the case for Europe …and how to play

We can divide the mature stock markets of the world into three groups:  Japan, the US and Europe.

My long-held view is that Japan is a special situations market, where disastrous economic policy, hostility to foreign investors of all stripes a shrinking working population, make putting in the time to understand this intellectually fascinating culture not worth the effort for mainstream companies.

That leaves the US and UK/EU.

the case for Europe

Looking across the Atlantic, Europe appears to be a big mess.  It has, so far, not really recovered from the recession of 2008-09.  Grexit continues to be an issue, although relatively minor.  But there’s also Brexit, with the additional possibility that Scotland will vote to secede from the UK.  And there’s possibility that Marine Le Pen may become the next French president.  She advocates Frexit + repudiation of France’s euro-denominated debt.  In her stated social views, she’s the French version of Donald Trump.  On top of all this, the population of the EU is older, and is growing more slowly, than that of the US.  In a sense, the EU is the next Japan waiting for unfavorable demographics to take its toll.

What, then, could be the case for having exposure to Europe?

Three factors:

–the plus side of Donald Trump–tax reform, infrastructure, end to Congressional dysfunction–now appears to be at best a 2018 happening.  In a relative sense, then, Europe looks better than it did a few months ago

–the EU began its economic rescue operations several years later than the US did.  Because of this, one way of thinking about the EU is that it’s the US with, say, a three-year lag.  If that’s correct, we should expect growth there to be perking up–and it is–and to remain at a somewhat better than normal level for a while.

–the mass of Middle Eastern refugees pouring into the EU has produced near-term political and social problems.  However, many are young and well-educated.  So as they are assimilated, they will provide a boost to the workforce–and therefore to GDP growth.

how to play Europe

the UK

Brexit will be bad for the UK economy, I think.  Although much of the damage has already been done through depreciation of sterling, UK multinationals, especially those with exposure to the EU are, conceptually at least, the way to go.  Even here, though, it’s not yet clear how access to these markets will be restricted as the UK leaves the European Union.  So the UK probably isn’t the best way to participate.

the Continent

Since we’re talking about local GDP being unusually good, multinationals are likely to be underperformers.  EU-oriented firms will be the stars.  Small will likely outperform large.

the US and China

About a quarter of the profits of the S&P 500 are sourced in Europe.  So US-based, EU-oriented multinationals are also a way to play.

Another 10% or so of S&P earnings are China-related.  Because China’s largest trading partner is the EU, some of the glow from the EU will rub off on export-oriented Chinese firms.  Here I haven’t yet looked for names. But it may be possible to play the EU either through Chinese firms listed in the US or through US multinationals with China exposure.  I’d put this group at the tail end of any list, however.

 

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.

another week, another crisis: life in the EU

background

The Maastricht Treaty (or Treaty on European Union), signed in 1992, laid down the minimum economic requirements for entering, and remaining in, the EU.  It specified, among other things, that any member country’s budget deficit should be no more than 3% of GDP and its outstanding government borrowings should be below 60% of GDP.

Members would be entitled to use the common currency, the euro–thus becoming part of the Eurozone.

One quirk of the arrangement was that the economic rules could be enforced only at the point of initially applying for membership–by denying entry to the EU to countries that didn’t qualify.  After that, there was nothing.  Why not?  No country wanted to give up sovereignty.

Italy, for reasons of bella figura, underwent an heroic restructuring of its economy so it could be among the charter members–and began backsliding almost immediately.  Greece probably never qualified for membership, but the EU overlooked its well-cooked books to advance its pan-European reach.

