Oxstones Food for Thought – July 2012 – E.U. Crisis – The Never Ending Story!

04-Jul-2012

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A banker turned social finance entrepreneur. Liu-Yue built and managed two social enterprises. Liu-Yue founded Oxstones Investment Club a searchable cloud-based content platform for knowledge sharing and financial education. Oxstones.com also provides global investors with direct access to U.S. commercial real estate investment opportunities and other alternative strategies. In addition, Liu-Yue also co-founded Cute Brands, Inc. Cute Brands is a cause-oriented character-based brand licensing and social impact fund that creates social awareness on global issues and societal challenges through character creations. Prior to his entrepreneurial endeavors, Liu-Yue worked as an Executive Associate at M&T Bank in the Structured Real Estate Finance Group where he worked with senior management on multiple bank-wide risk management projects. He also had a dual role as a commercial banker advising ultra high net worth clients on investments, credit, and banking needs while focused on residential CRE, infrastructure development, and affordable housing projects. Prior to M&T, he held a number of positions in emerging markets bonds and Latin American equities investment groups at SBC Warburg Dillon Read (Swiss Bank), OFFITBANK (the wealth management division of Wachovia Bank), and in small cap equities and special situation investing at Steinberg Priest Capital Management (family office). Liu-Yue has an MBA specializing in investment management and strategy from Georgetown University and a Bachelor of Science in Finance and Marketing from Stern School of Business at NYU. He also completed graduate studies in international management at the University of Oxford, Trinity College.







By Liu-Yue (Louie) Lam, Co-Founder, Chief Investment Strategist, Oxstones Investment Club

Why does U.S. model work and EU model does not?

It’s the 4th of July and I’m feeling patriotic.  In celebration of the birth of this great nation, let’s take a moment to reflect on why does U.S. model work and E.U. model does not?  What is an American?  The answer to this question is what I believe makes the USA the greatest nation in the world.  Being an American is to believe in an idea that anyone from any background, any culture, any gender, and any ethnicity can become American by believing in shared ideals: life, liberty, and the pursuit of happiness.  It is these shared beliefs that prove strong enough to bind all Americans together as one single nation.  In addition, the critical difference between USA and EU are the mindsets of its citizens.  People in the USA believe they are first Americans before they think they are Rhode Islanders, Californians, etc.  In Europe, people believe they are first French, German, or English before they think they are Europeans.

Ironically, only in emerging European countries do they have the mind-set where they believe in a United Europe and consider themselves first Europeans.  Perhaps it is due to the horrific experiences still fresh in their minds from living through communism.  In Western Europe, people have an entirely different mind-set where they continue to hold onto their nations past glories and rich history.  Europe’s greatest weakness is also its greatest beauty.  Europe is a colorful mosaic filled with beautiful traditions, multiple languages, and diverse cultures.  They have the right to be proud.

Unfortunately, it may take suffering from another tragic experience to finally bring about the dream of a United Europe.  The current EU sovereign debt crisis may ultimately unite Europe as they finally recognize that their nations are in grave danger, and only united do they stand the best chance of surviving.  Otherwise, this crisis will permanently separate them as they seek to save their own economies.

EU banking system is in default

The current EU banking system is in critical condition.  ECB continues to provide banks with liquidity but the banks are technically insolvent.  Without continue ECB funding, spreads would widen and interbank lending would dry up.  The transmission system is broken.  ECB can continue to pump liquidity into the banking system, but there will be no multiplier effect on the economy.  There is an unwritten rule that ECB funding will be funneled to banks in order to allow banks to re-cycle the loans to buy sovereign debts to support governments.  The EU banking system is caught in a liquidity trap.  Their current holdings of sovereign debts continue to rot on their balance sheets. They are unable to get rid of them without causing a negative loop of declining asset prices and making the whole situation even worse.  You can be certain there won’t be a lot of bank lending.  EU corporations are starving for credit and recession is guaranteed with the reduction in bank lending.  I would be cautious of EU corporations with large loan maturities.

ECB the only option and quantitative easing the only weapon left

I expect that ECB will need to ride to the rescue.  ECB is the only game in town with enough firepower to save EU from imploding.  The current lending capacity for EFSF/ESM will not have enough fire power needed to combat the crisis especially since every day the crisis claims a new victim.  There are not enough EU members remaining that are fiscally able to contribute capital to make ESM viable.  I expect that ESM or some other entity will be granted a banking license in order to receive capital from ECB to indirectly support banks and governments.  The alternative, ECB will have to break its legal mandate and launch a quantitative easing program and directly buy up the toxic sovereign debt.

