Searching for value abroad

The equity bull market is now the third longest in US history, and it is increasingly more expensive relative to international markets. At this stage, paying a higher price to participate in an extended rally is one reason to begin the search abroad for value opportunities.

The Cyclically Adjusted Price to Earnings Ratio (CAPE) for US stocks is around 27 compared to its historical average around 16. Meanwhile, CAPE is well below its historical average in many countries such as Greece, Austria, and Japan.

While valuation should not be used in isolation, it is important to note that  value opportunities appear more attractive as technical breakouts occur abroad. For example, it took about 20 years for Japan to work off extreme valuation from its bubble era in the late 1980s. The current pull-back in international markets should be assessed for opportunities to buy.

I compiled data featured on WSJ of selected markets that appear undervalued, overvalued, and near its historical average based on the CAPE measure.

Investors take an opportunistic approach as economy improves

The US economy is expected to strengthen this year, with consensus around 2.6 percent growth. Global business confidence continues to improve with manufacturing in the lead.  With both consumers and businesses more optimistic heading into the new year, the combined strength in shipments could lead to a rise in equipment investment which bodes well for a rebound in global business activity. Consumption growth also rose in November, with core retail sales reflecting better than expected holiday spending despite some concerns about budget priorities in the lower-income group. The general backdrop suggests that investors could continue to seek higher returns in riskier assets that are more economically sensitive as the focus returns to fundamentals.

Allocation still favors equities
Fund managers are increasing weightings in developed market equities: Europe, Japan, and the US being the most favorable markets. There is still the chance for a pull-back in equities this year. The S&P 500 started 2014 in the red, and Asian shares followed lower as the Nikkei moved below 16,000. This could reflect some positioning amid lower volume, but some analysts suggest that this could be another buying opportunity.

For now, there is still room to extend margin debt as traditional bond outflows continue. Historically, investors have been extraordinarily leveraged during market rallies such as the tech bubble in 2000. Times are different now as fundamentals improve and central banks continue to support a stimulative environment. The case is stronger in Europe where valuations are still relatively cheap and in Japan where more easing from the BoJ coupled with large pension funds shifting allocation to equities could prove attractive from a global perspective.

Economic slack remains
Despite the optimistic outlook for 2014, there are still some concerns in the real economy. The lower income group tends to be hit the hardest during budget issues which leads to political dithering. Wage growth has improved, but labor productivity has risen by only 0.3 percent on year, but the rise to 3 percent during the third quarter of 2013 was impressive given the solid GDP report and non-farm payrolls during the same period. Andrew Smithers of Smithers & Co states that bad news on productivity could lead to signs of realism that will continue to make the case for a low rate environment. If the market outlook is premature, higher inflationary expectations without the true fundamental backdrop could be a problem.

An opportunistic approach
After a period of lower interest rates and soft demand for loans, US large cap banks could benefit from an improving economy especially as the yield curve steepens. Profit margins expand as banks borrow at lower short-term rates and lend at higher long-term interest rates. The rebound in housing and auto demand suggests that consumers are more comfortable with taking out loans as the economy improves.

Industrial strength is leading demand for non-residential construction where wages are higher and supply is limited. This will be an important year which will test the true strength of the economy. We are still in a stimulative environment, and even as the Fed reduces its pace of asset purchases, rates could find some comfort around 3.5 percent on the 10-year this year. Financing conditions are still favorable for many sectors which could support expansion. For example, US airlines are posting stronger gains as nominal GDP is upwardly biased, but we will need to see capacity expand as demand picks up to confirm further strength into the next year.

Lessons from Lagarde - St.Gallen Symposium

Christine Lagarde, Managing Director of the IMF, gave a rare 50min long Q&A session at the St.Gallen Symposium. Tough questions regarding the survival of the Eurozone, whether the IMF is in fact the World Government, and others pertaining to global policy decisions were posed. Lagarde is aware that the current system is flawed, especially when she goes silent to the mention of some smaller countries within (or thinking of joining) the Eurozone, and whether or not they should be involved in such a collective group that is clearly not working for the generation of unemployed youth.

The argument is that the Eurozone in its current form, is not sustainable; which is why it must continue to evolve with not just increased oversight, but an improved structure that is quick to realize problems in its critical banking system. With that foundation, according to Lagarde, structural problems should be addressed on an individual basis - no one size fits all approach. The conversation shifted to austerity and whether or not it is acceptable to call it a failure; especially given that it was pushed by the IMF for nearly all constituents in its program last year. 

