The First Eagle Global Value Team has structured what we believe to be an all-weather portfolio for our investors. With 2014 being a strong market for risk assets, it hasn’t been the optimal relative performance period for the portfolio. We ended the year with sound absolute returns in most currencies but we were below our real return goals in the United States due to the strength of the U.S. dollar. The weak spots in our bottomup performance were concentrated in the companies that own harder assets such as precious metals miners or energy extraction companies. Generally, the harder the assets, the softer the balance sheets and/or the free cash flow, and thus the weaker the stock price performance in the portfolio. This price action is entirely consistent with the flattening of the yield curves that we saw around the world for the sovereign markets and the widening of high yield credit spreads which implies lower global growth expectations. Also, consistent with this was the dramatic weakness in commodities; not just in energy, but also in agriculture commodities, in iron ore (which lost more than half of its value based on spot price over the last couple of years) and more recently in copper. While commodities have continued to be weak early into 2015, gold has decoupled and acted more like a monetary reserve than a regular commodity in the wake of the Swiss Franc de-pegging with the Euro and the initiation of European quantitative easing measures.
You may have heard us refer to Bill White in the past and we continue to focus on his work. Bill White is the former head of the Monetary and Economic Department of the Bank for International Settlements who predicted the credit crisis before it unfolded in 2007. The Bank for International Settlements, given its legacy as the central banks’ central bank, has often cast a more cautious eye on the global financial architecture than say the IMF or Wall Street consensus. Bill White is now the current chair of the Economic Development and Review Committee at the OECD in Paris. Speaking at a conference in New York towards the end of last year, he posed a very interesting rhetorical question which we’d like to paraphrase. In reference to the global economy he asked, “What if there is no equilibrium, what if the world economy is much more like a forest, which is like a complex system that’s path dependent?” Path dependent complexity means that the system plays out in ways that are difficult to predict based on what you do to it. He went on further to ask, “What if we’re actually on a bad path, a bad path caused by too much debt, exacerbated by the disinflationary pulse of too much labor?” These observations resonate with the themes we have discussed at length in the past.
On the subject of too much debt, we’ve repeatedly made the point in the last several months that globally, we have more debt relative to the economy today than we had before 2008.1 In essence, the deleveraging in the U.S. private sector debt has been more than offset by the growth in Chinese debt. Furthermore, within the developed markets, debt has also grown relative to output due to large growth in government sector debt and in certain high yield issuers. Regarding the disinflationary pulse from too much labor, we’ve spoken at length about factory automation taking away manufacturing jobs. This presents a structural headwind to employment in the world and a structural challenge for the emerging markets like China which has moved many people into manufacturing jobs.
A recent TED talk on the subject of technology with guest Jeremy Howard,2 who heads an artificial intelligence (A.I.) company called Kaggle, was quite illuminating and disturbing. He not only reinforced the message about technology substituting for human capital on the factory floor, but he took the point further to show how computers are within a handful of years of substituting for humans within the services industries as well. The capabilities of A.I. programmed computers could cover many of the jobs in lower-end services. He also mentions that during the Industrial Revolution machines were created that were more efficient than humans, but the growth curve gradually plateaued as the level of capital grew relative to the economy. Now, Howard describes a phenomenon that becomes self-reinforcing in which the nature of artificial intelligence feeds on itself. So what starts to happen in the services sector in the next handful of years will be a trend in the next decade and beyond that accelerates in nature because machines will learn from their learning. Long term, it was beneficial to move people out of low-end agricultural jobs into manufacturing and services. Likewise, it should be positive long term for productivity to employ less people in manufacturing and services jobs in order to free their time for higher and better use; but these trends can be quite disruptive for the impacted generation.
The forces of too much debt coupled with IT substitution for human capital are going to be with us for a long time, exacerbated because debt levels are generationally high and the forces of disruptive IT-related change are accelerating. Add to that the geopolitical developments in the Eurasian continent—Russia, China and the Middle East—which are moving away from the American and European policy agendas.
Additionally, the broader emerging markets may be moving from the growth solution of the last 5-10 years to a more complex and potentially problematic set of markets. The emerging markets have had epic investment booms for the last decade that are starting to cool, as evidenced by tumbling commodity prices. This, in turn, is invoking policy behavior in those markets which may become more populist and nationalistic in nature.
Perhaps Bill White is correct in saying that we’re a long way from equilibrium. When we reflect on the patterns of history, in instances where there has been marked disequilibrium in the world, be it geopolitical or economic, it often takes a combination of policy blunders and crisis to force a more rational hand. Rational hands don’t always come about spontaneously from policy makers who otherwise have to deal with the agency issues associated with a short-term political process. Democracies sometimes struggle with making tough long-term decisions. We worry further about liquidity in fixed income capital markets—especially in a post Dodd-Frank world where dealers hold less inventories—if we get either policy blunders or a crisis. The stunningly low long-term developed market sovereign bond yields represent a flattening of yield curves without short-term rate rises and are potentially signaling a generation of lower than usual nominal growth in the developed world. Combining the questions over nominal growth in the developed world, the slowing growth message implicit in falling base metals commodity prices for the emerging markets complex and the questions raised around the world’s financial architecture on the heels of gold’s recent strength versus other commodities, it’s a complicated macro picture indeed.
