The Eurozone, Swiss National Bank, Market Strategy

The Eurozone, Swiss National Bank, Market Strategy, Erwan Mahe
David R. Kotok
June 14, 2012

“Remember: 7% is considered the danger point.”

–Sara Eisen, Bloomberg TV, as she opened the show Inside Track at 6 AM

This morning, Barclays called 7% “crucial.”

Bullets.

1. Earlier today Spain was 6.99%. Italy was 6.30%. Portugal was in double digits. Greece yields are so high we no longer pay attention to the numbers.

2. Risk management is necessary. Cumberland’s US ETF accounts are in the highest cash-reserve position they have seen since the October stock market bottom. Cumberland’s International ETF, Emerging Market ETF and Global Multi-Asset Class accounts have cash reserves. That trading was completed into the rally.

3. Those cash reserves may be redeployed at any time, or they may be held for a while as a reserve for a future buying opportunities. At this moment, we do not know when we will redeploy or at what target level. Politicians in Europe have failed their constituents. Election results and policy changes loom with growing uncertainty. This calls for some cash reserve.

4. The economic weight of Germany in the eurozone is about one-third. The German 10-yr benchmark bond is yielding 1.5%. The economic weight of the highest-yielding countries in the eurozone is now larger than Germany’s. Their weighted average 10-yr benchmark yield is above 7%. Their economies are shrinking. Their debt-GDP ratios are rising. Think about this barbell and try to picture what the business climate in the US would look like if New York had a 7% borrowing cost and Pennsylvania had 1.5%. Then add Rhode Island at 12% and you start to get the impact of this metaphor.

5. Banks in Europe are staying afloat because of the Emergency Liquidity Assistance (ELA) vehicle, which provides cash so that bankers can pay depositors who wish to withdraw their money. Europeans know that any visible bank failures will bring down the entire system. ELA and other mechanisms are the de facto ways Europeans are preventing bank failures. They lack a credible, de jure, FDIC-type deposit insurance system.

6. So why isn’t the euro weaker? One part of the answer lies in Switzerland. The Swiss National Bank (SNB) is maintaining a currency peg to the euro, regardless of the short-term cost. “The SNB kept rates unchanged and ‘will maintain the minimum exchange rate of CHF 1.20.’ But the SNB also ‘stands ready to take further measures at any time.’” Sources: Goldman Sachs comment, SNB, Bill Witherell

7. Erwan Mahé is a Paris-based analyst who has written about the SNB intervention. He has given us permission to post his essay on our website, www.cumber.com. Here is the link: http://www.cumber.com/content/special/GB%20Thaler.pdf . Note that the interest rates on short-term Swiss debt are negative. Note that the yield differential between the Swiss benchmark 10-yr bond and its German counterpart is about 100 basis points. Also note that Erwan is committed to participate in the GIC, Rocky Mountain Summit in Jackson Hole on July 27. Details @ www.interdependence.org .

8. We conclude that the massive expansion of the SNB balance sheet and the commitment to the peg now combine to make the Swiss 10-yr bond the European benchmark. Switzerland is considered the highest-quality, most truly AAA-rated credit in Europe. Switzerland is supposed to be a neutral country, but it clearly has linked its monetary path with that of the eurozone.

Cumberland has no investment positions in Switzerland in its international ETF accounts.

For the US, we still hold our outlook to be one of slow growth and no recession. We expect there to be lots of volatility. We expect the US stock market to provide entry opportunities so we may resume a fully invested position. Our longer-term targets for the US market are S&P index levels of 1550-1600 within two years and S&P 2000 by the end of the decade. We expect the nominal US GDP to approach $20 trillion by the end of the decade. We continue to assume interest rates in the US will remain quite low and that the US inflation rate will be low for several more years. We expect the US economy to feature ongoing recovery in the manufacturing sector and growth in the energy sector due to shale gas expansion. We see the US housing market as bottoming and then embarking on a slowly accelerating growth path. These three sectors will generate higher-paying jobs.

We are bullish on the American outlook, in spite of our awful politicians, who cannot coalesce on any important decision. Both parties are guilty of failing their constituencies and our country. If we had a parliamentary system in America, our political landscape would be different, maybe better, maybe worse, but certainly different. We would have thrown out many of the Democrats and Republicans presently in office. However, we don’t have a parliamentary system and we won’t change to one. We will continue to live with the two-year and four-year fixed election calendar.

So be it. It is our system for better or for worse. The power and durability of America is in its constitutionally protected institutions and freedoms. We succeed, not because of the scoundrels we call our politicians, but in spite of them.

Cash reserves today. Buying opportunity soon. We believe that investors with strategic timeframes (measured in months and years, not minutes and days) will be amply rewarded.

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David R. Kotok, Chairman and Chief Investment Officer