Austerity was not balanced, and it is true that the results show a prolonged economic dip instead of painting a path to recovery like many officials hoped for. The quick and painful cuts and higher taxes just to receive the next credit tranche was the problem. Now Lagarde suggests a slower pace of austerity in which structural issues are addressed for the long term. This is how it should be done, and frankly the pressure of competing authority with the Troika and IMF rushed a lot of these fiscal snaps. Hopefully with some time granted after the German election, we could see some organizational structure and better thought out policy on the country level. Lagarde says the same stands for the US in its austerity measures, although we still don't have a sensible budget in place to do so. 

Lastly, Lagarde's comments on Japan were interesting. Abe's promise of structural change seems like the best approach, but the monetary side still leaves many in question. Lagarde would like to see better utilization of Japanese talent - particularly women. The demographic imbalance in Japan is very worrying and will definitely skew the dependency structure. 

-- Also, the third prong approach of the IMF caught my attention. Providing technical assistance to emerging countries for better surveillance of their financial markets is a key investment. That sums up a few main points, but the full video is definitely worth watching. 

Long term troubles for the US and Europe despite year end breather. Who will win?

The events of the past few weeks suggest that a forceful attempt to get things right by year end will only last for so long. The authoritative approach by frustrated central banks; Germany's clever stalling strategy with Spain; and corrections in Canada's housing market, all point to a much awaited year-end breather. This is what we want to see, but the long term outlook is still troubling.

Let's start with Spain.

On Thursday, Spain announced its budget and economic reform measures which includes planned spending cuts for 2013. The government stated that the 2012 revenue target will be met, but plans to tap 3bn euros from the Social Security reserve fund to cover pension payments was quite the shocker. 

The fact that the demographic make up of Spain skews towards the elderly, coupled with high youth unemployment means that these crucial reserve funds are not growing at a sustainable rate to accommodate the pace of payouts.  Austerity measures will lead to further slowdown with no major growth in employment, and Spain will need to find a way to meet its liability needs; a larger pool of government dependents being one of them. Policymakers need to remember that most Spanish households actually rely on the retirement payments from the elderly family member to stay afloat.

Europe MUST Make Critical Decisions by Year End. ECB Disappoints.

A busy week so far brought along some disappointment as the US Fed Bank and Europe's ECB chose not to take immediate action. The decision was contrary to Draghi's pledge to do 'whatever it takes' to preserve the currency.  In the US, the Fed made no bold promises prior to the FOMC meeting, but continued to state the obvious and remain cautionary in its assessment of the US economy.

The problems in the US are relatively stable to comprehend compared to the ticking time bomb in the Eurozone. As expected, the FOMC left rates unchanged at 0.25% and will remain near zero until late 2014. US savings continued to increase, consumer spending is flat, and income is slightly up. Consumer confidence came out higher than expected, which produced a mixed view of structural conditions. ISM came out lower than expected at 49.8 from 49.7, when expectations were higher. There seems to be a slight slow-down in spending and productivity, while consumers and businesses are holding onto cash, indicating higher levels of uncertainty.

Explaining the Euro Deal

The Euro Group delighted us all late last week with hints of progress. The plan expands the scope of the European Financial Stability Fund (EFSF), European Central Bank (ECB), and International Monetary Fund (IMF). It also includes strict measures to enforce fiscal stability, but is gridlocked at the will of member country politics. The proposal places more hope in the ECB and Central Banks to liquidate our way out of the mess, but does nothing to solve structural issues, and places a heavy burden on the IMF. It is essentially a transfer of responsibility (the bad bank(s) method). It could work, but it involves a lot of risk. Let's step back and understand how the system works.

The two videos  accurately explain the European capital markets. 

The ECB strategy is to become a lender of last resorts. There is clearly an imbalance between surplus central banks like Germany and deficit central banks like Ireland and Greece. Too many Euro-zone countries riddled in financial misery have a high dependency on stronger countries to provide liquidity. The strong national central banks loan money to the ECB, which in turn loans to the deficit central banks in greater amounts than received. The new strategy is to tap the inter-bank market and borrow just enough funds from private banks in strong countries like Germany. These borrowed funds are then loaned to the private banks in deficit countries. The hope is to sure up the private banks, while reducing exposure to the deficit national central bank.

Solving the Collateral Crunch comes in when surplus national central banks loan to the IMF. The IMF then buys sovereign debt from the private banks in deficit countries. Euro group system lending by the surplus national central banks is also acquired by the IMF. Again, the hope is that the private banks, with cleaner balance sheets, will sure up the system. The trash held in the IMF and ECB will then regain value, and the IMF will now be equipped with collateral that was purchased by the surplus national bank sellers.

