Stunned disbelief

How can anyone have any faith at all in the so called ‘technocrats’ to resolve Europe’s problems?

After watching CNBC's Michelle Caruso-Cabrera interview Greece's new prime minister, Lucas Papademos, our reaction to the unfolding situation with Greece and with the Euro as a whole was stunned disbelief.

As my business partner, Paul Gambles, told CNBC’s Martin Soong, Lisa Oake and Sri Jegarajah recently, “If I were Greek, I would be on the streets rioting because I think that's the only appropriate response. There is an unelected prime minister installed by what we thought at the time was the ECB and the core of the European Union, but what we now know was Germany. There is a technocrat with no mandate, installed by Germany, who is part of a mechanism that denied the Greek people the referendum that they had been promised on the Euro, and who stands there and tells the world, ‘The Euro is what everyone in Greece wants.’ But if he looks out of the windows; there are thousands of people on the streets of Athens who don't agree with that.”

There are a million people in Greece living below the poverty line who are actually starving on a daily basis, and Papademos sits there and says, “We need this adjustment process, and yes wages are going to fall, but by the end of it we'll be okay.” This is a multi-year process. For Greece to become competitive is probably going to take five to ten years - at least. The people are not going to go along with it. They have been promised early retirement and lavish pensions. These are now nothing more than pie in the sky.

The Greeks would not have gone along with it even if they had elected the people in charge of it. We have been saying this for a period of time, and it is going to be painful in the short term which is why politicians do not want to do it, but the only way out for Greece is to leave the Euro.

People wonder exactly how this will happen as there is no provision for this type of scenario in the European constitution, but the EU does not have a constitution any more. It was torn up and buried on December 9th by Germany and France. The EU has no legal mandate.

Greece should actually just leave. It should re-introduce the Drachma and Drachmatize the Euro debt. There are actually two really good play books for this. We were all here in Asia in 1997. We saw what happened. Yes, it was six months of pain, but it was a pretty sharp recovery after that, and South East Asia has done very well. ASEAN is in the situation today where it does not have debt problems.

But there is actually an even more current example and it is a European example. Iceland. It devalued its currency, and yet Iceland had one of the strongest growth performances of any economy in the third quarter of last year. Iceland has started to adjust. It has not got anywhere near as far in adjusting yet as it needs to, but it devalued its currency and because of that it is starting to write off debt and assets, and actually starting to grow again. Iceland grew at 3½ percent in quarter three so it, at least, seems to be at the start of a path to recovery.

What we are seeing now is a situation where everything is politically driven. The dynamic is that Germany is now in charge of the cheque book. That is what happened on December 9th when we got an agreement that everything can be done in bi-partite deals now. If you need to borrow money, you go to Germany, and it is Germany who sets the conditions that will apply.

In our office, we have actually stopped referring to Angela Merkel; we now refer to her as Alaric Merkel. Alaric was the king of the Goths, who in the 5th Century marched on Athens, didn't get into a war but surrounded Athens and starved the city into submission, and then from there, in 410, he marched on Rome, surrounded Rome and starved Rome into submission. To me that is what's happening in the Eurozone right now. We have got Germany dangling the cheque book, calling the shots, making all the threats. But how long will everyone else go along with this?

So the current offering of 3% on 20 to 30-year bonds is really a bribe. It is an iron fist inside a velvet glove. What are the options if you don't? I think we are getting very, very close to the point where private investors are going to look at it and say, “You know, on a net present value basis, we need to just repudiate that debt.” So far, they have sort of pushed them along step by step, and they are getting closer and closer to the line in the sand; in fact they are probably re-drawing the line in the sand as we speak, so it is very hard to say the point at which they are going to turn around and say “enough's enough”, but we are getting close. There are clear signs.

Look at the CDS markets and everything they are pricing in. Not only that - there is so much distrust in the Eurozone. We have been saying for some time that the key figures for 2012 are TED (T-bill & EuroDollar) and LOIS (Limit Order Information System). As the TED spread shows, no-one wants to take the risk of lending dollars. And with LOIS, the Overnight Spread, nobody wants to be the one who is lending money to other banks, and that is precisely why there is so much money parked in the ECB every single night. This money is not circulating, which is incredibly bad for the global economy, but it is also a sign that we are getting closer and closer to a terminal event.

If you look at the TED spread and LOIS, they have gone from normal levels of around ten basis points, up to around 50 or 60 basis points. Over the last month or so, they have eased off, but we are closer and closer to capitulation. We are getting there, whether it is this week, this month, or six months from now, we are getting there. How far they can kick the can down the road we do not know, but the end is getting closer.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on stephen@mbmg-international.com

 

Advance Australia Fair?

Last year has fulfilled general expectations for the Australian Dollar and economy and for the global economy.

Although the Australian Dollar - high against the US Dollar - slightly exceeded expectations, our limited hopes back in January have been almost exactly met.

So, what exactly did we expect in 2011? Overall a continued battle between risk-on and risk-off, with the start of the year still driven by the positive momentum of QE2, driving global risk asset markets higher, supporting commodity prices and weakening the US Dollar. All three of these factors are supportive of the Australian economy, Australian equity markets (which are now dominated by resources and the banking sector to an unprecedented extent) and the Australian Dollar.

