In the second quarter of 2014, the MSCI World Index rose 4.9% while in the U.S., the S&P 500 Index increased 5.2% and in Japan, the Nikkei 225 Index increased 2.3%. In Europe, the German DAX and the French CAC 40 indices rose 2.9% and 0.7% respectively. Crude oil rose 3.7 % to $105 a barrel, and the price of gold rose 3.4% to $1,327 an ounce by quarter-end. The U.S. dollar fell 1.8% against the yen and declined 0.6% against the euro.
Asset prices are elevated, credit spreads are tight and generally, stocks have been reaching new highs, yet we look at the world through a cautious prism. We remain on watch for exogenous shocks to the financial markets.
We have previously shared our concerns about China, and we continue to see worrisome signs of potential destabilization—not least of which is that China’s six month moving average of monetary growth is at a five year low. Real estate transactional data in Beijing is weak. We have also seen further declines in iron ore pricing—a troubling indicator given China accounts for approximately half of global iron ore demand.
In contrast, in the U.S. the economy would appear to be overcoming earlier fiscal headwinds. There is increased optimism among business leaders and consumers alike, reflected in a general rise in stock and credit values. We are however mindful that excessive optimism is the enemy of the prudent investor.
The U.S. fiscal deficit is declining in large part due to a cyclical improvement in tax revenues but also due to ongoing interest rate repression. With Federal Debt at nearly one times GDP and interest rates anchored close to 0%, compared to a more normal rate of 4%, it is no surprise that the deficit and economic outlook appear benign. However, were interest rates to rise to more normal levels, conditions could swiftly change. The deficit would feel pressure from higher interest rates despite better tax revenues. Companies whose margins benefitted from reasonable demand being pulled forward from the future with easy policy coupled with moderating labor costs could see these trends reverse thereby making profits less responsive to the recovery.
In Europe, we continue to worry about the potential for deflation. Not only has credit growth failed to revive in Europe, but the currency has been on a strengthening trend for the past 12 to 18 months, forcing policy makers to make expansive comments regarding monetary policy. The European Central Bank (ECB) continues to extend wholesale funding to the European banks in order to revive credit growth, but the impact of this remains uncertain.
In the face of rising asset prices, despite these persistent vulnerabilities, we do not feel we are being particularly well rewarded for taking risk. Our underwriting approach is unchanged and we continue to be discriminating about allocating capital. We are alert to potential opportunities amongst new and existing investments, but our cash levels remain elevated as a residual of our selective purchases.
We continue to hold sizeable positions in gold bullion as well as gold mining stocks, and the portfolio benefitted when both rallied toward the end of the quarter. We consider it prudent to have gold as a potential hedge in an environment where risk perception is very low and real rates are structurally repressed. We have maintained a close to 10% asset weighting in the combined bullion and stock position in the portfolio.
Beyond gold, other strong performers for the quarter were our energy holdings, fueled in part by uncertainties in the Middle East, particularly the Sunni fundamentalist insurgency in Iraq.
Technology stocks also performed well, including Intel Corporation (INTC), as investors have recognized that that company’s scale in manufacturing may give it an edge in winning mobile device business as it evolves its product focus towards this market.
The largest contributors to performance for the quarter were Intel Corporation (INTC), Canadian Natural Resources (TSX:CNQ), ConocoPhillips (COP), National Oilwell Varco (NOV) and Cisco Systems (CSCO).
Top detractors during the quarter were Teradata (TDC), CRH (LSE:CRH), Berkeley Group Holdings (LSE:BKG), Vivendi (XPAR:VIV) and Jardine Matheson (SGX:J36). The biggest laggard in the portfolio was Teradata Corporation (TDC), a data analytics company. We believe it is a stable cash flow generating business based on recurring maintenance revenues with high customer retention rates.
We appreciate your confidence and thank you for your support.
First Eagle Investment Management, LLC