May 11, 2010

Confusion and Complacency Abroad

Even though Labor held a strong majority of seats in Parliament it looked like the conservatives would make important progress in gaining political power.  Suddenly, seemingly out of nowhere, the Liberal Democratic Party candidate, Nicholas Clegg, surged forward.  He was younger than the other two and proved to be a one-man Tea Party, lashing out at the other candidates and appearing to oppose everything they stood for.  For the first time in its history Britain had a series of three television debates giving Clegg exposure to a broad national audience and throwing the election into turmoil.  Clegg did not do well in the election, however.

Brown’s popularity was hurt in the week before the vote when he referred to a Labor rally attendee as a bigot after she asked him a question about his immigration policy.  As a result he had to pay a visit of apology to the insulted lady which lasted almost twice as long as his recent meeting with President Obama.  The result of all this is that the general election has resulted in a hung Parliament where it will be very difficult to pass any meaningful legislation.  This makes the situation in the United Kingdom akin to that of the United States where major programs have had a difficult time winning Congressional approval.

The parallels run deeper.  Both the United Kingdom and the United States have a high standard of living and are major centers of finance.  The U.K. has attracted a number of wealthy Russians, Middle Easterners and Asians because of its agreeable lifestyle and favorable tax policies regarding income earned abroad.  Both countries face a likely decline in their standard of living as a result of government measures to try to control the budget deficit and higher taxes as well.  But the general population of both countries doesn’t want to make sacrifices and any politician supporting service or benefit reduction programs is likely to run into trouble in the next election.

The budget deficit in the United States is about 12% of gross domestic product (GDP) and the Federal debt is 84%.  In the U.K. the deficit is 13% and the total debt is 71%.  Greece has a budget deficit of 13% and the total debt is 113%.  The numbers are not that different.  The difference is that both the United States and the U.K. can currently finance their deficits at attractive interest rates and Greece cannot.  The big question is whether the financing difficulties will converge if little or nothing is done about the deficits in England or America.  For some time I have been wrestling with the deficit problem, having seen the Federal debt rise for most of my lifetime.  I have never bought into the argument that our grandchildren will have to pay the debt back because I am somebody’s grandchild and I haven’t paid a penny of the World War II debt back that was incurred when I was young.  What I am worried about is servicing the debt.  The United States is expected to run a budget deficit of $1.6 trillion this year and the deficit is unlikely to drop below $1 trillion anytime in the next several years.  Debt service on the national debt will be about $250 billion this year or less than 2% of gross domestic product of $15 trillion.  If interest rates rise and we keep running trillion dollar deficits, the debt service might be as much as $750 billion on a $20 trillion economy or almost 4% by the end of the decade.  A condition where the debt service is growing faster than the economy is threatening because it puts the country in an economic spiral where it is always having to raise taxes or cut spending just to service its financial obligations.

Overseas, as you would expect, there is a great deal of concern about the resolution of the financial crisis in Greece.  Most investors worry that contagion throughout southern Europe is an imminent danger and are confused about its implications.  They see little political will in Germany or the European Union generally to alleviate the situation and believe the International Monetary Fund lacks the resources to deal effectively with the problem.  If Greece defaults, the effect on European banks would be serious.  The fear is that overall trade and business activity would slow down as a result of austerity measures taken in Europe’s southern tier and this would happen at a time when Europe’s recovery is both shallow and fragile.  Recent data from Germany, France and the Netherlands, however, indicate stronger growth than was expected earlier but that doesn’t mean that the momentum can’t change to something less favorable.

We now have a €110 billion aid package for Greece over the next three years.  The European Union was unprepared for the Greece crisis and worked out a plan to defer the problem. I believe that the Union will hold together in its present form for another year.  Greece will promise to get its budget deficit in line and Spain and the other countries with large deficits in relation to their economies will promise to exercise fiscal discipline.  Right now the German banking system has too much to lose by a Greek default.  Over the next year the European Union will get ready for a split.  If the financial situation in southern Europe and Ireland has not improved, I believe the weaker countries will be asked to leave the common currency plan but will be able to remain members of the Union.  In that way they can devalue to increase their competitiveness and restructure their debt.  The euro will continue to be used in Germany, France and the Netherlands, but we may see a return of the drachma, lira and other currencies.  I hope it doesn’t come to that but that outcome is a possibility we should prepare for.  It would be very complicated to implement, however. 

Aside from Greece, the second worry I encountered from U.K. investors was whether the economic recovery in the United States would continue. In my mind the prospect of a double dip in the U.S. economy where the economy goes back into recession has diminished during the first four months of the year.  In January I would have put the odds at 25% but now with consumer spending strong I would reduce the probability to 10%.  In England, however, concern about a U.S. double dip remains real, perhaps because that economy, while in a recovery phase, is not as strong as what’s happening in America where first quarter real gross domestic product growth has just been reported at 3.2% in spite of the severe winter storms.  This is good but not as strong as I expected.  I anticipate a further increase in business activity as we go through the year.

