Market Overview In the third quarter of 2013, the MSCI World index increased 8.2% while in the U.S. the S&P 500 index rose 5.2%. In Europe, the German DAX increased 8.0% and the French CAC 40 index increased 10.8% during the quarter. The Nikkei 225 index increased 5.7% during the period. Crude oil increased 7.6% to $102.33 a barrel, and the price of gold increased 7.7% to $1,328.01 an ounce at quarter-end. The U.S. dollar fell 0.9% against the yen and dropped 3.8% against the euro.
Looking back on the quarter, investors might be cheered by the strong market performance. But with the fifth anniversary of the financial crisis upon us, we think it is important to recall the financial fault lines that we monitor globally which keep us from feeling complacent.
There are numerous signs of improved business and market sentiment in the U.S.: The National Association of Purchasing Managers’ Index is currently above average; implied volatility has declined from 40% to approximately 16% in the equity markets.1 The spread between high yield bonds and Treasuries has dropped from 1000 basis points to below 500 basis points.2 Further, cyclical commodities, such as oil and copper, have rallied relative to the price of gold.3
The global imbalances we have previously discussed have moderated somewhat, but sovereign debt levels still approach 100% of GDP in developed economies around the world and with unemployment levels in many of these developed countries still close to double-digits, we expect to see a continuation of the financial repression that we have seen since the crisis.
Our views regarding these macro-economic imbalances are analogous to the analytical approach we take toward the securities in our portfolio—they may be viewed as the macro equivalent of exactly the kind of things we’d focus on when we look at individual businesses, such as the health of the firm’s cash flow statement and the strength of the company’s balance sheet. A current account deficit is akin to being free cash flow negative. The persistence of current account imbalances over long term periods of time has led to investment and credit risks in both surplus and deficit countries respectively.
A company with sustained negative free cash flow will need to either issue debt or dilute existing stockholders. In the U.S., if we refer to our business analogy, the government has effectively taken the route of increasing the number of “outstanding shares”. The Federal Reserve has kept interest rates low for an extended period and at the same time is growing the money supply by approximately 6-7% a year.4 This strategy is equivalent to a company that does not pay dividends on its stock, but instead issues 6% to 7% more shares each year to “fix” its balance sheet.
In the short term, these artificially low rates have caused a rally in stocks and corporate bonds while not of bubble levels. Stocks in many cases are trading 10% or 20% above where we would feel comfortable being buyers. The housing market has also strengthened, as the cost of mortgage financing has declined.
Clearly, the Federal Reserve wants consumers to feel comfortable spending again. The problem with this strategy is it discourages Americans from saving. Household savings rates are at just 4% — half their historic levels.5 The shortage of domestic savings is arguably the root cause of many of our balance sheet problems. While the government’s policies may stimulate short- term demand, they do not promote long-term health of the U.S. economy.
In China, imbalances of a different sort persist. To continue with our analogy, China’s spending policies are similar to those of a company with plentiful free cash flow that does not know what to do with its money. The Chinese economy has experienced an epic investment boom with fixed investment close to half of GDP compared to world norms close to 20%, according to IMF data. So, while many investors believe China has already adjusted spending, in fact that transition has barely begun.
At the same time, China is adjusting its investment spending; its currency is suddenly looking less competitive relative to its neighbors. Just in the last quarter, we saw approaching a 20% adjustment in the Indonesian rupiah and the Indian rupee.6 Over the last six months, we’ve seen a 20% similar decline the price of the yen.7 The Malaysian ringgit and Thai baht have also softened. This will place competitive pressures on Chinese export margins.
Our concern is that, just as investors in 2009 underestimated the positive impact of China on the world recovery, they could fail to anticipate the potential for China to go through an adjustment that could have a negative impact on the price of risk assets globally. A slowdown in Asia, led by China, could hurt emerging markets that sell a great deal of commodities, such as Brazil. Stock prices among the BRIC countries have started to moderate in recent months, but most sovereign businesses in these markets are still trading above levels that we find attractive.
Similarly in Europe, we feel investors may be too aggressive in pricing in a recovery. While some of the weakest countries have made strides, we remain wary regarding the core of the euro zone. For example, France has not adjusted its labor costs like Spain and Greece. Despite this underlying weakness, some of the more defensive names in Europe continue to trade above levels we find attractive.
In the meantime, we maintain what we feel is a healthy cash balance and are selling some of our less-liquid positions. We remain patient as we await bargains and focus on producing long-term real returns by identifying businesses that we believe embody some form of scarcity value.
First Eagle Global Fund Q3: Portfolio Review
Among the strongest performers in the third quarter were European cyclicals such as Bouyges SA, due to the optimistic economic sentiment regarding a recovery in the region. In addition, the price of gold recovered, reflecting investor unease. Keyence Corporation (TYO:6861), SMC Corporation (OR) (OTCMKTS:SMECF) and Secom Co. Ltd (TYO:9735) were also top contributors to performance for the quarter.
We saw weakness in our food-related holdings. This included our holding in fertilizer producer Potash Corp./Saskatchewan (USA) (NYSE:POT) (TSE:POT) and also Sysco, a food service retailer.
The decline in SYSCO Corporation (NYSE:SYY)’s shares reflects a weakening in restaurant spending – perhaps notable signs of caution by U.S. consumers. The fertilizer company was affected by the decline in agricultural commodities, particularly corn. That price weakness in turn impacts expected demand for fertilizer, as farmers adjust their harvest plans.
The market for potash, a key fertilizer, was also disrupted last quarter by the breakdown of the longtime oligopolistic marketing cartel, which consists of two main players. We believe that long term, potash suppliers should remain a highly consolidated commodities market.
Intel Corporation (NASDAQ:MSFT), Astellas Pharma Inc (TYO:4503) (OTCMKTS:ALPMY) and Microsoft were also among the top detractors to performance in the third quarter.
We continue to believe Microsoft Coporation (NASDAQ:MSFT) is misunderstood by investors. The company has more than doubled its cash flow over the last decade, has offered a significant dividend and repurchased shares. Microsoft generates most of its earnings power from its corporate business—not just sales from operating systems but also the whole ecosystem tied to that, including its Office and server suite of software. Much of these corporate revenues have been