Saturday, October 29, 2011

The Price of EU Indecisiveness, the New EU Debt Agreement: What Does it Mean for Investors?

Introduction
As you know we aren't exactly big fans of what European leaders are doing: trying to solve their debt issues together without inviting those with big pockets to help solve the issue.

And not just that: the whole operation is not aimed at penalizing Greece or even PIGS nations as a group. OK, borrowers having a credit problem is part of the story. But we should also look at the lenders in this case. European government institutions and institutional investors (banks, insurance firms and pension plans) simply invested too much in Southern European nations. A horrible, naive mistake. Pretty much comparable to the investments of Dutch and British local government institutions in the Icelandic bank Landesbanki (through its affiliate Icesave). 
Did investors really assume that when Europe would get one currency and a - not that powerful - European Central Bank (although the ECB under Trichet developed into Europe's best financial institution!) credit risks would be the same anywhere? I.e. that Southern European investments in sovereigns or corporate bonds would simply translate into higher returns? There was never such a simple free lunch in bond investments. Normally: when something like this happens, you have to penalize the borrower and the bad investors. And that is exactly where the problem is.
Already back in 2008-2009 European governments were not willing to play it really tough. Very quickly did they announce that a failure of one of the big banks, insurance firms or pension plans would imply 'too big a system risk'. So instead of Lehman like scenarios of bankruptcy or AIG like scenarios of 'scaring the shit out of managing boards in affected bad investors' they started to create one of the world's largest moral hazard problems through a series of support actions, including nationalizations. The outrage of Western and Northern European populations when hearing about bank bonuses 1-2 years later is totally understandable. Being in the management layers of big system investors is like getting a call option to take as much risk as you can, and in case something goes wrong the tax payer will get the bill. 
But financial markets have become complex institutions. Somehow the major players, be they politicians, central bankers or institutional investors in Europe's North and West have succeeded in blaming only the South (including Ireland that seems to be recovering surprisingly by the way, thereby strengthening the argument that this is all about the behavior of Southern borrowers!).
However, when you increase the funding that is available for rescue: 'Isn't it then true, that the bulk of the money transferred to Greece and others will automatically move back into the North and West as payment (interest and/or principal) on earlier loans (yep, the bad investments) that Northern and Western European banks and other institutional investors invested in? If you know that a lot of these institutions are either led by former politicians or at least have strong ties with politics things sound totally different. But that is not the type of story European leaders want to tell, because failure to control in combination with poor investment skills is then becoming too much of an internalized story. The externalization into 'them' (the South) versus 'us' (the prudent North and West) is a far better political story to tell.
Northern and Western European Prudence: Not willing to Invest and Suffer. There are more beggars involved here. Not just Greece, but also Northern and Western Banks who made bad investments!
But what about the System Risk? The Introduction of a New Idea that might help
We are sure that when politicians or even those economists closely involved with institutional investors in Europe's North and West would read this, that they might classify us as 'dangerous rookies'. System risk could easily translate into total collapse. LMG agrees with the latter. But we believe that there are solutions possible. And in a way the US example shows that - if anything - that country did not collapse, unlike some of its big financial institutions.
System Risk: Are Big Financial Institutions really so big that they could make the whole system fail? Or is it the structure of the system that has led to this situation?
Why not do things in a way similar to sports competitions? Making tough rules, also for system risks by creating leagues (groups of financial institutions categorized according to size, international operations, financial solidity, etc.) and telling upfront that every year or every couple of years at least x percent of those in one of those leagues could fail. That will a) make people more careful before allocating to less solid banks or insurers that offer higher rates or lower premiums (freewheeling on the credibility of the more solid ones!) and b) reduces the moral hazard related to excess risk taking of bankers and other institutional parties within a certain league! Compare the system to the classification of hotels or restaurants with stars, where guests are willing to pay more for a larger number of stars and penalize those who do not live up to expectations. 
LMG believes that people are smart enough to make their decisions when that type of system is introduced and communicated in an open and transparent way. As long as you don't do that and continue in the old-fashioned way any system will always lead to
  1. Size being an asset, with bigger parties trying to get even bigger so as to reduce the risk of collapse thereby betting on the moral hazard game knowing that politicians could and would not let them fail.
  2. Within any non-transparent, informal quality or size group of institutional parties the least solid ones will always get some kind of free ride on the shoulders of the more solid ones.
In the latest plan Europe's leaders went a different way. The new European Agreement with its insurance-like solution is not really a solution. Think about the insurance component. If you are afraid that your house might collapse since it is too close to a cliff in an environment that might be struck by an earthquake: would you really care about a 20 percent insurance for the first loss?

Rogoff's Warning
Yesterday, Harvard Professor Ken Rogoff told Bloomberg TV that he believes that the biggest risk for the US economy is Europe. Rogoff is a great economist and former chess grand master. He is so right here. The US is gradually but slowly getting there, leaving the problems of the 2008-09 financial crisis behind it. Not really through a sensational V-shaped recovery, but with a slow economic growth path bringing it step-by-step into safer territory. To quite some extent this is also the result of bold FED policy (keep interest rates as low as possible thereby keeping the dollar low while at the same time ensuring that the biggest lenders from countries that 'have' will not leave 'the world's biggest have-not' in disarray), but Europe is still a major risk.

Gradual growth at a low pace is the most likely scenario for the US but European indecisiveness to a) go for a painful solution, even if that pain could hurt some of the Northern and Western European big institutional investors, could still lead to trouble. Especially when you know that they are continuing to play music in an orchestra without a) a clear, good conductor and b) good instruments (all have debt and economic growth issues themselves!). True, Sarkozy and some high level bureaucrats are talking to the Chinese and other Emerging Markets leaders (finally!) but nothing clear there yet. And you can compare it to the rescue of Swedish automobile manufacturer Saab, also this week. If you wait long enough, once thing is sure. The conditions under which the 'haves' can step in will get better and better.  
Is EU following a SAAB like scenario?
Nonetheless, also looking at the M&A data posted earlier this week by the OECD (with 2011 being the third best year in history) we do not think that a situation in which US growth is killed by what is going on in Europe is the most likely scenario. The most likely one is that things will gradually improve also in Europe (assume a 60-70 percent chance, 10-20 that things will remain volatile and nervous and 10-20 for the US being torn down by Europe's mess) with it only being uncertain who will benefit there: Europeans themselves or wealthy outside investors. But European indecisiveness and political games can still lead to renewed global problems.
Conclusion
In this scenario we would clearly favor US stocks over European ones. However, the interest of big financial institutions, wealth funds and conglomerates from Emerging countries in the asset and knowledge base of European relatively healthy financial institutions (they do still exist, although one has to be careful picking the right ones) might make them interesting speculation objects, also when knowing that the OECD's M&A data do confirm growing activity by EM investors (especially those from China, but Indian and Russian investors are also in the top-20).
And the longer Europe's leaders wait with getting the rich EM nations to the table the more the story will be like the one of Saab. In the Swedish car manufacturers case two Chinese firms were initially supposed to get a (rounded) 55 percent share for about Euro 250 million but ended up getting the whole firm for Euro 100 million half a year later.
A US overweight in your portfolio, in combination with a EU underweight is a logical top-down allocation with a - probably surprising - overweight to EU solid financial institutions with good asset and knowledge bases and 'too big too fail by European standards' characteristics within that EU sub-portfolio seems to be a logical strategy.

Will be continued.

3 comments:

  1. investors absolutely accept that if Europe would get one bill and a not that able European Central Bank acclaim risks would be the aforementioned anywhere?

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