Tuesday, March 13, 2012

Prem Watsa's 2011 Shareholder Letter - Fairfax Financial

We continue to fully hedge our common stock portfolios as our concerns about the United States discussed in our 2010 Annual Report persist, and have been magnified by the financial crisis in Europe, including the underlying austerity programs, and the recent bursting of the Chinese real estate bubble.

As for the United States, as we have discussed many times before, if we thought the 2008/2009 great contraction was like any other recession the U.S. has experienced in the past 50 years, we would not be hedging today. However, we continue to worry that the North American economy may experience a time period like the U.S. in the 1930s and Japan since 1990, during which nominal GDP remains flat for ten plus years with many bouts of deflation. To combat the great contraction of 2008/2009, the U.S., as well as Europe and most countries in the world, went “all in” with huge stimulus programs. They have no ammunition left now and austerity is the slogan of the day, worldwide! While the Fed continues its many quantitative easing programs and the ECB and others follow suit, the key question in our minds is whether the central banks can get consumers and businesses to stop deleveraging and perhaps releverage again – given the very high leverage they begin with. Total private debt as a percentage of GDP in the U.S. has just begun to come down from levels even higher than the 1930s.

As for Europe, 2011 laid bare the leverage there, with the assets of its banking system being 2.6 times its GDP. France’s top five banks, for example, have assets of $9 trillion versus a GDP of $2.7 trillion for France. Much of the assets of the French banking system (and other countries in Europe) are financed by “wholesale” funds as opposed to stable retail deposits. Today, while we think this is very unlikely, there is the possibility of the Euro breaking apart, with disastrous consequences to the world economy.

All of this reminds us of the late 1980s in Japan, when it was reported that Japanese housewives were buying stocks with grocery money. For the last ten years, after the Nikkei Dow Jones came down by 75% from its high, the Japanese housewives have been keeping their money in Japanese government bonds or in bank deposits yielding less than 1%. The point is, the psychology changed in Japan, and the question today is whether the same thing has happened in the U.S. and Europe after the great contraction in 2008/2009. With house prices down by almost half and lots of concern over unemployment and the economy, the question is, has the psychology changed in the U.S. towards saving and away from spending. Only time will tell but it is an area we continue to monitor closely.

As for China, late in 2011 the Chinese bubble in real estate burst. Developers have reduced prices by 25%+ to sell apartments in Shanghai – causing riots by angry buyers who paid full price. Expect apartment prices in China to come down significantly in the next few years. This may result in a hard landing in China, again with major consequences for the world economy.