15 May 2015
2015 Q1 Investor letter (Extracts)
This may be the worst geopolitical situation of my lifetime. The situation the West faces today is more unpredictable than it has been since the end of the nineteenth century. All the big foreign policy decisions by the West since 9/11 have been proven wrong. As a result there is chaos in the Middle East, continuing conflict in Ukraine where a sovereign European state has been dismembered by the force of Russian arms and manpower, and there is significant tension in East Asia, where both Japan and China are rearming. We are likely to see increased military expenditure globally because of this uncertainty.
In Europe, increased defence spending will not happen immediately, but over a five-year time horizon it is likely that military spending will at least double. Germany will probably be the first to increase spending with the UK likely to follow. By some estimates around 6 per cent of GDP will need to be spent on rearming in Europe if Europe is to offer a proper deterrent to Russia. This increased spending will have consequences for inflation and perhaps interest rates; however, it will also help to absorb some of Europe’s long-term unemployed.
We often forget that it was not the New Deal that saved the US from the Great Depression, but there armament needed to fight the Second World War. Similarly, rearmament in Germany in the 1930 screated significant growth and reduced unemployment.
The Americans would doubtless welcome European rearmament; many Americans have long felt that Europe has been receiving American protection at no cost. A big question is the direction that America’s next president will take in terms of foreign policy. Some have suggested that a Republican victory at the next presidential election would result in a more interventionist and engaged US foreign policy, but there is a strong isolationist streak in the Republican Party and certainly the Russians, the Chinese and indeed the Israelis are expecting the US to continue to retreat from the world stage.
Meanwhile, the strong popular reluctance in Germany to further subsidise Greece’s membership of the European Union is likely to ultimately lead to Germany supporting a future ‘Grexit’ from the single currency. This could well happen in the run-up to the next German election, if not before. Chancellor Merkel would use this to neutralise the German Eurosceptics, the AFD, ahead of the election.
I believe a Greek exit from the European Union would be good for the Eurozone and good for Greece. Although there would undoubtedly be substantial short-term pain in Greece, the risk of contagion from a Greek exit is much less than it was a couple of years ago. The current situation humiliates the Greeks and frustrates the rest of Europe. There are also now warnings that the Greek crisis is starting to impact the broader economic recovery in the Eurozone.
In the West, falling oil prices are driving down inflation and may well result in a period of deflation. That is often talked about as a bad thing. But we shouldn’t forget that cheap oil is providing a significant shot in the arm for many industrialised economies, particularly Japan, China and Europe, all of whom are very dependent on imported oil. The big loser here is the Middle East, where the years of plenty might be coming to an end just as military expenditure is increasing.
Nevertheless, regardless of the world political and economic situation, most markets continue to be driven by central bank cash liquidity as opposed to economic fundamentals. Recently it has been the roll-out of the ECB’s $1.2 trillion asset purchase facility and Janet Yellen’s testimony about possible tightening at the March Federal Open Market Committee meeting that have most driven market sentiment.
It is believed that the US economy will be able to handle a rise in interest rates. After all, it got through a significant tightening in public spending with the ‘sequestration’ cuts in 2013, which were also widely seen as a potential brake on growth. The broader question, however, is the impact that it would have on emerging markets – when the Fed ‘tapered’ they were worst hit and a strong dollar is raising all kinds of questions for many emerging market countries.
Overall, we are near ‘full’ valuation in terms of world stock markets, and there may be a correction on the way. In particular, US price to earnings ratios are already looking distinctly 'frothy'. Even if we are not yet necessarily approaching ‘bubble’ territory, we are definitely in the later stages of a bull market cycle.
European stocks have made up substantial ground this year following on from the ECB’s commencement of quantitative easing. However, there will still be opportunities for Terra Firma as the European banks continue to get the distressed assets they are still holding off their books.There are a lot of under-invested, under-managed European companies: ‘zombie’ companies being funded by ‘zombie’ banks, of which many have not been fully recapitalised. That’s why we are still relatively bullish on Europe as an investment arena, despite the higher valuations.
The broader picture for our industry is that private equity exits are now at the highest level on record while buyouts have fallen to the lowest level since 2002. Private Equity News recently reported that there has been approximately $20 billion worth of acquisitions by private equity firms globally this year, down 53 per cent compared with the same period last year, when there were $42.7 billion worthof deals. Meanwhile, there have been 166 sales of assets by private equity firms for a record $63.5 billion so far this year. And with the industry sitting on over $1 trillion in ‘dry powder’, it’s clear that GPs are finding it hard to find good buyout deals. Nevertheless we remain convinced that there are good opportunities available for Terra Firma. They may be on the periphery, in difficult or distressed situations featuring complex regulatory or political circumstances, but those are often the opportunities where we can best add value.