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Now, structural issues still remain. Public trust is not evident in Europe as savers deposit less money into banks. These banks have less cash on hand to make loans; the hope is that the IMF and ECB can offset this. With new cash on hand, will private banks lend? Not quite. Just like int he US with QE, banks know that there is greater risk of default among borrowers. Austerity and further slowdown is a big factor, and growth is still nowhere in the agenda.

In the UK, Prime Minister Cameron chose to veto the decision to join in the Euro Group proposal. The plan calls for tougher fiscal surveillance and high standards; if the UK does not perform up to par it faces the risk of financial sanctions. London is all it's got at this point, with finance being its economic life-support.

Bottom line - we still have major work to do. But, the plan makes sense. It just lacks the structural gut to make sure that it is executed as planned, and that the private banks realize the economic uptick to actually perform. That economic uptick is unfortunately political.

The US markets turned soar on Monday as the Dow dropped 162 points. The Euro declined as well, as the dollar strengthened giving rise to Gold and Crude Oil. Gains from last week Friday were virtually lost. Moody's warned that the EU Summit does not decrease the chances of a downgrade - citing political and structural constraints as the big factor (the European culture). S&P raised a red flag again as it now looks to review Germany and France.

Markets Prepare for an Italian Size Problem

Italy was tested this week as bondholders sent yields rising near 7%, increasing the cost of borrowing for the country. The timing was perfect as the markets realized the growing risk of an Italian size problem for the Euro zone. We realized that the European Central Bank (ECB) is not capable of artificially buying enough Italian debt to push yields down, thus decreasing Italy's borrowing costs despite market based movements. We also saw a win situation for investors as they were able to use their selling power to force the incompetent Prime Minister of Italy, Silvio Berlusconi, to pledge his resignation after a budget bill is passed, paving the way for structural reform and cooperation with the ECB over debt issues.

It all started when two major European clearinghouses raised collateral amounts for investors wanting to borrow Italian bonds. By doing so, the clearinghouses sent a message that Italian debt is deemed too risky, and therefore requires more money up front to protect against losses while dealing with Italy. Not wanting to take on the extra costs while anticipating a sell-off, more banks began reducing exposure to Italy. This lead to the sell-off that sent yields rising near 7%, the dreadful levels reached by Greece, Ireland, and Portugal during the height of their debt panic. The Financial Select Sector SPDR Fund dropped 5.4% on Wednesday - further proof of the sell-off by banks with exposure to Italian debt.

The worry is whether or not Italy can sustain the high cost of borrowing. If not, will the country be on a path to default? Not quite.

Again, the timing is perfect. Italy has time to make the necessary reforms. If it does not, it will certainly be a major blow to the region, causing an eventual break-up or break-down of the Euro zone. With Greek troubles, Spanish structural issues, and Germany becoming financially exhausted, economic leaders are not prepared to tackle another problem. Not to mention that nothing has been solved for the current mess that's becoming worse, except mere agreements among leaders to meet.

The scariest part of this situation is that the ECB does not have enough market power to artificially decrease yields. The Central Bank desperately tried to purchase Italian debt to decrease the burden on the country's borrowing, but this hardly placed a dent in the sell-off.

Italy can get this right, and Berlusconi made the right decision to resign as the markets pressured him out of his role as Prime Minister. Now the hope is that the Italian Senate approves the budget deal (which it did) so that Berlusconi will officially resign, and the new government under Mario Monti, the man touted as the next Prime Minister, will move forward with reforms.

The Italian government will need to implement the budget plans which includes spending cuts and tax increases, but must also focus on growth.

In a world of high growth or high inflation, those interest costs would be manageable. Either income covers the outlay or inflation erodes the debt burden.
But Italy has neither to look forward to. The International Monetary Fund forecasts Italy to grow by less than 1% a year over the coming three years and for Italian prices to rise by little more than 1% over the same period. -WSJ

This will result from incentives for investments and productivity; the economy needs to produce enough revenue to pay the increasing costs of debt accumulation. Investors particularly find Italian debt  attractive because it is very liquid. Italy is the world's fourth largest borrower, and is a magnet for European bondholders. This is why Italian leaders must present a plan that focuses on growth in order to calm the markets and eventually send yields lower to comfortable levels. Even if the plan is not implemented properly, at least borrowing costs will be lowered so that the expectations for economic growth are reasonable.

The political shake-up in Greece and Italy are good first steps to calming the markets. Getting rid of incompetent leaders is always reassuring. It is not a complete reset though - this will only come in the form of default and a completely new government. Realistically speaking, new politics and budget plans have already proven to calm markets in the short term. The Euro currency and US stock markets gained some ground after Berlusconi made his pledge to resign, and the Italian Senate approved the budget bill on Friday.

