David R. Kotok, Cumberland Advisors
May 16, 2010
“… after less than a 12 year period, many observers are claiming the great European experiment is dead. Twelve years after thirteen colonies on the east coast of North America claimed independence from the most powerful empire at the time, they still did not have a constitution. It had a weak central government, without the power to tax and under the Articles of Confederation required unanimity in decision making. Yet to discount its future was a grave error.” -Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman, May 13, 2010
My friend Bob Brusca publishes his research as Facts and Opinion Economics (FAO). We will follow his order in this email brief, which summarizes some research done this weekend in preparation for two discussions. At 10:30 am on Monday, CNBC plans a discussion about the Eurozone (they call it a debate) with Jeremy Siegel and me. That is a prelude to a one-hour conference call sponsored by WisdomTree on Tuesday, where Jeremy and I will get into more depth on the subject. WisdomTree arranged the Tuesday conversation (they, too, call it a debate). Their contact info is: http://my.wisdomtree.com/forms/Q210BullvsBearEuroDebate-nonprepop.
Fact set 1: Greece is an economy about the size of Connecticut and has been restating its economic statistics since it became the 12th member of the Eurozone. It is widely known for its profligate government spending patterns, indulgence of public-sector labor unions, corruption and tax evasion, an underground economy, a debt-default history … and its present difficulties. Markets and financial agents are highly skeptical about its promises to impose austerity, correct budget imbalances, and comply with Eurozone requirements. Runs have occurred on Greek banks. 75% of Greek government debt (bonds and bills) is held by non-Greek creditors, mostly European banks in countries like France and Germany. Greece is rated BB+ by S&P and its debt trades like a junk bond credit. It faces repeated public-sector-led strikes and protests, even though its parliament has enacted budget austerity measures. An immediate 110-billion-euro Greek bailout package is in place.
Fact set 2: Portugal is an economy about the size of Kentucky, and is considered to be the next weakest credit in the Eurozone. It is rated A- by S&P. It has announced a credible budget austerity plan that is projected to cut the deficit from 9.4% of GDP in 2009 to 7.3% in 2010 and to 4.6% in 2011. According to a Barclays Capital summary, steps to be taken include: a “5% pay cut for state-company managers, a 5% pay cut for political officeholders, a 1 to 1.5 point rise in personal income taxes, a 2.5 point rise in corporate tax, and a 1 pp increase in the VAT rate (to 21%).” The majority government and its opposition have agreed on the need for emergency action. It appears that the public-sector labor unions in Portugal support the austerity measures and understand their importance. 72% of Portugal’s debt is held by foreign creditors.
Fact set 3: Other countries in the Eurozone are rated as follows by S&P: Italy A+, Ireland and Spain AA, Belgium AA+, Netherlands, France, Germany, Austria, Finland AAA. Ratings notwithstanding, Ireland, Italy, and Spain are routinely identified as the other troubled Eurozone members.
Fact set 4: For the years 2010-2013 the gross government financing requirements of the following four countries are: Greece 158 billion euros, Portugal 70 billion, Ireland 69 billion, Spain 448 billion. Total gross financing needs are 745 billion euros. Note that the total announced European Stabilization Fund (ESF) package from the IMF, Eurozone, and EU authorities happens to be 750 billion. We will skip the composition of that 750 billion, since it has been widely reported in the press and detailed by our colleague Bill Witherell in a previous commentary. See www.cumber.com.
Opinions about the Eurozone and the EU range from expectations of total demise and dismemberment (Dennis Gartman) to more sanguine and positive strategic views like ours or Marc Chandler’s. In our opinion Europhiles and Eurozone bulls are in the distinct minority.
Our conversations with European policy makers this past week confirm that they are committed to the Eurozone and to the correction of the structural deficiencies that led to the Greek-induced crisis. Furthermore, they learned from the US housing-finance-induced global crisis. They are moving ahead rapidly with major efforts to create whatever liquidity is required to calm markets, while implementing changes to deal with management of the debt loads.
