Chairman's letters

24 November 2014

2014 Q3 Investor Letter (Extracts)

The global economy seems to be moving in two different directions. While the American and British economies are enjoying steady growth, the rest of the world seems to be slowing down, with the Eurozone possibly facing stagnation or even deflation.

The US economy, in particular, is gaining traction as the year comes to a close. Following a decline in the first quarter, it grew at an annual rate of 4.2 per cent in the second quarter followed by 3.5 per cent in the third quarter, propelled by solid gains in business investment, exports sales and the biggest jump in military spending in five years. On the back of this positive outlook, the Federal Reserve has announced an end to the quantitative easing programme it started nearly six years ago, while reiterating its commitment to leave rates on hold in the coming months. The UK, too, has solidified its position as one of the fastest expanding G7 economies, recording third-quarter growth of 0.7 per cent and giving an annual growth rate of 3 per cent.

This positive news is in contrast to the problems currently being experienced in the Eurozone. Whilst some member countries undertook structural reforms and are now reaping the rewards, others continue to struggle or are seeing their recoveries slow down.

Eighteen months ago, Spain embarked on a major programme of financial sector reform and, as a result, has substantially reduced the economic threats that were emanating from the banks. It has restructured what was previously one of the world’s most generous pension systems and has made its tax system simple and more efficient. Clearly Spain still has a long way to go; however, it is currently enjoying an annual growth rate of 1.2 per cent. Ireland has also made progress, with banking sector and labour market reforms and the introduction of a raft of new taxes since the crisis began. With the Irish government taking active steps to restore the long-term stability of public finances, the public deficit is set to fall to 4 per cent of GDP by the end of 2014 from a high of over 32 per cent in 2010.

Ireland and Spain’s approach differs from that of France and Italy whose economies are now either stagnating or deflating. Whilst France continues to insist it is not the ‘sick child’ of Europe and Italy experiences its third period of recession since 2008 both have, up until now, avoided structural reform. This may be set to change as the European Central Bank has admitted that current monetary policy may not be sufficient to stimulate enough demand for the Eurozone economies to recover and that a viable plan to save the Eurozone must also include structural reform, banking reform and sound public finances.

Even Germany, which has long been the powerhouse of Europe, is stalling. Economic growth forecasts for next year have been cut to 0.8 per cent from the government’s target of 1.3 per cent, largely due to a steep decline in forecast investment growth. The Eurozone is on the verge of tipping into its third recession in six years. Overall inflation for the area has slipped to 0.3 per cent and may well result in outright deflation next year.

The emerging markets too are a cause for concern, with growth in the region falling to its lowest level since the aftermath of the financial crisis. This is primarily due to spluttering growth in Eastern Europe, a slowdown in Latin America and Russia, and China losing some of its sheen. The Chinese economy grew by 7.3 per cent in the third quarter year-on-year, well below the 10 per cent pace it has averaged over the last 30 years. Dr Bob Swarup discusses China’s predicament in more depth in his article “Recasting the Iron Rice Bowl: Chinese Whispers from Consumers” later in this report.

Meanwhile, the world is facing the most dangerous combination of geopolitical crises since the Cold War. We have seen that social media can quickly mobilise large groups of people, meaning that social unrest can escalate at any time and in ways that are unpredictable. This happened recently in Hong Kong, with the so-called ‘umbrella revolution’. Although the movement is now more manageable from the government’s perspective, it seems that Hong Kong is headed into a difficult situation where there will be constant, nagging protests from activists who will continue to demand reform.

In the Middle East, the situation is dire with Islamic State having gained control of a quarter of Iraq and a third of Syria in just two months. Having used social media to attract recruits, raise its initial finance, transfer money and mobilise support both locally and internationally, Islamic State is engaging in further military campaigns under the momentum of its victories, bringing its war against Western values to the very edge of Europe. Indeed, the threat from Islamic State militants is considered by many to now pose the biggest threat to the West since the Soviet Union with Western governments, facing a crisis of leadership, slow to react.

There is also the prospect of a global pandemic in the form of Ebola. With wealthy countries focused on healing their economies, politicians were initially slow to address problems they felt were far away from home. However, Ebola is now a serious global threat with the World Health Organisation declaring it an international health emergency in August. Such an outbreak could have been prevented if it wasn’t for political lethargy in the West and a lack of crucial funds.

The West has finally woken up to the reality that this virus could have a serious global impact. Less than 100 years ago, Spanish influenza swept the world, killing tens of millions of people. The world population today is more than three times larger than that in 1918, and while modern medicine has made tremendous advances since then, it is entirely possible that Ebola could have a similarly devastating effect on parts of West Africa and beyond.

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