14 August 2015
2015 Q2 Investor letter (Extracts)
The drama in Greece has dominated the news recently and, although at the time of writing a deal has apparently been done, I am not optimistic about its chances of success. Greece’s creditors, led by Germany, have adopted a hard-line approach in order to prevent other countries with similar problems trying to renegotiate their debts. A write-down of the sort advocated by the IMF would have encouraged countries like Spain, Italy, Portugal and Ireland to seek to have their debts reduced, and that would have been unacceptable to Germany and its allies. Syriza played its hand badly, managing to exacerbate the situation by destroying any remaining goodwill that other European Union (‘EU’) states may have felt towards Greece with a series of aggressive and erratic tactics.
The deal that has been struck leaves Greece with too much debt to service and is too punitive in trying to force a country in distress to deepen an already painful austerity programme and run primary budget surpluses. A future Greek government will be back at the negotiating table when the current programme fails. By that time, we will be left with the only solution which is going to work long-term for Greece – namely, it having its own currency which it can then devalue.
The result in the British general election was a major surprise for nearly all the pollsters and pundits – and for me personally. There are obviously consequences for Terra Firma’s investments, given our substantial UK holdings. At a simple level, the Conservatives have clearly done a good job on the economy and their continuing in power is a positive for our UK portfolio businesses that depend on ongoing retail confidence, like Wyevale Garden Centres or Odeon & UCI. However, do have grave concerns about the Conservatives’ policy on onshore wind, their raising of the minimum wage, and their disastrous cuts in local authority funding for care homes.
The biggest concern though is that the Conservative victory means there definitely will be a referendum on whether Britain will remain in the EU. I don’t think David Cameron wants the UK to leave the EU. However, can he get a deal with the Europeans which he can then sell to his party and then to the British people? European leaders seem to be sympathetic to a deal and appear willing to offer some concessions so it is likely that Britain will remain in the EU. Nevertheless, there may well be some political theatre because it is in the interests of both Cameron and the other European leaders for there to appear to be a titanic struggle in which the UK demands major changes, is rebuffed, and finally a reasonable compromise is agreed.
However, this could get very messy because not everyone in the Cabinet, or indeed the Conservative parliamentary party as a whole, will accept whatever deal is done. The recent fuss over what would happen to Cabinet ministers who wanted to campaign against the UK continuing in Europe in the referendum is just a small taster of what is to come on this front. And as we saw with the Scottish referendum, once a campaign gets going, a whole new set of dynamics comes into play and the outcome becomes less predictable.
I think Britain leaving the EU would be a disaster for Britain, but also a tragedy for Europe. It would be calamitous in economic terms for Britain and from Terra Firma’s perspective would jeopardise our investments in the UK. We would have to think very carefully about whether we wanted to stay invested in Britain. For the rest of Europe, a British departure could set in train a series of events that could lead to a break-up of Europe. Consider what happened to the old Soviet Union and the former Yugoslavia. When one of the big states left, the rest started squabbling, and before long the bickering turned to violence. If the EU is estabilised, I would really worry about the prospect of another war in Europe, something the EU was originally set up to prevent.
It is a pity that Europe is having to devote so much time to its own internal problems at a time when it faces significant external threats both to its stability and its security from the ‘arc of instability’ that surrounds it, stretching from Russia in the east, through the Middle East and into North Africa. The violence in Iraq and Syria, the wave of North African refugees and the recent terrorist shooting in Tunisia are symptomatic of fundamental problems in the MENA region. Ongoing civil disorder, huge population growth and continuing economic stagnation mean that there will be ever-larger movements of refugees and migrants from the MENA region towards Europe, a journey often fraught with grave danger.
The instability in the Middle East is one of the consequences of the continued retreat by the US from its former role of global superpower. American military withdrawal from Iraq has created a power vacuum in which terrorists like ISIS have flourished and US inaction on the civil war in Syria has meant the conflict has not been resolved, with tragic humanitarian consequences. In Libya, the US let others take the lead in the overthrow of Gadaffi and has been unwilling or unable to help restore order in the ensuing chaos. And most recently in Yemen, a proxy war between Iran and Saudi Arabia has broken out with the US again on the sidelines.
One consequence of heightened tensions across the Middle East is that regional rearmament is likely to intensify. Increased military expenditure may well come at the expense of money being deployed to the large sovereign wealth funds in oil-rich states which would have a global economic impact. Assets as diverse as British real estate, French football clubs and Canadian farmland, for example, have all benefited from Middle Eastern investment. Those investment flows could now slow or even reverse.