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When Germany Leaves The Euro.


The stronger Euro nations must choose. Will they abdicate national fiscal sovereignty, co-mingle responsibility for and ultimately guarantee payment of the debts of weaker Euro nations or not?  Given the choice, Germany, in particular, may choose to back away from the negotiation table. Whether a feint or not, it may well create market chaos and hence, opportunity, for investors.

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Historian, Niall Ferguson has said that usually, in a game of chicken, one car swerves at the last-minute just before a collision. Euro member nations, however, seem to be headed for a crash.

The headlines since 2009 have highlighted the financial plight of Greece and played on a theme of inevitable Greek exit from the Euro given the Greek debt default (called a debt swap). Then it was Portugal and Ireland, and now Spanish bailouts with Italy, Cyprus and Malta in line. But some thought-leaders have an alternate view.

sPAIN

State Street’s mathematician and historian turned economist, John Nugee, points out the next step, fiscal union, may be the most challenging yet. Fiscal union implies common Eurozone-wide funding through Eurobonds and fiscal transfers between nation members. Fiscal union means joint liability. Stronger Euro nations, Germany in particular, would be on the hook for all or part of the debts of the rest of the Eurozone.

George Athanassakos wrote that while the European Financial Stability Facility, set up in 2010 by euro members to aid it weaker members, considers issuing Euro bonds (guaranteed by all Eurozone members), Germany, as well as other core Eurozone members, may decide to opt out of the common currency rather than share the costs.

What might the costs be? J.P. Morgan’s Michael Cembalest has estimated the cost to Germany of back stopping the Euro crisis in the periphery [on its own] to be in the neighbourhood of €1 Trillion. That could double Germany’s Debt/GDP ratio. (~60% before 2008. ~80% in 2011). Is this cost acceptable to Germany? Indeed, German Chancellor Angela Merkel has indicated Euro bonds will not be considered.

Is this the tipping point for the stronger Euro nations?

Some context:

Euro politicians have no mandate by way of referendum or otherwise from their peoples. Again, Nugee has written, “the electorates of Europe have never expressed any desire” for full fiscal and implied political union. Stratfor’s George Friedman adds that it was vital that a Greek referendum on Euro-imposed austerity terms NOT be held. (Instead of a referendum, Greek Prime Minster Papandreou stood down). As always, the price of austerity is paid by the broader public who lose jobs, benefits and pensions. Who would vote for this? In essence, the price of retaining the Euro is a massive decline in Europeans standard of living. Further Stratfor indicates that with few remaining scheduled electoral contests in 2012, the general population of most European states will not be consulted.

The proposed austerity measures demanded by stronger Euro nations cannot be achieved. The math simply does not work. Further, austerity programs fail when taxpayers are unwilling to endure the pain. They riot. Governments fall. And markets panic.

The intentions of debtor nations. Again, Cembalest has pointed to one view from Italian newspaper Il Giornale which wrote that Germany, not Greece, is Europe’s real problem, [because it is bursting with health]. Further, “Germany has to adjust to the rest of Europe, not the other way around.” (Il Giornale quote as reported in Der Spiegel Online, May 26, 2012).

The Catalyst.

Given this backdrop, imagine the pressure of German politicians trying to convince the German public to accept joint liability for the debts of Europe.

If a Euro bond issue moves closer reality in light of weaker Euro countries inability to meet austerity objectives and pay their debts, Euro bond yields will creep up. Germany (and others) may realize they have lost control and may decide to give up strategic control over Europe before they commit. Germany must decide to underwrite the debts of Euro zone nations or push back from the negotiation table.

At the brink, as Cembalest and Nugee summarize, Germany must either concede that Greece is probably never going to pay back its loans whether they stay in the Eurozone or not and that the costs of bank and sovereign debt outstanding will double by 2014 or accept full collapse of the EMU and a return to national currencies.

Whichever it decides, the uncertainty will create an investment opportunity.

Valuations.

A BCA Research chart shows European stocks relative to U.S. stocks are at their cheapest in 40 years.

J.P. Morgan has indicated that the European stock market has under-performed the U.S. stock market by 38% since the EU crisis began in November 2009.

Risks.

These same thought leaders identify the risk of a lingering Euro recession dipping into depression zone.

There is the risk of further dithering by policy makers. Imagine several more years of Euro nation negotiations.

The risk of a larger global economic slowdown is always present and not central to the Euro issue. But it would impact Euro stocks as some of the larger Euro Multi-National Corporations (like Nestle and HSBC) earn some 40% of their revenues from export markets.

There is the risk of having little or no exposure to Europe for when it all works out.

Strategies.

For Institutional investors, buying Euro stocks and bonds with the expectation of government intervention was a temporary tactic not a strategy. Now Institutions are now incorporating different risk management tools into their Euro portfolio strategy. Some institutions are buying call options on the Swiss Franc or (relatively less expensive) Danish Krone. Others use swaption collars to protect against (further) interest rate drops. Still others are using derivatives to hedge against tail risk (small probability but with dramatic impact of a Euro breakup for example). These strategies complement the old school strategies like focussing on Multi-National Corporations (MNC’s) (that get significant revenue from non-Euro sources) while underweighting Euro Banks. (Wilfred Hahn began increasing strategic focus on MNC’s years ago).

Individual investors have a number of strategies available to them.

Dollar-cost-averaging into Euro and/or EAFE stocks dulls the impact of one-time high or low price because the investor averages in incrementally.

Rebalance. Rebalancing is a buy low and sell high discipline that works especially well at market extremes.

MNC’s. Like Institutional investors, Individual investors should focus on MNC’s as well. Likely through Exchange Traded Funds (ETFs) rather than individual stocks. (See How to buy Europe below – Next time).

½ now ½ later. The line between market timing and tactical asset allocation is sometimes blurred. A ½ now, ½ later strategy straddles the timing fence. Despite all the analysis, one simply doesn’t know if now when the exact right time is or is not. Better to be ½ right than all wrong.

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Next time? How to buy Europe.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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