“The problem of socialism is that you eventually run out of other people’s money”
Margaret Thatcher
A couple of market letters back I made reference to the movie Groundhog Day and used it as a metaphor for investors. The main character in the movie, Bill Murray, is forced to re-live the same day over and over, powerless to have a lasting impact on his reality past midnight. Each morning he wakes to the same song on the alarm clock and no matter what he does throughout the day, nothing carries forward into the next day.
This metaphor is only growing more appropriate as time passes. Each day, we wake to the same song on the radio that contains very familiar words and phrases like Greece, Euro Debt Crisis, Spanish and Italian bond yields, bank bailouts, unemployment, etc. It has been well over two years since Greece (a country with an economy smaller than that of the state of Washington) began having an outsized influence on the global financial system and our collective net worth. And true to a Greek tragedy, the Greek populace is so divided and confused regarding their future, that no government could be formed after a national election last month. This was one of the reasons for the market slide last month. The TSE and US markets were all down about 7% which was brilliant compared to most European markets.
Greece is holding another election on June 17th, which is shaping up to be a referendum on whether or not Greece should stay in the European Union. While most Greeks want to stay with the Euro, they don’t want the conditions attached with staying. So for the next 2 weeks, global equity markets will likely rise or fall according to which party (Pro Euro or Anti Euro) leads in the daily polls. I personally think that the majority of Greeks realise staying in the Euro and the European Union is in their best interests but never underestimate the madness of crowds, especially on complicated issues like this one.
Of course, while Greece is the lightning rod for all of this uncertainty, it is just one of the European countries with severe economic challenges. And if Greece leaves, does that pave the way for Spain or Italy and then what is left of the Euro? And with France electing a socialist government last month (which ran on the seductive platform that growth, not austerity is the better way forward), there is more uncertainty than ever.
Now Germany is pretty much on her own in the “live within your means” camp. The pressure is mounting for Germany to go “all in” on the Euro and agree to the creation of a Eurobond that effectively would bind all the countries more tightly together with Germany’s strong economy and credit rating backing the rest of Europe. This would lower the borrowing costs for weaker countries and raise Germany’s interest rates from all time lows. The analogy of a parent “co-signing” loans for their children comes to mind and you can imagine that the German people are a tad reluctant to go down this road. Why would Germany provide this support without having additional control over how these spendthrift economies operate going forward? Well, as unpleasant as it may be for the Germans to continue supporting these wayward countries, the German banking system is filled to the brim with their sovereign debts and defaults would cripple the German banks. So it is in Germany’s best interests to keep moving forward. As the former CEO of Deutsche Bank was recently quoted as saying “Destruction is move expensive than further construction”.
So it appears that Europe really is very close to a watershed moment. Either the 17 countries acknowledge that further integration is needed to navigate the debt and banking challenges or Europe attempts to “unscramble the egg” and end the union or scale back to the core countries. But status quo is not working and markets are tired of painfully slow progress. And there are some decisions that need to be made quickly. For example, while these 17 countries share the same currency, there is no collective banking guarantee on deposits so capital is leaving the weaker countries and going to Germany and now some Spanish banks need to be recapitalized. This will happen because it is in everyone’s best interests for it to happen but waiting and watching the process is painful.
A lot of money is also leaving Europe outright and going to America which is a double-edged sword for the USA. While they have to love the capital inflows to fund their own deficits, the last thing the USA wants right now is a higher currency which will hurt their exports. Over the last 6 weeks, the US$ has appreciated almost 5% and this has caused commodities to drop in price (since they are all priced in US$) hitting the TSE Index very hard. So our market is suffering not only because of global uncertainty but also because of currency dislocations.
Markets don’t like uncertainty and besides Europe, China and the USA have some challenges. China is trying to dampen down the unsustainably high levels of economic growth experienced in recent years with a target of around 7.5% with more tolerable levels of inflation. The markets are worried that the Chinese economy will stall and I see this as completely irrational since China can step on the gas very quickly and is in fact doing just that by lowering interest rates. China navigates economic conditions without the political indecision that the rest of the world suffers through. Lastly, there is a lot riding on the American election this November because that process needs to provide a clear mandate to the next government in order for it to address their budget and fiscal challenges. If nothing gets decided, the scheduled tax increases and spending cuts that are set to occur in 2013 would most likely push the American economy back into recession so continued political gridlock is not going to work.
We all know it is not an easy time to be an investor these days but I remind everyone that we do not own stocks, we own companies (directly or by way of our mutual funds). Most of these companies pay higher dividends than government bonds and these dividends have been going up over the last few years and will most certainly go up many times over the next 10 years. As a matter of fact, about 75% of the stocks in the S&P500 index yield more than 10 year US government bond yields currently. And at the moment, that 10 year US bond yields about 1.60% after hitting the lowest yield in recorded history last week. If (when) the yield on the 10 year bond goes back to where it was just last July (remember back then when the USA lost its AAA credit rating?), investors will lose multiples of this 1.50% return. And keep in mind that almost every pension fund in the world needs returns of at least 6% and this is getting increasingly hard to expect from the bond market. At some point, when the tide reverses, there will be a tidal wave of money flowing out of bonds and that money has to go somewhere.
The recent Facebook debacle highlights the risk of thinking like a trader as opposed to an investor. vast majority of participants that paid $38 for Facebook had no interest in being an investor but intended to flip it for a profit. I suspect few really believed that the company was worth about $100 billion but expected there would be a greater fool to pay more for their shares. The stock has dropped by almost 1/3 in just over 2 weeks and in my opinion, is still overvalued. All the while good companies continue to trade at depressed valuations. Let’s remember that we are investors.
My longer term inflationary concerns have not changed. Every time the markets stumble, governments intervene and provide support and much of this support has created more government debt. Ultimately, this debt has to be accounted for and as France just demonstrated, it is hard for politicians to get re-elected telling voters what they don’t want to hear. I reiterate my conviction that at some point the only way governments can pay back these debts is to devalue them by engineering higher levels of inflation. I continue to worry about this and position for it by investing in companies that can navigate inflation and be in a position to raise dividends. I would rather be a year early than a month late on this call.
Don’t bet on the end of the world. It will only happen once and you will not be able to collect.