Market Overview
In the second quarter of 2015, the MSCI World index returned 0.3% while in the U.S. the S&P 500 index fell 1.9%. In Europe, the German DAX dropped 8.5% and the French CAC 40 index fell 4.8% during the quarter. In Japan, the Nikkei 225 index increased 5.4% over the period. Crude oil rose 24.9% to $59.47 a barrel, and the price of gold fell 1.0% to $1,172 an ounce by quarter’s end.
The U.S. dollar strengthened 2.0% against the Yen and weakened 3.7% against the Euro.
Longtime investors in our portfolios know that we have been concerned for years about the financial repression by central bankers as well as the long-term impact of artificially low interest rates. We have recently seen signs that others are beginning to focus on these matters.
In its annual report published last month, the Bank for International Settlements asked: “Is the Unthinkable Becoming Routine?”1 The report noted the extended period of low global interest rates and went so far as to say low interest rates beget low interest rates through the perpetuation of debt growth and competitive policy easing. A cyclical response by central banks to the world financial crisis of 2008 has devolved into a generational shift. Global debt-to-GDP is higher today than it was in 2007, as debt shifted from the household and corporate sectors to the sovereign sector.
The day of reckoning cannot be delayed indefinitely, as Greece painfully demonstrated at quarter’s end. The standoff in Greece is reminiscent of the emerging markets debt crisis in the mid-1990s. In both cases, sovereign governments got into trouble by borrowing in foreign currency, so that they had to pay their debts in a currency they could not print. The challenges facing Greece are the exact opposite of the fiscal dynamic in the United States or Japan, where there is the ability to control the monetary supply. Consider that Japan has yet to reach economic equilibrium some 25 years after their financial crisis with interest rates still at virtu-ally zero. One could be cynical and say that Greece’s outstanding sovereign debt is a fraction of Apple’s market capitalization, and so, why does the country’s fate matter beyond its borders? Greece may be the proverbial canary in the sovereign coal mine. The outcome of Greece’s debt crisis will have potential repercussions for how the markets price sovereign risk, the European financial architecture, the emergence of broader capital controls, and the shifting political equilibrium in a world with excessive sovereign debt.
We are also keeping a watchful eye on China, given the recent decline in equity prices there. The Chinese are in the midst of a complex adjustment period, following an investment boom of record proportions. Now the government is tasked with shifting focus from investment spending to consumption spending. The problem China faces is that it is hard to stimulate spending when the core economic growth engines—exports and property development—are starting to soften. As a result, we strongly suspect the Chinese government will take further steps to ease policy. China’s leaders have a lot of levers that they can pull. But the equilibrium there is getting more complicated to maintain, and bears watching. While Greece may be a small economy, China is the economic equiva-lent of the proverbial elephant in the room. Its softening is already manifesting itself in pronounced weakness in global commodity prices and an evolving geopolitical dynamic in which there is a rapprochement between China and Russia whilst the relationship between China and the United States becomes more thorny.
As far as the health of the stock market overall, prices feel high to us. While price-earnings ratios are only slightly elevated, margins are quite high. By some measures we are approaching 1999 peaks in price-to-sale ratios—which could be a bad omen for equities.
As always, we never attempt to predict the overall direction of the markets, beyond highlighting where we see excesses and vulner-abilities. We continue to search for idiosyncratic opportunities in businesses that remain resilient in the face of cyclical disruption.
1. www.bis.org
Portfolio Review
On the surface, there was no common theme to our investments last quarter. Our opportunity set was fairly diverse reflecting primarily bottom up opportunities whereby long-term resilience became undervalued at the individual company level due to weak stock price performance in response to short-term fundamental disappointment. Our patience and company by company imple-mentation of investments enabled us to avail ourselves of these opportunities despite a rich market overall.
The five leading contributors to performance in the second quarter were Grupo Televisa (TV, Financial), Berkeley Group Holdings (BKG, Financial), Microsoft (MSFT, Financial), Sompo Japan Nipponkoa Holdings (TSE:8630, Financial) and Comcast (CMCSA, Financial). Strong performance in these names reflected sound business operating perfor-mance in the case of Grupo Televisa and Berkley, and the impact of rising Japanese asset values on Sompo’s book value.
For the quarter, the most material negative contributors in the portfolio were Oracle, Omnicom Group, Astellas Pharma, Teradata and Fanuc. The weakness in these names was not pronounced but the position sizes were larger than average. We believe the weak-ness in these names reflects the increasing tendency of investors in a narrowing market to shun companies reporting uneven results, even if those earnings misses are cyclical, rather than secular, in nature.
For the six-months ended June 30, 2015, the top contributors to performance were Sompo Japan Nipponkoa Holdings, Fanuc, Keyence, KDDI and MS&AD Insurance Group Holdings. The top detractors over the same period were National Oilwell Varco, Oracle, Intel, American Express and Cenovus Energy.
We appreciate your confidence and thank you for your support.
Sincerely,
First Eagle Investment (Trades, Portfolio) Management, LLC
