Living On The Edge

There is a prevalent view today that common shares are great long-term investments, irrespective of their prices. This is a great example of long-term investing gone astray. Of course, there is no country more entrepreneurial than the United States, with the rule of law and deep capital markets that are the envy of the whole world. But as history shows, being bullish in 1929, when the Dow Jones hit 400, meant that you had to wait almost 25 years (until 1954) before the Dow Jones touched 400 again. In the meantime, you had to survive a 90% decrease in the index. More recently, in Japan, the Nikkei has yet to hit the 40,000 level that it traded at in 1989 — more than 27 years ago. The index is still over 50% below its all-time high in 1989. As they say, caveat emptor.

China devalued its currency on August 11, 2015 by 1.9% — the biggest move in 21 years. The Chinese government is trying frantically to support four major markets: its exchange market, its stock market, its bond market (no debt defaults allowed) and, of course, the biggest real estate bubble we have ever witnessed. In 2015, China’s foreign exchange reserves dropped for the first time in 20 years — by almost $800 billion from its high. Early in 2016, the trend continues.

The high-yield bond market — mainly due to oil and mining issues — is moribund. Spreads have increased dramatically — particularly for energy issues. Of course, distress in the energy area is being transmitted to the pipelines and then to the banks and bond markets that funded significant pipelines and transmission expansions and acquisitions. Distress is spreading into other areas of the high-yield market. Recently, three high-yield funds — one very prominent — were not able to redeem for cash and closed down, similar to the Bear Stearns real-estate funds in June 2007. This may well be the Hyman Minsky moment.

Record emerging market bond purchases by mutual funds reaching for yield is another bomb waiting to explode. For example, Venezuela has some $115 billion in US dollar bonds outstanding, with $8.6 billion maturing in the remainder of 2016. Oil and gas accounts for 25% of its economy and 96% of its exports, and inflation is running at 181%. A default would have a significant impact on bond mutual fund redemptions, which would cause major losses to the retail investor — and potentially a run on these funds. Many emerging market countries in Latin America, Africa and Asia are facing similar challenges.

Japan recently decided to expand its quantitative easing program, which resulted in its ten-year yield going negative (-0.03%). Its yen-dollar exchange rate weakened for a day and then strengthened by 7% — much to the shock of the Bank of Japan and most investors. Prime minister Abe and the Bank of Japan’s governor Kuroda have tried to create inflation in Japan by weakening their currency but have failed so far.

As I write this article, Japan is still under deflation — the economy shrank 1.1% in the fourth quarter of 2015. Declining interest rates and negative interest rates have caused a major problem for banks all over the world, as their net interest margins get compressed. Japanese bank net interest margins have been declining for the past ten years, while European and US banks have experienced the same over the past five years. Concerns about bank profitability have led to a 40% reduction in European bank stock prices in 2016, with Deutsche Bank making 30-year lows and selling at 35% of book value. Imagine my shock when I recently found out that a friend’s 90-year-old grandmother had an equity weighting of 85% — yes, 85%. And she has a very reputable bank as her investment advisor. When asked to reduce her exposure, she said she couldn’t get income any other way. I have not given up on changing her mind — but it will not be easy.

Tipping point
I have purposely given you a quick summary of all the problems and challenges that the world faces at the present moment. The potential for unintended consequences — and, therefore, for pain — is huge. This is why Ben Graham said if you were not bearish in 1925 — yes, 1925 — you had a 1 in 100 chance of surviving the depression; really, the 1930 to 1932 crash in the stock market that resulted in an 86% loss from the high in 1930. We continue to protect you, our shareholders — and our company — as best we can from the potential problems that we see. As we have said, it is better to be wrong, wrong, wrong, wrong, wrong and then right, rather than the other way around. We remember that it took 89 years for AIG to build $90 billion of shareholders’ capital and only one year to lose it all.

As we [Fairfax] said in last year’s annual report, with deflation in the air, our CPI-linked derivative contracts, with a notional amount of $109 billion, have come to life. Early in 2016, ten-year TIP spreads (ie, the spread between ten-year inflation adjusted bonds and treasuries) have made new lows, second only to the 2008-2009 lows. Declining TIP spreads, reflecting lower inflation expectations and higher volatility, result in higher prices for our CPI-linked derivative contracts.

If some of the risks that we have discussed earlier materialise and deflation becomes embedded in the US and Europe, as it has been in Japan since the 1990s and as it was in the US in the 1930s, these contracts can become very valuable and protect our company from deflation’s deleterious effects. In our 2007 annual report, we discussed how the value of our CDS contracts increased from June 2007 to February 2008 after declining for the previous four years. They went from a market value of $200 million to $2 billion, that is, a 10x increase in the course of eight months.

And this was long before the Lehman Brothers crisis at the end of 2008. On average, our CPI-linked derivative contracts have 6.6 years to go. In the five years between 2010 and 2014, we had significant losses, mostly unrealised, from our hedging programme and from our CPI-linked derivative contracts. This began to reverse in 2015. We hope the unrealised losses reverse out and turn into profits, as they did in 2007-08. We had to endure years of pain before harvesting the gains in 2007 and 2008. We continue to be focused on protecting our company from the significant unintended consequences that prevail today. The speculation in the high-tech world ended in early 2016 (see: The dust is yet to settle). When it is all over, we will not be surprised if most of these stocks are down 90%. The speculation in private high-tech companies (the most valuable of which are known as ‘unicorns’) has also ended with a thud. As many of them cannot fund their losses internally for more than a few months and now have almost no access to external funding, a friend of mine said the new name for these companies should be ‘unicorpse’.

Edited extracts from Fairfax Financial Holdings’ 2016 annual letter to shareholders