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Prepare for a Muddle-Through Economy

Jeremy Glaser

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I am pleased to be joined today by Abhay Deshpande. He is a portfolio manager at First Eagle Funds. I am going to ask him a few questions about European growth, Japan and gold.

Abhay, thank you so much for joining me today.

Abhay Deshpande: Thanks, Jeremy. It's a pleasure to be here.

Glaser: My first question is on Europe. We've talked to a lot of managers during the last few days. They said that it's really not the S&P downgrade of U.S. sovereign debt that's driving this volatility. It's worries about European sovereign debt. Do you agree with that assessment? Do you think that Europe is really driving a lot of what we're seeing in the markets right now?

Deshpande: It's a piece of the puzzle. I think clearly the markets had been weakening in advance of S&P downgrade, though the noise of a downgrade had sort of permeated the conversation at the same time, but it's clear that the European situation which is really an ongoing situation that began early last year is driving investors to sort of question the credibility of the central bank and policymakers in Europe.

That said, from our perspective, European stocks having come down 20% and in some cases more, there are some values to be had. European multinationals in particular were not egregiously valued to begin with; they were kind of at fair value. We've been terming our European stock exposure for a while. In fact three years ago, we had about 30% in Europe, and now we have closer to 20% in Europe. But with the recent declines in prices, we find some opportunities again, and we've begun to reinvest in Europe.

Glaser: So are you expecting a large slowdown in growth that's priced into the stocks, or do you think that fears over European growth are somewhat overblown?

Deshpande: Whether it's the United States or Europe, some of this volatility reflects the difficulty that investors have coming to terms with this muddle-through environment that we're in. We have a couple of limiting factors. One, on one hand you have excessive leverage in most of the developed world that kind of puts a cap on growth rates. And then on the other hand, you have potentially extreme policy responses to weakness, both of which kind of create a limiting factor on upside and the downside. So at any given point, it's not either going to be as good as or as bad as it seems. It's kind of a muddle-through environment, but the investor base seems to have trouble coming to terms with that and becomes very disappointed. At one point the investor becomes very depressed and then on the other hand, a few months ago, there is almost a buoyancy in the marketplace. So we just keep going back and forth between these two extremes, and that creates a lot of volatility, which for First Eagle and value investors generally speaking, we had cash going into these periods, so we're able to take advantage of some volatility.

Glaser: Turning to Japan, can you give us an update on how the Japanese economy is performing as the effects of tsunami and earthquake start to wear off?

Deshpande: There are really two direct effects of the tsunami and earthquake. One is what's going to happen with power supply and energy supply as the nuclear power plants have shut off and sort of checked and restarted over the next few months. So there is rationing of power, that's going to be an effect. That's kind of a short-term effect, maybe in the last quarter or two.

And the other fact was the hit to the logistic chain. So that's had more of a global impact, it's not just Japanese impact. Both of those events are, I think, more temporary than permanent, and I think growth there can recover. How does it affect us? Well, we have some companies, such as Fanuc and SMC, that really are more global in nature. Much of Japan is really more reliant on global economic growth and especially what's happening to China.

Of the companies that we own in Japan that are more reliant on domestic consumption, one is Chofu Seisakusho, which is a boilermaker, and it trades at net cash. So, it's not as if the market is assigning any hope or optimism to some of these domestic-oriented companies in the first place. So, I guess our outlook for longer-term Japanese growth I wouldn't say is any different than anyone else's outlook. It is hard to get excited about that. That said we own some wonderful global franchises, and we own some ridiculously cheap stocks there.

Glaser: You mentioned that the trading with China and the exports to China being important components to a lot of Japanese companies. Do you see any slowdown in China's growth, or do you think that country will be able to keep up its current rate even if there is a slowing in North America or in Europe?

Deshpande: At some point the epic fixed-asset investment boom that China has been in at some point will come to an end or slow markedly, and that could have an impact on the country's growth rates. On the other hand, consumption growth in China could continue to increase at if not double-digit rates, at least at a high-single-digit rate, which is still good for Japanese exports. I'm not saying that they would be unaffected by the slowdown in China, but there are still pockets of opportunity for Japanese companies in China.

Glaser: Then turning to gold for a moment, you hold a reasonably higher stake of gold in your portfolios. Can you talk to us little bit about why you hold that gold and also your outlook for the gold price given the recent rally?

Deshpande: Yeah. We've owned gold for a long time. We've managed a gold fund since 1993. So, this is not a new thing for us. Gold is now acting as almost a currency substitute; in a way people are acting as their own central banks, accumulating a reserve currency to maybe hedge against their exposure to fiat currency. On the question, is it expensive or not? Since gold has no intrinsic value, it's neither expensive nor cheap. It is what it is; it is a almost hedge against fiat currency. Now, if you look at the current environment, it seems to make sense that people will somewhat question the value of the fiat currency model, and so it makes just by extension make sense for people to have some of the reserves in gold.

Glaser: Abhay, thank you so much for your time today.

Deshpande: My pleasure. Thanks, Jeremy.

Glaser: From Morningstar, I am Jeremy Glaser.