One other thing:  most EU members adopted the euro.  A few, notably the UK and Sweden, did not.  The latter are in the EU but not in the Eurozone.

the crisis

Trouble had been brewing for years. Even less creditworthy countries could borrow large amounts of money at favorable rates by issuing sovereign debt in euros, on the idea it would be guaranteed by the full Eurozone.  The situation reached a boiling point in 2010 when Greece announced it had been falsifying its national accounts for years.  Belatedly, lenders began to worry that the Eurozone would not stand behind all euro-denominated debt.  Worries soon expanded to include Berlusconi-led Italy.

the problem

Moral hazard.  Germany balked at stepping in to bail out Greece–and potentially Italy–without a way of enforcing the Maastricht economic criteria.  Otherwise, it risked throwing good money after bad.

where we are now

At the latest in a series of “summits,” the Eurozone countries agreed last week to amend the Treaty on European Union to give EU institutions the power to enforce the Maastricht economic criteria.  That was the final condition Germany wanted before it would be willing to stand behind Italian debt.

But…

…the UK vetoed the idea of using EU government institutions to police Eurozone member countries.  Why?  It wants concessions that will preserve its position as the premiere financial market in the EU.   (This, even though the UK’s “regulation light” philosophy nearly brought the country to its knees, gave protection to the perpetrators of the US sub-prime mortgage debacle, and resulted in sketchy ex-Soviet bloc mining companies becoming major forces on the stock exchange).

So the Eurozone countries say they’ll develop an alternative enforcement mechanism by Christmas.  But until they do, the securities markets will continue about the survival of the Eurozone.

my thoughts

It seems to me that a necessary condition for politicians to back any measure that will bring pain to their constituents is that the alternative appear worse, so that they can cast themselves as heroes for having “rescued” voters from a worse fate–even if they themselves have created the worse alternative by their inaction.  That’s just life.

The Eurozone countries are making progress, though.

Either the Eurozone will cobble together a new enforcement mechanism or–more likely, I think–it will grant some concessions to the UK in return for permission to have Brussels enforce the new Eurozone economic rules.  After all, I don’t think the UK wants to be left completely on the outside of Europe, looking in.

In any event, ratification of the new rules won’t be completed until next March.  Until then, I don’t expect to see significant Eurozone action to support the bonds issued by Italy.

My guess is that support will come, but not until Spring.

For equity investors like us, I think two factors are important:

–Europe will be in recession in 2012.  The question is only how deep it will be.  This is a time to think through how well our holdings of global companies are insulated from European demand weakness, with an eye to emphasizing those with the least EU exposure.

–it’s still too early, in my opinion, to be bottom-fishing in the EU.  There’ll be time enough for that in, say, February.

more on “discounting”

discounting

“Discounting” is the jargon that Wall Street uses to describe the process of factoring changes in consensus beliefs about future happenings into today’s stock prices.  I’ve outlined the basics of discounting in an earlier post.

fundamental vs. technical analysis

Fundamental analysis, the study of company-specific and economy-wide economic and financial information, and technical analysis, the study of charts, can be seen as two approaches to discounting.  In the first case, researchers try to figure out what information is most important for making a security’s price go up or down, and then actively search for relevant data.  In the second, investors study chart patterns as a way of figuring out what fundamental analysts are doing and then riding on their coattails.

the internet

The internet has changed the amount, quality and cost of information in dramatic fashion. For example:

–When I was building an international equity investing organization for a major financial institution in the early 1990s, it cost about $300,000 a year in today’s dollars to get access to all corporate SEC filings.  The data came on microfiche and was available about six weeks after the documents were filed.  Today, the information is free on the SEC’s Edgar website; documents are available the instant they’re filed (companies do this electronically).

–Thanks to regulation FD (Fair Disclosure), company presentations are routinely webcast and are available through the company website.  Typically, they’re archived for at least a year.  True, breakout sessions at conferences, small group meetings or one-on-ones aren’t, but these mostly serve to fill in the blanks for analysts not familiar with a firm.  Companies may sound like they’re revealing new information, but they’re not.

–A Bloomberg terminal still costs $30,000-$50,000 a year, depending on its capabilities.  But discount brokers offer most of what an individual investor needs to their customers on their websites for free.

discounting and Greece

Discounting isn’t a one-time event.  It’s a process.

