Saturday, June 5, 2010



Financial markets ended the week in turmoil. Europe's struggles are more or less known by now. On the one hand we saw that EU leaders worked out a large bailout package (USD 900 billion) for weak Southern European nations and Ireland (the PIGS group of Portugal, Ireland, Greece and Spain with Greece as the by-far most affected country; and some saying that even Italy might have to be included in this group), and on the other hand general market nervousness remained. Was 2009 a 'normal' post crisis J-shaped recovery on financial markets or will we see a continued struggle with a W-shape? Disappointing labor market statistics from the US lead the Euro to a new 4-year low below USD 1.20 yesterday.

Since it was also end-of-month, we had the opportunity to look at fresh LMG Emerge output of our Global Tactical Asset Allocation Model. What do we think of PIGS countries? Let's include Italy and make it PIIGS countries. Well, with the newest Hungarian turmoil: let's make it PIIGSH. The word even starts sounding Hungarian in that case!

If you want to read more about the Hungarian turmoils caused by senior officials of the new Fidesz government (in power since last April) click here.



Applying a top down analysis we are still slightly underweight in equities, albeit that the underweight is lower than what it was. It consists of a larger underweight in developed markets with an overweight in Emerging Markets.

The June 2010 allocations in our GTAA system

We believe that - with live results of our GTAA model indicating that its analysis does have substantial value - a look at detailed weights for these countries will shed some light on where we believe (based on in-depth analysis of tons of economic and financial variables) European markets are. For those of you who want to know more about our system and its performance we refer you to our updated presentation at SlideShare.

Portugal and Ireland are the least interesting markets with (combined) a more or less neutral position in equities and no allocation in bonds. Forget about them. The interesting bunch out there consists of the two giants Spain and Italy and the periphery countries Greece and Hungary.

In equities we overweight Italy substantially and Spain to a lesser extent. Greek and Hungarian stocks aren't really bothering us. On the bond side the Italian weight (a large market within Global Bonds) is kept more or less neutral whereas Spain, Hungary and Greece receive large overweights!

Remarkable: our models seem to go against most observers who would translate economic fears into financial withdrawal at the moment. But then again: one of the main characteristics of overreaction is to do the same what everyone else is doing at the same time and while applying the same 'logic'.




In all these cases people seem to be afraid of debts, especially government debts and the ability of these countries to bring the budget deficit back to normal proportions. When looking at our databases we see that the average country in the world posts government debts of 45.6 percent of GDP. Greece and Italy do far worse with percentages in excess of 100 percent: 113.4% for Greece and 115.2% for Italy. Spain and Hungary fare a bit better with scores of 50% and 78% respectively. However, in the case of Spain it is not just government debt people worry about but also the bursting of the bubble in the housing market. And the new Hungarian leadership that came into power after Fidesz kicked the Socialists out of power in April announced that 'official numbers might be incorrect'.

But fundamental figures related to debt positions are but one part of the story. Sure, they are important but it is not just about debt, but also about cash generating potential, size of the financial market, availability of liquid assets to cope with short-term emergencies etc. That is probably also why countries like Singapore (one of our long-term favorites) and Japan post government debts far in excess of 100 percent (Japan even close to 200 percent) without people worrying as much as Europeans now seem to worry about their continent. Both Singapore and Japan have well-functioning export and financial markets that ensure an inflow of hard currencies to cope with larger debts. And they are of course both in a continent characterized by far-above-average growth, whereas Europe is all but that. And: a country like Belgium is also in the 100+ percent debt zone, but we didn't hear that much worries about the Northern European regions, did we? That is also an indication that market move through 'themes' that are often just as much psychological as they are rationally-based.

