exports and place additional contractionary pressures on their economy.

This repatriation could have secondary implications for the US Treasury and its cost of borrowing. Japan is currently the second largest foreign owner of US treasury bonds. Should Japan need to reduce its treasury holdings, or slow or cease its ongoing purchases in order to finance its reconstruction, the cost of borrowing for the US Treasury could rise as demand for its bonds falls. This could coincide with the planned phaseout of the Federal Reserve’s treasury purchase program known as QE2, which is scheduled to be completed by June 30th. The result of two of the largest US treasury buyers exiting the market at the same time could pressure the Federal Reserve to consider a new buying program, or QE3.

It has been a long-held belief that nuclear power is one of the lowest cost energy sources, that is until there is a problem, and then it can become the absolutely highest cost. In the days immediately following the fires at the Fukushima-Daiichi reactors, many countries, including Germany, China, and the US, announced that they were going to review current facilities and future plans for nuclear power. The recent election defeat of Angela Merkel’s political party resulted in a major breakthrough for Germany’s Green Party, a group that rejects the use of nuclear power which currently accounts for 20% of its electricity generation. Globally, there are 442 operational reactors, and 302 or 68% are between 25-44 years old. These 302 are a product of older technology. Further compounding global energy policy is that this comes at a time when regime changes in the Middle East could reduce global oil supply, while the rest of the developed world has struggled to replace reserves. These events have placed further upward pressure on energy prices. A second and critically important effect is that politically secure sources of oil, natural gas, and coal have become more valuable. China, through Chesapeake Energy, and South Korea, through Anadarko Petroleum, have recently made significant investments in US assets to secure some of their future energy needs, swapping depreciating US dollars for appreciating US assets. Another effect is a growing focus on building Strategic Petroleum Reserves (SPR) by China, Saudi Arabia and others which if undertaken would create an increase in short-term demand.

Having grown into the world’s largest exporter and second largest importer, China has now woven itself deeply into the global economy. The Chinese government has been continuously accused of currency manipulation to keep its exports strong and build its foreign reserves. To become less export dependent, foster rising living standards, and promote social stability, China has been raising wages as part of the recently announced five-year plan. This will raise the cost of Chinese exports, thereby reducing the external political and economic pressures to revalue the Yuan. This adjustment will moderate global imbalances where the pressure has been on China to become less dependent on exports and more oriented towards domestic growth. By promoting higher incomes through wage increases, living standards will be rising much more broadly than would otherwise be the case. The Chinese leadership intends to raise the minimum wage by at least 13% for each of the next five years and, for more skilled labor, by 20-30% annually for the next three years as part of the country’s restructuring.

Another pillar of the plan’s economic restructuring is the creation of social safety nets that would have a positive impact on domestic spending by lowering the population’s need to maintain as high a savings rate.

To compensate for the lack of welfare programs, the current savings rate in China is 50%, compared to the American savings rate of approximately 5%. Recently the Chinese government proposed spending hundreds of billions of dollars to build 36 million affordable housing units by 2015. This plan will result in an increase in demand for a broad array of raw materials and manufactured items, at a time when the world needs to rebuild from natural disasters in Japan, New Zealand, and Australia. To put China’s urbanization in perspective, McKinsey Global Institute estimates that 350 million people will move to new and existing Chinese cities by 2025. Just to create a workable electrical grid will require a buildout equivalent to the size of the entire US electrical system. China’s currency reserves are so large, reportedly $2.8 trillion and growing by an estimated $400 billion this year, that it can fund powerful growth initiatives for many years and also give them the wherewithal to stockpile critical resources to meet its current and future needs.

For the United States, however, it should be noted that as wages rise in China, the goods China exports to the US will become more expensive for American consumers, putting upward pressure on the US cost of living, or said another way, would result in lower living standards for many. Any increase in import costs comes at a particularly difficult time for the US consumer as rising oil prices, austerity moves by federal, state and local governments, and the Federal Reserve ceasing its stimulative monetary policy of QE2 after June 30th would weigh on economic growth and consumer spending.

For many developed countries such as Greece, Portugal, Spain, Ireland, and the US, austerity measures will reduce aggregate demand unless offset by an increase in investment spending or the introduction of smart growth policies. Under current economic conditions, austerity measures aimed at reducing the deficits will promote more unemployment by stifling growth and decreasing the purchasing power of consumers, resulting in lower economic activity which in turn leads to increased government deficits. To finance its debt, the US has two potential buyers, foreign and domestic. Up to now, foreign buyers have been significant owners of US debt. If increased debt issuance does not continue to attract foreign purchasers, the Fed will have to be the buyer of last resort. Knowing that the US has not addressed its long-term problems, without monetization by the Fed, higher rates should be expected as potential buyers would require appropriate compensation for the risk of ultimate inflation. In the end, this will likely result in the Federal Reserve monetizing a greater portion of the federal deficit as there is a low probability of increased demand from domestic buyers. Under these circumstances, the dollar could come under renewed pressure as other nations reduce dollar holdings knowing that required monetary creation will depreciate the currency. Debts and deficits are too large and represent too big a burden for many governments. There are three ways for a country to lower the burden, either through economic growth in excess of its debt service requirements, through a much lower interest rate than the growth rate of the country, or through default. While there are legitimate concerns about a sovereign default in Europe as the countries are facing punitive costs servicing their debts with minimal growth prospects, the US is able to default more elegantly. By printing money, the Fed can depreciate the dollar and continue paying both interest and principal in full. Effectively the US is able to default without the lenders losing a penny of income or principal. However, the dollars will be worth less in the future. Unfortunately for the European countries with debt problems, this option is not available. The European Union with its single currency has struggled for over a year to come up with an effective solution, and remains unable to reconcile the different political and national agendas.

Because currencies are depreciating assets, and because resources are finite, many countries have been actively diversifying their currency holdings into hard assets. The current fiscal situation of the developed world is encouraging surplus countries to build strategic reserves more quickly than they may have initially planned, which will continue as the prices of these vital raw materials increase in dollar terms. This strategic buying may very well fuel price increases of hard assets as well as the companies that produce them.

The secular trend of globalization has significant social, economic, and political implications that extend to investment policy. In spite of the awareness of globalization, it seems to have snuck up on many investors. We believe that the traditional style-box approach to investment allocation that was popular in the 1980’s and 1990’s is less relevant today and makes it more difficult to build capital by limiting investment opportunities. Many market participants in the US build portfolios with a significant portion of their assets invested in strategies that seek to closely replicate the S&P 500 and other global benchmarks. It is our view that this is an approach that underweights some of the most important industries. This ensures average results at best as witnessed by the lost decade of 2000-2010 when many investors in the broader markets not only failed to build capital but did not keep up with inflation. Today, the beneficiaries of globalization are underrepresented in the global indices and therefore in many investors’ portfolios.

To put this into perspective, industries which are critical to global growth, rising living standards, increasing productivity, and currency devaluation represent a modest portion of the weightings of the S&P 500. Below are select industries and their weightings in the S&P 500 that we find particularly attractive. While there are other important investments on which we focus, this highlights some of the most attractive opportunities.

Our long-term success has come from our willingness to invest away from the crowd as popularity leads to overvaluation which in turn limits potential returns and increases risk. We are attracted to undervalued businesses that are best-positioned to benefit from globalization, businesses that we consider the “crown jewels” of the global economy. These companies tend to have strong balance sheets, strong cash flows, secure assets, high barriers to entry, resources that are costly to duplicate and managements that are committed to shareholder value. With the dramatic events that have unfolded this year, in times like these, we are reminded that to successfully build capital requires time, focus, clarity of thought, judgment, and conviction.

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