EU policy is similar to US policy after the failure of Lehman Brothers. The ESF has been called the European TARP. The ECB response is viewed as similar to that of the Fed balance-sheet expansion after Lehman failed. Both the Fed and the ECB will now be using the tool of management of reserve deposits as the way to avoid inflationary outcomes. Both central banks and their global colleagues quickly resumed swaps to provide liquidity. Markets have accepted these initiatives, and credit spreads have narrowed from their extremes.
We must note that the response to the Greek debt crisis came relatively quickly and on a large scale. It has been nicknamed “shock and awe” by many. The key is that Europeans learned about the need for fast action by watching the slowness of the American response following Bear Stearns and the Fannie and Freddie announcements of 2008. Not until after Lehman failed and AIG became government controlled did the Fed expand its balance sheet. It took several months after that to get the swaps in place and several more months to achieve the “shock and awe” size needed to stem the damage to markets. The response time to Greece is measured in weeks not months. It is already working.
Our second opinion about markets and valuations of securities comes from the fact that the Eurozone has achieved a near 20% devaluation of its currency versus the US dollar. At 1.50 the euro was widely considered overvalued relative to the dollar. At 1.15-1.20 it is closer to a parity estimate. We expect the euro to continue to weaken for the balance of the year, or most of it. We also expect the results of the devaluation to appear in northern European economic statistics. We already see some signs in Germany.
Devaluation means growth of exports for manufacturing countries in Europe. Germany is one of them. And the revaluation of the US dollar is one of the concerns that the US stock market is confronting as it tries to reexamine the earning estimates of those companies whose earnings reports are influenced by currency adjustments. This process of restatement and re-estimation will continue for the rest of the year.
In the Cumberland portfolios we are now overweight Germany. We also have exposure to Austria, Belgium, and Netherlands. We do not have exposure in Greece or the “Club Med” region. We expect economic recovery in northern Europe to be more robust than previously estimated. We also see a longer-term benefit from the imposition of austerity budgets, which will force a shift from the heavily unproductive public sector to the more efficient private sector. Evidence from other crisis periods supports the notion that this improvement can happen and has happened in the past in Europe. See the Scandinavian experiences for evidence. Greece and its history of recovery failures is one of the exceptions.
It may be that Greece repeats its history. George Santayana’s poetic warning may apply to Hellenists. It may be that the turmoil in the streets will result in a change of the Greek government and that a new and radical government will repudiate Greek debt. That is about as severe an outcome as one may project. That would be debilitating for the Greeks. Their standard of living would decline.
But would it sink the euro and the Eurozone and the European Union? We think the answer is no. And is it likely to happen? We think not.
Furthermore, the plan for the ESF and the changes already underway set the stage for the needed rescheduling of Greek debt. Greece faces a solvency issue. To achieve stabilization, Greece must eventually reschedule its debt, in our view. By taking the initiatives already announced and removing Greece from normal market access, the authorities have put in place a structure where the debt will transfer to them from banks and creditors worldwide. They can then negotiate a rescheduling with the Greek government once it has implemented the austerity program. Meanwhile, European banking systemic risk will have been managed through a crisis, without a major failure like Lehman Brothers or AIG.
In our view the euro will emerge as a battle-tested currency. This is its first crisis of any proportion and comes on the heels of a Maastricht Treaty passed in 1992, a virtual-euro currency launched in 1999, and a paper currency successfully introduced in 2002.
Only time will tell if the Maastricht Treaty and subsequent Lisbon Treaty and other measures announced or underway will lead to a stronger EU confederation and a restored euro as a world-class reserve currency. Now that the worst news of the crisis is public and on the front page of every magazine, we think it presents opportunity for investors. As with every crisis, investor opportunity is best when things look their worst and when uncertainty is high. We are here, and the time is now.
Until tomorrow or Tuesday.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com