The third major concern of U.K. investors is inflation.  Many investors there were trained in classical economic theory and know that high levels of money supply expansion usually lead to inflationary pressures.  I worry about this also but without wages increasing (most of us are glad to have our jobs these days) or house prices rising I see little near-term danger of sharply rising inflation.  A fourth concern is monetary tightening to control inflation (India and China) or real estate overbuilding and speculation (China).  My view has been that India, China and the emerging markets generally are rapidly growing economies subject to both economic and stock market volatility.  Valuations can become excessive and dangerous short term but I believe the developing world will grow at better than 5% (in some cases much better) over the next five years and Europe and the United States will struggle to grow at 3%.  Most U.K. investors are underweighted in emerging markets (like investors elsewhere) and intrigued by the potential opportunities there but they are wary, complaining that good values are hard to find and the volatility makes them uneasy. 

Finding value is the major concern of Middle East investors.  With the price of oil above $80 the region is in excellent financial shape.  The landscape is continually changing.  Universities are being built, wide highways stretch in all directions, traffic is heavy and cranes seem to be working everywhere.  The financial problems of Dubai have been absorbed without causing significant dislocations and the focus now is finding profitable industrial projects in the Middle East that can take advantage of inexpensive energy sources and finding rewarding investments abroad for the vast resources of wealthy families and the sovereign wealth funds.

In the Middle East there seems to be a theme that too many bad things are happening in the world at once.  There is a rescue package but not a solution to the Greek financial crisis.  The U.K. and the U.S. appear to have dysfunctional governments incapable of dealing with budget or social problems, India has growth but also serious inflation and China’s real estate problems are troubling.  At the present time all of these seem containable but in a world where economies are interrelated there is the fear that one day in the near future the whole financial system will start melting down again.  Investors remember that when the sub-prime mortgage problem first appeared in the United States in 2007, it looked like it could be handled without becoming toxic to the whole financial network and look what happened.  One question that was asked plaintively was, “Where are the risk-free assets?”

My tenth surprise this year was that Mahmoud Ahmadinejad would be removed from power in Iran using election fraud as an excuse.  My reasoning was that the youthful population of Iran wanted more economic opportunity and the chances of that developing with the sanctions being imposed and little investment or aid from the developed world were dim.  If a less radical leader were in place and the nuclear weapons program were suspended, Iran would be able to join the world economic community.  Most, but not all, of the investors I spoke with in the Middle East thought that was wishful thinking, but nobody wanted Iran to have a nuclear weapon.  They thought that would radicalize the entire region.  While the countries I visited were fearful of Iran, business was being conducted without much concern.  Iran was viewed as a market for the region’s goods but not a competitor.  Some believed the United States should be much more proactive in negotiating with Iran even if efforts have been unproductive so far.  There was a feeling that the more the West challenged Ahmadinejad, the more deeply entrenched he became and bombing Iran would be viewed as imperialist encroachment on the region, which would bond countries with opposing interests together.  The region is currently operating as though war were not a possibility.

The most important issue in the region was the Israel/Palestine problem.  Many expected the United States to play a stronger role in resolving the conflict by forcing Bibi Netanyahu to agree to a two-state solution and to definitively divide the territory fairly, which might involve removing some of the settlements.  I explained that the United States did not have that much influence over Israel and Netanyahu himself did not have sufficient power over the right wing in his own country.  I didn’t think a solution was at hand but many in the region believe that if an agreement would be reached, Iran would be more agreeable to withdrawing from its nuclear program and other problems in the region would diminish.  A friend of mine who is very knowledgeable in this area once said to me, “This is not a problem that can be solved; it can only be managed.”

I told all the overseas investors I met with that I did see values across the globe.  I said high yield bonds, mortgages and leveraged loans in the United States were attractive.  I thought investments in hedge funds, private equity and real estate would prove rewarding.  I believed most investors were underweighted in emerging markets like India, China and Brazil and, while volatile, there was the prospect of good returns in these regions.  I recommended Japan where economic conditions are improving and most investors are underrepresented.  I advised looking at countries with a favorable natural resource to population ratio and pointed to the equities in Australia and Canada as examples.  I recommended commodities because of the rising standard of living in the developing world and gold as insurance against a financial catastrophe.

Overall I found a great deal of apprehension among investors in both England and the Middle East.  Few were enthusiastic about any concept or theme.  Most felt it was right to be defensive.  While a few investors were buying gold, it was not embraced as widely as I thought.  On the other side I got the feeling that investing in U.S. Treasury securities was continuing especially since the dollar was appreciating.  Perhaps Treasurys were still viewed as a safe place to park money until a better opportunity came along.  Certainly there are some major economic challenges facing the world but the skepticism of investors may be creating more opportunity than we realize if you search hard enough and are willing to act boldly.

The Blackstone Group L.P.
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Notice: Change of address
Byron Wien
The Blackstone Group
345 Park Avenue
New York, NY 10154
Tel: 212 583 5055