01 August 2011
2011 Q2 Investor Letter - TFDA
As I have said over the last few years, high levels of volatility in financial markets are set to continue for the foreseeable future. The imbalances in the West will not be dealt with easily and will cause grave concern for the world’s economic system for some time to come. In the 1970s, when the West confronted similar problems, it grew its way out of them, largely through globalisation. This time any solution will involve the pain of reallocating the global economic cake. This will require substantial political will – something that the West has demonstrated recently it does not have.
In Europe, company and sovereign debt problems are typically being addressed by an ‘amend and pretend’ policy and there has been a failure to deal with the weaknesses in the banking system. As a consequence, there are few effective ways of dealing with the sovereign debt issues that are affecting Europe without jeopardising the overall banking system. My estimate, based on conversations with senior bankers in Europe, is that somewhere around €300 billion of fresh bank equity needs to be injected into the European banking system if European banks, including those based in the UK, are going to be strong enough to take the pain needed to clean up the European company and sovereign debt problems. Only then will they be in a position to start actively lending again to small- and medium-sized businesses, and it is only by promoting growth within those that general European economic growth will be rekindled.
European politicians are avoiding the question of how to recapitalise the European banks and are instead focused on the debate between those who want fiscal and political union and those who will not accept its consequences. Pro-union supporters are clear that, in the long term, the choice for the Eurozone is either to evolve into a federalist Europe or to face the political and economic consequences of the breakdown of the European Union. Opponents, meanwhile, want to leave Greece and other peripheral countries to the fate of the free market and have them leave the euro.
While it is difficult to predict the outcome of this debate, it is clear that the route of European political and fiscal union would take time and would continue to require substantial economic support from Germany. The alternative option, of Greece and other peripheral countries leaving the euro, would see the southern European Union countries becoming substantially poorer than they are today, but regaining the ability to determine their own futures.
Meanwhile in the US, the political impasse over raising the debt ceiling has demonstrated that while ‘extend and pretend’ is not sound fiscal policy, it is the only policy for which there is any political consensus amongst American politicians. With the US economy barely out of recession, if at all, it is clear that persistent high levels of borrowing by the US government, and the effects of pumping vast amounts of money into the US financial system, has been as unsuccessful in the US as it was in Japan. While the long-term economic problems the US faces are, on the face of it, far greater than those in Europe, the view has always been that the American people are united and have the political will to solve such problems in time. Unfortunately, recent events have put America’s political will in the spotlight and shown it to be lacking. It is little wonder that S&P downgraded the US credit rating and that central banks are increasingly nervous of holding the dollar. The West is likely, for the time being, to muddle through these crises.
In my opinion, the adjustments needed in the West will become increasingly painful, both economically and socially, the longer that the overspending in the US and the lack of banking capital in Europe are allowed to persist. At the same time, political instability in the rest of the world is going to increase and the West will be progressively less able to affect what happens. Involvement in political unrest occurring in non-Western countries through military action, like that taken in Libya, will become increasingly expensive; and citizens in the West will become less and less likely to support such actions.
Investors and the capital markets are also searching for stability. While credit conditions had eased considerably since the worst of the credit crisis, they are now tightening again, and we are still at risk of returning to conditions as bad or worse than those that existed in 2008/2009. It is little wonder in these circumstances that Western investors are searching for safety, be that through buying gold or keeping their money in cash. This, of course, further starves the Western economic system of the funds needed to grow and increases the likelihood of a meltdown. If history is any guide to the future, Western governments now have less than 18 months to restore confidence before the effects of a reduction in long-term investment push their economies into a depression.
However, although the West faces serious challenges, the Eurozone in general – and Germany in particular – is a more attractive market in which to invest at present than the UK or the US. The US has barely begun to address its fiscal imbalances, and continues to bank on a consumer recovery that is unlikely to happen; the UK has taken a greater number of steps to reduce the size of government, but lacks the catalyst to drive sustained economic growth.
By contrast, while the Eurozone has a very large banking problem to solve, it is better positioned to solve some of its economic problems by exporting to Asia and the emerging markets: and certainly Germany is among the best placed within the Eurozone to do that. Nonetheless, the sovereign debt negotiations, the most recent ‘solution’ and the scope of the bailout have hit German consumer and business confidence. It therefore comes as no surprise that the manufacturing and services sectors, the drivers of German exports, are showing signs of slowing as we enter the third quarter. However, German unemployment held steady at 7 per cent and remains at its lowest level since reunification. Housing prices rose slightly in June led by apartments, which were up 1 per cent according the Hypoport House Price Index.
It is important to remember that Germany has not experienced either boom or bust in its housing market over the past decade. From the depths of the credit crisis in the fourth quarter of 2008, residential real estate values in Germany fell just 0.7 per cent from a year earlier; while the UK suffered a 15 per cent decline, the US was hit by a 12 per cent drop and Ireland fell by 9.1 per cent. Of course, Germany still has one of the lowest incidences of home ownership in Europe at 43 per cent.
In this economic environment, Deutsche Annington is an excellent asset to own. The stability of its rental portfolio makes it precisely the type of investment one wants to hold as the Eurozone comes to terms with the recapitalisation of its banking sector.
During the quarter, Deutsche Annington experienced a material pick up in sales volume and prices; a trend seen in a number of German markets. Its rental business also performed solidly and, overall, it finished the first half of the year ahead of budget on all of its financial targets.
Meanwhile, we continue to make progress on the restructuring of Deutsche Annington’s debt. We are working closely with the company and its adviser, Blackstone, to explore refinancing options for the bond securitisation and hope to make significant progress during the remainder of the year.
We very much appreciate your ongoing support.
With best wishes,