Season Investments

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Macro Update: Europe Still Front Page

Posted on December 9, 2011

EUROPE STILL FRONT PAGE NEWS 

It’s necessary to comment on the situation in Europe despite the fact that after two years of drama this story is getting to be very old. First, here’s a very simplified recap of how we got here… 

  • The Euro was introduced as a common currency roughly a decade ago, and is currently used by 17 of the 27 member states of the European Union
  • The Euro is administered and managed by the European Central Bank (“ECB”), which controls the money supply and interest rates for all of the Eurozone countries
  • Despite sharing this “monetary” union, the member states never established a “fiscal” union – this would be akin to the US having the Federal Reserve but no federal government, leaving all the individual states to set laws, collect taxes and manage their budgets in isolation
  • As a result of the monetary union, the market began assigning the same credit risk to all the member states, meaning less-healthy countries (ie, Greece) gained access to more credit at lower interest rates as a benefit of being “in bed” with the stalwarts of the Eurozone (ie, Germany)
  • This occurred right as a credit-fueled consumption boom took hold across the developed world
  • The end result…countries such as Greece, Ireland, Spain, Italy, Portugal and Belgium borrowed too much money and have now reached the tipping point 

How do we define the tipping point? Well, there are three “legs to the stool” required to support the path of ever-increasing indebtedness that these countries were on: 1) the ability to borrow more money, 2) the ability to do so at reasonably low interest rates, and 3) stable or increasing income that can be used to service the debt. The tipping point is reached when one of these three legs is weakened to the point of breaking. In Europe’s case, it’s all three at once. On the first and second point, investors are no longer willing to lend money to these countries without charging prohibitively high interest rates. On the third point, government revenues are increasingly unstable as the region tips into recession.

The vast majority of European sovereign debt is held by European banks, and most of it by banks in the healthier core countries such as Germany and France. Historically European banks have been able to treat sovereign debt as “riskless” on their balance sheets and have not had to hold capital to hedge against any default risk (how could a riskless loan ever default, right?). As a result European banks carry leverage ratios that are roughly 3-4 times higher than US banks

So, why does this matter? It matters because the European banking system, while remaining solvent on paper, is actually bankrupt. A country like Italy, which carries the second highest debt-to-GDP ratio in the Eurozone and has three times more debt than Greece, Ireland and Portugal combined, is simply too big to fail. Any material restructuring of Italian sovereign debt would wipe out enough bank capital to take down the entire system. 

European leaders know this and will be forced to do whatever is necessary to bail the system out. All attempts thus far have been awkward and inadequate, which is why this issue is still by far the greatest macro-level risk facing investors. However, the most recent summit which concluded just last night may turn out to be a historical turning point in which the Eurozone finally begins taking steps towards a central governing body similar to the US Federal government. This would essentially mean that Germany would step up to the plate and backstop the debt of bankrupt countries, and in return those countries would cede a great extent of their independence and sovereignty to Germany. This is a lose-lose for the Europeans, but from our perspective they really have no other choice. 

PORTFOLIO POSITIONING

We didn’t intend to focus exclusively on Europe in this post, but for the sake of time we will reserve other topics for the next write-up. Meanwhile, our current positioning is actually leaning bullish for the following reasons: 

  • The Europeans are in a desperate enough situation that they now have no other choice than to bite the bullet and move towards fiscal union. This should stabilize the crisis and improve sentiment for the time being, although we’re absolutely not out of the woods and we will continue to monitor this situation.
  • The US economy is fairly closed-off and doesn’t have a great deal of direct exposure to a slowdown in Europe. It appears that a decoupling is shaping up in which the US continues to grow at a modest pace into 2012 while Europe slips into recession.
  • After the failure of the super committee to reconcile differences over tax policy and social spending, it would be seen as a major failure for Congress to not agree on something prior to year end. Thus, despite the continued back-and-forth, we do expect that some form of extension of emergency unemployment benefits and payroll tax cuts will be resolved this month. This will boost sentiment and risk taking in the near term.
  • MarketVANE, our proprietary tool used for managing exposure to risk assets, is currently on a neutral signal for commodities and a bullish signal for equities. We will dedicate an entire post to providing further explanation of MarketVane in the coming weeks. 

We want Transparency to be one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Macro Updates will address our economic and capital market viewpoints and discuss top-down portfolio positioning. Also watch for Micro Updates which convey our reasoning behind specific investments.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.