1.  For one thing, what’s painfully obvious to a seasoned observer or an industry specialist may only dawn on the average investor a considerable time later.

2.  Also, bad news that relates to a specific event is typically not fully discounted until the event occurs–no matter how far in the future that may be.  The financial crisis in Greece is a good example.

A year ago, a new administration in Athens revealed that the country had been falsifying its national accounts for many years.  Greece had taken in less in taxes and also spent a lot more than it had ever revealed.  How so?  Its membership in the EU had allowed it to borrow much more than it could ever repay.

For at least six months, it has been clear that either the rest of the EU will be forced to pick up the tab and let Greece remain in the EU, or that Greece will default and lose its EU membership.  In default, holders of Greek sovereign debt would lose most of their money.  But, since that’s mostly big EU banks which might need government bailouts as a result, the effect is basically the same.  EU taxpayers ultimately foot the bill.

Over recent months, however, EU stock markets–and the financials, in particular–have been subject to periodic waves of selling, driving prices ever lower, as investors express their fears about Greece.  …despite the fact that in general terms everyone has already read the closing chapter of the story.

This pattern of discounting the same news over and over again is typical.  It begins in denial (inadequate discounting) and may end in despair (overdiscounting), the same emotional pattern that shapes a bear market.  While bear markets end in a whimper sometimes, however, discounting that anticipates a discrete event usually involves a final selling bout as the event actually occurs.

Over the weekend, the G-20 seems to have given the EU an ultimatum to resolve the Greek crisis quickly.  We’ll see tomorrow how the markets react.

BIS: a currency collapse is a good sign, not a bad one

In its latest quarterly review, published this morning, the Bank for International Settlements (the organization that comes up with international bank capital adequacy rules) presents results of research into currency collapses that is of particular importance to stock market investors.

the bottom line

The research studies a large number (79) of past currency collapses, mostly in developing countries.  There’s a complicated definition of what constitutes a collapse, but it’s basically meant a drop of 22% or more in the value of a country’s currency in a short period of time.

Collapses are associated with a permanent loss in real GDP of 6%–not a good thing.  –also something you’d expect to see.

What’s interesting about the study, though, is that it finds the output loss begins three years before the currency drop.  Therefore, although the currency decline is correlated with the output loss, the currency movement doesn’t cause it.

In fact, quite the opposite.  The currency collapse appears to mark the beginning of a period of accelerating economic growth that would likely not have occurred in the absence of the currency decline.  The better economic performance continues for several years, and ends up offsetting about two-thirds of the economic loss.

In other words, the currency decline, although frightening, is the first sign of economic healing, not the harbinger of further economic doom.  (Note, again, there’s no claim to have established causation.  The only assertion is that the better economic performance comes after the currency debacle.)

think:  the euro

The fall in the euro vs. the US dollar has been 21%+ over the past half year or so.  For my money, this counts as a currency collapse.

We know in theory that currency decline has three effects:

–it acts like a drop in interest rates as a stimulus to economic growth,

–it redistributes economic energy toward exporters and import-competing industries.  It channels growth away from importers and foreign manufacturers.  And,

–it increases the value to locals of foreign hard-currency assets.

Said a different way, a stock market investor should look for companies that have hard-currency revenues and weak-currency costs.

My experience with European stocks has been that recognition of the new currency facts of life lag the actual currency movements by a couple of months.

What does the BIS study add to these theoretical musings?  The fact that in 79 past instances, this is the way things have turned out.

Is it time to buy Euroland stocks? I think so.

the recent EMU numbers are ugly

The euro peaked against the $US on November 25, 2009 at a rate of  1€ = US$1.5139.  It now stands at 1€ = $1.2464, which is a decline of 18%.  Over that same time frame, the S&P 500 is up about 4%.  In contrast, the MSCI EMU (= European Monetary Union) index is down about 2% in euros and just about 20% in dollars.

we all know why

In the simplest terms, the EU was created to give Europe the economic heft it needed to compete with the United States.  A side benefit was that it raised Europe’s standard of living by breaking down the then-ubiquitous border controls that inhibited intra-European commerce.