So let's look at current account and economic growth situations as well. For Italy we expect a current account surplus (exports-imports) of about 0.5% of GDP. But economic growth for the period 2009-2012 will be very limited. However, in the Italian case we cannot deny that when nervousness about the Southern European problems hit markets hard, people seemed to forget that the country is home to some excellent, internationally operating companies as well. So basically, overreaction hit the stock market and that translates into our overweight in stocks while at the same time keeping the bond weight neutral. Another aspect: when people are already worried to see Greece fail, be sure they won't let Spain and definitely not Italy feel. That would trigger back to EU as a whole and indeed pose a system risk.

Spain is more in trouble with a 5.5% of GDP current account shortage according to our analysis and also limited economic growth. So if anything, we are more dependent on the 'too big too fail' story here than in Italy and with Spain being smaller than Italy that might be risky. Then again: we should not forget that financial market prices are at such levels that a lot of Spanish pain is already incorporated.




Greece is definitely far more unhealthy with a current account deficit of more than 12% of GDP and poor economic growth prospects. The only thing working for them is other EU leaders that after the bailout seem to be determined to ensure that Greek troubles don't backfire. We don't like Greek stocks at all and stick to an overweight in Greek government bonds not so much because we believe they will do a nice reparation policy now. No, this is a small country that is now in the claws of the IMF and bigger EU nations. We believe that the latter will not let the Greeks get away with it this time round. Not so much because they care about Greece, but only because they care about Euro. And that is what investors could speculate about by buying Greek government bonds. The enormous rebound in Greek bond prices over May is indicative of the first herds of speculators joining us on this one.

Now Hungary. Compared to the other nations this story is slightly different. Sure, Hungary is a EU country, but one that did not introduce Euro. In that respect it is more like the UK that kept the Pound Sterling. It is also like the UK in that both were the last mainstream European nations to end up having serious trouble with the IMF. The Brits in the 1970s and Hungary more recently, back in 2008. We believe that Hungary has the best current account situation of the countries analyzed here (+4% of GDP) but a similar poor growth profile for the short run.

Therefore not an easy story at first glance. But unlike the others, the country has more opportunities to repair things since it does have the Forint. Devaluation will make imports more expensive and hurt a substantial part of the population who were silly enough the last 5 years to borrow in foreign currency ''because those interest rates were so much lower than that in Forint''. On the other hands, it does have the type of export package that will benefit from currency devaluation. And: just as important, it does now have the type of government lead by technocrats who are willing to take tough measures. This is a difference with Greece, where the government continues to cater to the needs of herds of unnecessary government officials (hidden unemployment) and far too powerful labor unions that do not seem to understand that they have no choice anymore.

Hazy Budapest.... Why did Fidesz senior officials fuel international fears?

With Fidesz and the international community (EU and IMF) determined to avoid further escalation we are willing to take a small Emerging Market Debt bet with Hungarian government bonds. And: the fact that Hungary - unlike the other countries mentioned - is part of the Emerging Markets group and not considered developed - is very important. Hungarian government bonds are part of portfolios bought as Emerging Markets mandates, i.e. allocations with higher risk in the first place. Actually, taking into account recovery from a Global Crisis, Hungary moved from low-risk to higher-risk within a category that was already seen as above-average-risk by most institutional investors.

Therefore: we agree with some of the leading financial analysts / Hungary experts at banks like ING and Royal Bank of Scotland who felt that the Fidesz government is exaggerating things. But why?

The only reason we can think of is one along the lines that we sometimes see when new CEO's have to replace failing ones in firms that were doing poorly. In those cases it is best to make sure that people understand you inherited garbage. In other words: whenever something seems to be a tough struggle, you can always refer to the big mess that you had to start with!

That being said, we conclude by saying that markets in Europe seem to overreact at the moment but that the solution for a speculation is not simply to buy them all and sit and wait. Volatility levels are high and the VIX index should be followed almost on a day by day basis. Reason: our bottom up allocations might be reduced due to top-down arguments the moment levels of nervousness move once again counter-clockwise.

Who could have expected this: good, old boring Europe one of the most fascinating places for investors in the Summer of 2010.

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