All thanks to our resources oriented economy

Quarterly Letter

As the numbers show, the third quarter of this year has not been kind to investors worldwide, with the exception of Canadians. As you might have guessed, thanks to its resources oriented economy, the Canadian stock market has been one of the best performers since the beginning of this year.

Moreover, with oil prices above US$ 50.00 a barrel, Alberta has become totally debt free as of 2004. Even though many love to criticize Ralph Klein and his drastic policies, credit should still be given where credit is due and he did do a fabulous job in restraining government spending during his tenure. Now, Albertans will have the freedom to decide how to invest their surplus without the constraints of a heavy debt load. Wouldn’t the federal government or the province of Quebec like to be in this position? The moral of the story is that tough medicine is usually painful in the short term but it does cure the disease in the long term. It does take courage to make that decision. Alberta did and the rest of Canada has not …yet.

The price performance of the main indices for the third quarter and the first nine months of 2004 are as follows:

  3rd Quarter First nine months
  In local Currency In Canadian Dollars In local Currency In Canadian Dollars
S&P/TSX (Cnd) + 1.44% + 1.44% + 5.44% + 5.44%
S&P 500 (US) - 2.30% - 7.55% + 0.24% - 2.52%
Nasdaq (US) - 7.37% - 12.34% - 5.32% - 7.92%
Europe (EUR) - 1.13% - 4.63% + 3.46% - 0.66%
Nikkei (Japan) - 8.73% - 14.63% + 1.38% - 3.95%

The US economy is sending mixed signals: Gross Domestic Product seems to keep growing but employment creation is weak at best. Overall, economic risks are increasing. It may seem early to begin watching for signs of an oncoming recession but the reality is that we will see one in the next 12 to 24 months if not earlier. Combining the consumer debt load, rising interest rates, rising energy prices and weaker US Dollar, these will not make a very good economic cocktail mix. It is time to be more cautious.

In contrast to the weak US Dollar, the Loonie has put on a wonderful performance, rising from a low of US$ 0.716 several months ago to a high of US$ 0.796 recently. For those who are skeptical regarding the strength of our Dollar, it is still our belief that by the end of this decade, we could see parity with the US Dollar. With resources as our main assets, after two decades of declining commodities prices, supply-demand is finally in our favor for the decade to come.


For those who survived the inflationary markets of the 70s, they know that rapidly increasing oil prices also means painful inflation. So why has a 150% run up in oil prices in 3 years produced such modest inflation, 2-3% in the US over the latest 12 months?

A simplistic answer would be Wal-Mart. Ironically, this is not far from the truth. In fact, this powerful retailer along with others has helped hold down inflation by sourcing their consumer products from Asia, mainly China. Wal-Mart is ranked among the top ten trading partners of China if it was considered as a “country”.

In the following section, we will try to help you understand the repercussions China will have on the global economy and how we are dealing with the rise of this powerful player.

In the past century, economic recessions and expansions have been analyzed within the context of advanced industrial nations – the White Men’s Club, as a global strategist would call it, although Japan joined in the 80s.

Emerging markets such as “the Asian Tigers” – Korea, Taiwan, Malaysia, Singapore and Thailand -- were strictly driven by export growth, thus fragile and accident-prone. A major global financial crisis developed in 1997 with the devaluation of the Thai Baht and culminated with the Russian and Long Term Capital Management defaults in 1998. For those who are interested, we highly recommend Lowenstein’s book “When Genius Failed”.

Almost going unnoticed was the steadiness of the RMB (the Chinese Currency) during these volatile periods. By its monetary stability, China made a great leap forward from backstage to center stage in the global arena. It became the largest economy in Asia and the second largest trading economy in global markets. Thanks to its steadily growing 100 million strong middle class, it is developing a powerful domestic economy alongside its exporting one. China’s success has meant it has achieved a level of power in global trade never achieved by any emerging economy – ever.

China is now the global price setter for any product it chooses to export (i.e. deflation for the west since Chinese wages are still so low).

It is also the global price setter for any industrial raw material it needs to import (i.e. inflation in commodities since additional supply has not been developed due to two decades of declining prices).

China is both disrupting and restructuring the global economy. Its gigantic trade surplus with the US shows no signs of weakening anytime soon. Its cheap exports limit the pricing power of US companies and prevent them from passing along their raw material price cost increases, such increases being created by China itself. So both the economic and the profit recoveries are more problematic at this stage than in any postwar recoveries.

The China factor has created a lot of discomfort and even danger. Manufacturing sectors in the west are in crisis, laying off thousands of workers and outsourcing their workload to countries with lower wages.

Fortunately, the economy and businesses are dynamic and they adapt to the new environment fairly well, albeit sometimes with short-term pain. Let us remind you that during the mid 80s, our universities were touting the Japanese business model as the best one while Japanese companies were buying up US assets. Fast forward to the 90s, “oh my” how things have changed.

For investors, there is one Chinese word that should be learned: the word CRISIS. It is actually made up with two words: DANGER and OPPORTUNITY. As we navigate through these confusing periods, well-managed companies will stand out and benefit from whatever the changes are going to be. It is during these instances of perceived DANGER that OPPORTUNITIES surface, allowing patient investors to purchase great companies at distressed prices.

In selecting stocks for our portfolios, we apply our disciplined, quantitative analysis approach. Moreover, we always put emphasis on picking companies that, we think, know how to avoid big and obvious trouble. Competing against China in mass consumer products has evidently become one.

The Claret Team