Shaping a portfolio for 2012 (II): Europe

Europe–I’m not an expert…

I’ve been watching European stock markets for over 25 years, but I don’t consider myself an expert on Europe.  There are too many social and political quirks for me to get motivated to master its intricacies, given the relatively small size of each country, and of continental Europe in the aggregate, in stock market terms.  So I’ve taken an “American” approach and tried to just pick stocks.

…but everyone has to have a plan

On the other hand,  most stock market investors have to have a plan for dealing with Europe, since it’s a big trading partner with China and maybe a quarter of the revenues of the S&P 500 come from Europe.

Even a simple plan is almost infinitely better than nothing.  It gives you a baseline to monitor for signs that the reasoning behind your stock selection is wrong.  Rather than simply watch your stocks go down in flames, you can try to fix the budding problem.

Here’s my take on Europe:

There are a number of political groupings in Europe.  The widest is the EU itself.  Then there’s the Eurozone (all the countries which have adopted the common currency, the €) as a subset of the EU.  And there are other things like the Schengen free travel area.

For investors, the Eurozone is the most important of these.

To my mind, the defining characteristic of the Eurozone is that it has a common monetary policy, but fiscal policy that’s determined by each country.  This is what has the EZ in trouble today.

The ECB sets interest rates at a level that’s appropriate for the EZ as a whole.  For traditionally slower growing countries at the core, like France and Germany, that has arguably been too restrictive.  For faster growing, smaller economies on the periphery of the EZ, the rate has been extremely stimulative.

Easy money sloshing around the periphery found its way into massive numbers of speculative real estate deals.  Of course, each country should have recognized this and restrained speculation through cautious fiscal policy.  But what politician is going to take the punch bowl away from the party?  After all, there’s always an election around the corner.

To some degree, real estate speculation also infected the periphery with the “Dutch disease,” meaning that demand for construction workers drove up wages elsewhere–making other, export-oriented manufacturing industries less competitive.  For Americans, it’s like Detroit and the car industry.

If that weren’t bad enough, two countries, Greece and Italy, decided to game the system.

In my experience, Italy has always been the least economically responsible large country in Europe.  Yes, it took heroic measures to restructure itself to qualify to enter the EZ as a charter member.  But then it fell back into its old slovenly ways.

I’ll confess that I know next to nothing about Greece.  My impression is that it thinks membership in the EZ was a fabulous chance to scam the rest of Europe.  My impression is that it will happily default on its sovereign debt and leave the EU as soon as it gets a chance–sort of like skipping out on a restaurant check.  Luckily, its small size makes it a rounding error for Europe as a whole.

That’s the problem.  But where are we now?

I think we’re past the worst and on the way to fixing the current EZ problems.  I don’t mean the structural flaws in the EZ, but just today’s crisis.

We’re already seeing serious reform out of Ireland and Spain.  Greece and Portugal (another country where I have no clue) are too small to matter.   The real EZ economic uncertainty comes down to what happens in Italy.

Italy went through another painful wholesale economic reform process to enter the EZ and it has appointed economist Mario Monti as premier with a mandate for reform.  I think these are good signs that Italy is wiling to make the necessary changes to its economy once again.

One other point to mention:  a much simpler fix to problems in Italy and Greece would be to have the ECB loosen money policy by, for example, buying up Italian government bonds.  Doing so removes any incentive for Italy to reform, however–so it just kicks the can down the road.  More than that, money policy that’s inappropriately loose for Germany creates the need to use restrictive fiscal policy to offset it.  Angela Merkel certainly doesn’t want to have to do that.

my bottom line

economics

Politicians in any area of the world only seem to me to act when the situation has deteriorated so far that the painful measures they need to implement are greeted with relief by the electorate as a “rescue” from a worse fate.

I think we’re at, or past, that point in the EZ and that the essential measures are already agreed to, through changes in government, that will end the current EZ crisis.

The main means of change will be austerity.  Once the ECB is convinced that Italy is sincere in its reform efforts it may provide some monetary assistance.  But cutting government spending and enforcing tax laws will be the order of the day.

For the European periphery, this spells recession today and low growth for a while after.

stock markets

The bigger question for equity investors is often not so much what the economic reality is likely to be as, rather, what economic scenario is currently being discounted in today’s stock prices.

I have four conclusions:

1.  I think today’s European stock prices discount a more pessimistic outcome than I see as probable.

2. I don’t think that attitude will change, however, until we see changes in EZ laws that are slated for March plus further concrete developments from Rome.

3.  I don’t want to bet the farm on my analysis.

4.  No matter what the precise outcome, Europe is likely to be the slowest growing area of the world in 2012.

Therefore,

I’m substantially underweight Europe.   I hold small positions in a couple of equity mutual funds, and one stock, through its ADR, IHG.  I would prefer Europe-listed companies that have most of their business in other parts of the world over primarily domestic-oriented firms.  I’d also prefer to reach into Europe through multi-nationals listed elsewhere that have some European exposure.

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