There are things that could go right. Low oil prices are arguably a boon for the world economy and the low level of interest rates are stimulative in nature. These combined forces ought to produce some short-term positive demand boost. However, the longerterm secular issues remain in place against a backdrop where the global business capital spending cycle may already be above trend and moderating based on the huge and slowing China-related investment cycle. If the world experiences low secular growth in nominal terms in an atmosphere of geopolitical uncertainty, it will make generationally high levels of government debt less sustainable. It makes us wonder how resilient our social contract will be in a world of crisis that requires either higher taxes, lower entitlements or further monetization measures to cure public debt levels.
When Kimball and I sit down and think about the world, these are the things that weigh on us heavily. The reason we are casting a wary eye is that when we look at the world bottom-up, despite the fact that we view ourselves as being in a troubled world, new investment ideas that embody a margin of safety in price and prospects have actually been harder to find. You would think in this kind of complex and troubled backdrop the world would be replete with bottom-up opportunities, but it’s not. What has actually happened is that higher prices have forced our bottom-up search for opportunity to move from a broad-based search across many sectors in the wake of the crisis in 2008-2009 to something that’s far more selective. It’s become a careful search for resilience.
We’ve talked a lot about the notion of scarcity either in tangible business assets or in intangible market position as a root cause of resilience. However, the kind of resilience we’re starting to look for is not just based on scarcity. More than ever we’re starting to focus on management teams that have a willingness to distribute cash to shareholders be it through dividends or repurchase, and that are in a phase of what we’d refer to as “behavioral prudence.” The emergence of prudent behavior typically arises when specific sectors are already out of favor in a world of otherwise peak margins and high multiples or because specific companies are facing new and potentially threatening competing product trends that necessitate some form of adaptation. As part of our selective business search, we are seeking franchises within cyclical areas that are cyclically depressed or franchises that are in question—but that have the potential for durability (with adaptation at the margin) because of their existing competitive advantages. In a more risky and more highly valued market, there has to be some form of a negative sentiment for you to get a resilient business at a good price. Some of the areas that are cyclically out of favor that have grabbed our research attention in recent quarters have been pretty varied—areas such as insurance, agriculture and more recently in energy with the price of oil dipping below $50 a barrel in January.
One thing we would like to mention though is the patience that served us well as sellers on the way up in the market is also likely to be deployed as we become selective buyers in these areas of cyclical or product distress. We are waiting for what Ajit Jain and Warren Buffett (Trades, Portfolio) refer to as “the fat pitch;” so don’t expect dramatic shifts in the portfolio. We’re legging our way into situations one at a time. To see a more dramatic shift in the composition of the portfolio would probably require lower risk asset prices across the board; that’s when we tend to get most emboldened. When people start to price risk, we put capital to work. In that regard, it’s been a healthy start to the year with markets softening.
In terms of our cash reserves, which we think of as deferred purchasing power, we have also spent some amount of time looking at sovereign opportunities in countries where fiscal realities may be better than the United States and currencies may be cheaper after the pronounced recent strengthening of the U.S. dollar. These are not yet large positions, but we may see more opportunities to diversify our deferred purchasing power on advantaged terms if the dollar strength persists. The market is starting to price in a healthy dose of U.S. exceptionalism. While we agree that the U.S. has certain structural attractions in terms of the dynamism of its business, labor and education markets, the U.S. also suffers from excessive levels of total debt and a structural shortage of domestic savings relative to investment due to its reserve currency status. The strength of the dollar could exacerbate these imbalances and lead to a moderation in business confidence. We don’t try to predict interest rates, but it strikes us that the U.S. would likely struggle in the face of more normal interest rates.
The final thing we would like to reiterate is that gold remains a mainstay for us. If the concern is finding areas of less sovereign debt risk, then gold is nobody’s liability. The criticism of gold has always been that it doesn’t have a yield but nor does the sovereign debt today! The opportunity cost of owning gold has gone down dramatically when you think of the yield curves of Japan, Germany and France all being anchored below 1% going out a decade. The Swiss yield curve has actually been negative over this time horizon and the U.S., even in a window of perceived relative economic strength with a 5% GDP growth quarter, has a 10-year Treasury yield below 2%. The opportunity cost of owning something without credit risk is lower still. Easy money does not cure structural imbalances and it arguably makes the long term worse by encouraging more debt and less restructuring than would otherwise be the case. Central bank balance sheets have weakened too with large amounts of quantitative easing and a proliferation of promises to be credibly irresponsible in order to lift inflation expectations.
Meanwhile, gold cannot be printed and generally gold miners are slashing capital spending. Gold, which remains scarce and long-lasting with limited opportunity cost, remains an important potential hedge to the frailties of today’s global financial architecture. In heated markets, we thank our long-standing clients for sharing our sense of patience and discipline in capital allocation and we look forward to serving you as prudent stewards of your capital in the years ahead.
Sincerely,
Matthew McLennan
Head of the Global Value Team
Portfolio Manager Global, Overseas, U.S. Value and Gold Funds
T. Kimball Brooker, Jr.
Portfolio Manager Global, Overseas and U.S. Value Funds