Don't think Europe is off the hook yet. There still needs to be drastic changes. Getting rid of incompetent leaders is only the start.

What to do about Greece

Greece isn't so much of a headache as it an opportunity for traders. It allows us to step back and think like an economist; evaluating the what ifs of contagion and speculating the fate of the Euro. The task list is complex.

Last week, the Prime Minister successfully passed a confidence vote, but voters outside his elite backing remained angry. Protesting outside government buildings continued, spreads on Greek/Spanish yields widened, and traders sold off on the Euro sending the currency on a decline. The markets are one step ahead, as the value of the Euro rises ahead of key meetings and votes just to show that expectations are rising, only to increase fears about the next step.

The fact is that Greece is and will continue to be a burden on the Euro zone - lower GDP per person coupled with higher government debt as a percent of national GDP. The country is in desperate need of a 12 billion euro life-line loan by mid-July. This, along with a plan for further austerity measures will be the next task for Greece. The Prime Minister and his cabinet must balance the interest of pleasing bond holders and pleasing voters. This battle is essentially the same, as voters, who want to continue life as it once was (living beyond their means) are the major holders of Greek debt.

Contagion is based mainly on fear rather than the actual. Although the euro zone is becoming entangled in the mess of Greece through its Central Bank (a bad bank of debt) and the flows of bail out cash extending a line of dependency, the risks are greater at home. Greek banks will ultimately feel the pain in the event of a default. The National Bank of Greece, Piraeus Bank, and Eurobank EFG, all have 6-8% of capital tied up in Greek government bonds. However, outside banks such as BNP Paribas and Dexia group, have 2-5% of capital in Italian and Spanish bonds. This is a big problem.

Banks within the euro zone and around the world don't have to be tied up in Greek debt specifically. If the balance sheet has Italian, Irish, and Spanish bonds, it is indirectly affected by Greek default or other types of restructuring. Yields will fluctuate in response, as investors display emotion with their dollars. Banks around the world that have holdings in funds that are exposed to European debt face risk. Similar to the financial crisis, in which investment banks struggled to determine counter-party risk -- who the heck owns the stuff? Eventually, the knot becomes too tight to untangle, and we end up with a Lehman style collapse. Not so much the case here. Transparency is much greater with government debt, but still, exposure and contagion fears remain.

Investors are already evaluating exposure. Shares of Dexia Group, a Belgian bank with major holdings of euro zone debt, have declined significantly (down 24% YTD). However, banks like Dexia are insured through credit default swaps. Back in June, Dexia joined other banks to rollover a combined 30 billion euros of Greek debt for an emergency package. On the other hand, taxpayers and public workers have savings in Greece, and they should worry. The people of Greece can begin with tightening their belts so that the government can get on with tackling its fiscal woes.

So, what are the options.

A second bail out will continue the spiral of dependency and will only succeed if its backed by strict austerity measures. Voters even see a second bail out as a continuing problem. Investors will see this as some certainty, but only short term.

In the long run, the euro zone will continue to funnel money through a stabilization fund (essentially a little IMF of their own). Countries need to get away from this. The money just stalls time.

Default will ripple the markets, but will force people to get serious. If this happens, Greece should think about a gradual exit from the euro zone to focus on creating an organic model that will be more sustainable.

Restructuring is the best bet. First, greater privatization should be considered. Already, Greece is selling shares of its ports and an immediate sale of state assets. Second, a private 'bail-out' focused on restructuring debt should occur. Give Germany and the rest of the euro zone a break, and consider this:

SWFs [Sovereign Wealth Funds] have the might and the risk appetite, but do they have the interest? China has repeatedly pledged support to Europe’s periphery, motivated by the prospect of currying favour with Europe in order for its domestic firms to gain greater access to the European markets.

Norway’s sovereign fund—the world’s second largest—also has an interest in the euro area’s speedy recovery, given its home country’s proximity and links to the euro zone. Although the fund largely tracks public equity and bond indexes, it leaves some room for active management. Recent statements from government and fund officials suggest that the fund may use its discretion to buy more euro area peripheral debt. As of the third quarter last year, Norway’s SWF held US$3.9bn in Spanish sovereign debt, its seventh-largest individual bond position. -- Economist Meg, SWFs: the euro zone's white horse? (May 2011)

For now, we wait. Honestly, I enjoy the buzz among my Twitter and Facebook friends as we frantically try to make sense of this mess. Traders will continue to monitor these events, taking pulse of the Euro. In the meantime, the US should prepare for a shift of interest and get its budget deficit under control to show investors that the country is serious about becoming solvent.