Expect more social unrest and eventually strategic default and revival

The current protest across Europe will only intensify as citizens begin to realize that generations of taxpayers will have to toil away to pay for the mistakes of those who made poor business decisions.  Undoubtedly, these bad debts will eventually default because the pain is too great to shoulder for too many years.  After a few years of internal devaluation, people will say – ‘Enough! Let’s just default and start over again’.  The current EU debt crisis is no different than past emerging market debt crisis.  You can use history as a guide.  The problems of too much debt and fiscally irresponsible borrowings all lead to the same conclusion – bankruptcy.  Creative destruction is a natural economic cycle that needs to happen.  The vehicles in the misallocation of capital whether corporations or governments are punished with default in order to make way for the re-allocation of capital to new opportunities for future growth.

The root of the problem – G.I.I.P.S. needs to be restructured

Not only is EU suffering from a sovereign debt crisis and a banking crisis, but the underlying root of the problem is the lack of competitiveness in some these economies.  G.I.I.P.S. are just not structurally competitive in the global economy.  They currently do not make enough products or services to export that other people around the world are willing to pay for.  Until this underlying issue of competitiveness is addressed the crisis will not go away.

A political dance to the bitter end

Politicians will continue to make nice and make promises they cannot keep, and delay the day of reckoning.  They will keep the game going for as long as the markets will allow them or until they figure out a way to save their own economies.  Right now the asset holdings for most EU banks are co-mingled with other sovereign debts.  Now EU banks are primary investing in their own sovereign debts.  The end game will come once Germany and other creditor nations have untangled this web of debt obligations, then they will pull the plug on supporting G.I.I.P.S. Or perhaps G.I.I.P.S. may pull a magic trick by drawing down ELA from their respective national central banks.  By allowing their citizens time to safely transfer away savings before committing a strategic default, they leave the rest of EU to hold the bag.

What to do and how to invest?

I would long European stocks and short the euro.  After two years of severe losses, European stock valuations are at basement bargain prices.  I expect the Germans to eventually turn the ECB loose as a temporary solution to save the EU until they find a way to untangle themselves from this mess.  This will lead to another asset bubble in commodities. There are many high quality dividend paying European corporations on sale; strategic crown jewels such as Total of France (TOT) and Repsol (REPYY) of Spain.  These companies are considered cheap using any financial metric from single digit P/E ratios to their low PEG ratio and Price to Sales Ratios.  Both TOT and REPYY are also trading at multi-year lows and possess very attractive dividends of 5%+.  They will benefit from the next boom in oil prices once quantitative easing begins again.  In addition, Telecom giants such as Telefonica de Espana (TEF) and French Telecom (FTE) are also trading at multi-year lows and paying attractive dividends too.  FTE has strategic assets in emerging markets such as Eastern Europe and Africa. TEF is an indirect play on Latin America; with 50% of its earnings from its Latam operations.

Conclusion

The name of one of my favorite childhood movies – ‘The Never Ending Story’ provides a good representation of the ongoing crisis in the EU.  The world they knew has changed, and they need to adapt quickly otherwise they will become obsolete.  When people stop believing in the EU vision, it takes great courage and great creativity to save the EU. They need a true leader to emerge.  The current German endorsed band-aid approach to crisis management treats only the symptoms, but does not the cure the underlying causes.  Unfortunately, the current leaders most likely will continue to push the can down the road for as long as possible to delay the inevitable day of reckoning.

It is incredibly difficult to have so many different countries with different agendas to agree on anything.  In the end, I am very doubtful this crisis can be resolved politically.  Therefore, the only option is for the ECB to print money to bailout G.I.I.P.S., or else these countries will need to leave the EU in order to regain monetary control over their exchange rates and interest rates in order to adjust and bail themselves out.  The crisis needs to be stopped at Spain otherwise it becomes systematic and will eventually engulf even France and Germany.  The questions that needs to be answered from the current EU debt crisis – Is the drive for a United Europe stronger than the individual national identities? Will they sacrifice some of their national identities for the benefit of the greater good or will they let this crisis tear the union apart?

For value investors a time of crisis is also a great opportunity to buy assets on fire sale.  Make sure to take advantage of the current crisis by bargain hunting for blue chip, dividend paying European corporate equities.

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