One key feature of the EU is that it is a monetary union, but leaves the determination of the level of government spending to the individual member countries.  The rules for attaining membership required that candidate countries display economic solvency and a minimum level of fiscal prudence in spending.  The tacit assumption was that any country that made the effort to walk the straight and narrow path in order to get into the union would continue to do so afterward.  That, of course, has turned out to be wrong.

This is not 100% the members’ fault.  The EU got things off on the wrong foot by running a money policy that was too loose of the smaller countries.  It did so to aid Germany, the union’s largest member, cope with a “lost decade” of economic performance as it dealt with the reintegration of East and West, as well as a chronic problem of too expensive labor.  Then, of course, it bent the rules to let Greece in and, generally speaking, turned a blind eye to excesses in places like Ireland, Spain and Portugal.

The current crisis was sparked by revelations late last year that Greece had falsified its national accounts over an extended period, thereby allowing it to run up an amount of government debt so large that it’s hard to see how Greece could ever pay it back.   EU rules said no bailouts allowed.  Kicking Greece out wouldn’t solve anything either, since investors would start to worry that, say, Portugal might be next to be tossed overboard and the funding crisis would migrate there.  In fact, markets quickly coined the acronym PIGS (Portugal, Ireland, Greece, Spain) to refer to the EU situation.  Violent demonstrations in Greece to protest proposed cutbacks in Greek government spending also raised the worry that Greek citizens had no intention of trying to repay the bills they had run up.

where are we today?

Greece is being bailed out by the rest of the EU, with some help from the Federal Reserve in the US.  Portugal and Spain have announced austerity measures.  We’re probably on the road to greater fiscal integration in the EU as a way of preventing the Greek situation from occurring again elsewhere.

As the figures in the first paragraph above show, the euro has been crushed.  And we should probably expect that economic growth in the EU will be sub-par as formerly profligate governments pare back their spending.

bonds vs stocks

This bad news has expressed itself almost entirely in weakness in the euro and falls in government bond prices.  Other than the fact that all the negatives appear to be out on the table now–and therefore one would think that they’re to a great extent already factored into today’s securities prices–this is a real disaster for foreign holders of EU government bonds.

It hasn’t been fun for holders of EU stocks, either.  But for the latter, there’s a potential silver lining.  About half the earnings of publicly traded EU stocks come from subsidiaries located outside Europe.  For those firms, profit growth is going to be surprisingly strong over the coming year.  So, too, will gains for export-oriented and import-competing businesses within the EU.  On top of that, a currency drop acts somewhat like a decline in interest rates–not only rearranging the composition of domestic growth but adding to it for a while.

Typically, in a case like this the currency moves first and stocks only begin to discount the new realities a month or two later.  I haven’t done an exhaustive check, but from the names I’ve looked at, it seems to me that stock market investors are still in shock from recent events and haven’t done much work in figuring out the plusses of the new reality.

Now is the  time to do so, in my opinion.

There is a risk to this idea, however–apart from the normal uncertainties surrounding any investment in equities.  I think the big political and emotional crisis over the stability of the EU structure is pretty much over as far as the financial markets are concerned.  So it’s safe to go in and pick up the pieces.  In this regard, I see Euroland now as in somewhat the same position today as the US was a year ago.  Valuations are, of course, much higher, so the absolute returns won’t be as great if I’m correct.  The point of comparison is the different pattern of stock performance for domestic-only (= bad) and multinational/export-oriented (= good) that the US has shown since march 2009.

If, on the other hand, if you think we’re only in the eye of the storm, it’s much too soon to act.