However, the events of Q3 last year (which had really started to surface almost six months earlier) showed us that what the carry trade gives it can also take away. The sharp snap back below parity was a stark warning of what can happen to the AUD when the problems that have dogged the global economy for over a decade finally flare up in a way that short term measures can no longer smooth over. This should be seen as a warning shot with downside risks of the Aussie sliding below 65 cents in extremis (although the jury is split as to whether that’s more likely in 2012 or 2013).

Further US and European QE and interest rate manipulation, such as the Fed’s much vaunted ‘twist’, undoubtedly bought more time, delaying the grim days of reckoning, whilst making the ultimate problems more severe. 2012 still seems the likeliest ‘red alert year’, although noted economist, Professor Nouriel Roubini, believes that the central bank masters of the universe can buy another year before reality bites.

The challenges facing the global economy largely stem from the inefficient allocation of resources and wealth across developed economies as a whole over the last three to four decades. This created the unprecedented debt bubble that hangs like a dark cloud over the global economy from America to Zimbabwe.

The most widely read economic book of 2010 was 800 years of debt, why this time will be different by Reinhart and Rogoff. It mainly concludes that this time will not be different - the bursting of the European, US, UK and Japanese debt bubbles will inevitably lead to severe global depression from which there will be few if any places to hide. The expectation is that debt crisis 2012-13 style will initially see the following result:

• A global depression

• A collapse of global equity and property markets

• A liquidity crisis

• A flight to US Dollar and US T-bills

A second phase of the crisis is likely to see the decoupling of economies like ASEAN which has low levels of external debt and healthy balance sheets as a result of the post-1997 period of adjustment.

The gorilla in the room remains China whose politicians have yet to decide how to handle the imminent slowdown. Will they take pain on the chin and encourage a period of adjustment as a pre-cursor to further growth? Or will China’s politicians copy Western mistakes of ‘extending and pretending’ putting off the inevitable but making it much worse in the process.

China, the last driver of global growth, holds all the aces in this round table discussion. What we expect with a reasonable degree of certainty is that the onset of crisis will provoke the fall in AUD, referred to earlier and a sharp correction in the ASX, where a ‘three handle’ seems inevitable. We thought we could have got there in the last couple of weeks of 2011. Any global slowdown will seriously depress commodity prices, further squeezing the Australian currency and economy.

A sustained correction in Australian property prices - now the singly most overvalued property market - will take place over several years. Although the severity will vary from region to region we expect WA along with the Gold and Sunshine coasts to be the worst affected. Residential properties could ultimately see falls exceeding 30 percent.

Australian currency, property and equity markets might not revisit recent highs again for many, many years. This is not a typical, cyclical event - the global economy, the Australian economy and global and Australian equity and currency markets are undergoing a seismic shift that has been coming down the line for over a decade. It has been looming larger and closer since the credit crunch and Global Financial Crisis but it is now inevitable.

The only real questions are how quickly will each part of the world recover and what will the world look like afterwards? China’s longer term growth potential remains the key to Australia’s bright, long term future but for the next few years the lucky country’s resources-dominated equity market, overheated housing market and carry-dependent currency appear to offer meagre rewards in return for a risk element that goes off the scale.

Expat Aussies with a range of international currency, investment and deposit choices can position themselves very nicely to make the most of the opportunities that will inevitably arise from such dislocations much more easily than the countrymen that they have left behind back home. Expect periods when the best results come from staying well away from Australia’s equity and property markets, holding very little more than an emergency reserve in AUD and working in the faster recovering, less indebted markets of South East Asia.

Aussies who can do that might turn out to the really lucky ones! Advance Australia? If it can stop still they will have done well.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on stephen@mbmg-international.com

 

Strategic Asset Allocation

We have just completed our annual review of our neutral strategic asset allocations and, basically, the executive summary is that we have increased our core fund’s neutral global equity exposure from 30% long and 10% long / short upwards to 35% and 10% respectively thus giving a total of forty five percent. This is at the expense of Government Bond exposure, which we have now reduced from 15% to 10% on a long term neutral basis. Whilst the move may appear small it will have a material impact on the tactical asset allocation moves and risk management within the overall portfolio on a daily and monthly basis.

This comes from an annual review based on our expected ten year forecast returns optimized within the portfolio. It is important to know that it does not change very often. The neutral long global equity exposure was effectively reduced in 1999/2000 from 50% to 30% and has remained there until now. We have always believed that strategic asset allocation is not static asset allocation based on averages, but is driven by asset class valuation. We see risk in terms of making absolute not relative returns. An efficient frontier portfolio based only on historical standard deviations alone would have produced the same static allocation for global equities for the 1990s and 2000’s.

However, in one decade the S&P produced 400% returns and the other 0%. No further explanation is needed.

For those who have not read GMO’s James Montier’s white paper entitled “I want to break free or Strategic Asset allocation # Static Asset Allocation” please contact me for a copy as it explains this whole subject much more clearly than I ever could.

Valuation of asset classes matters greatly. The chart below from GMO’s report illustrates the point very clearly.  For global equities (using S&P500 as proxy) if your allocation when PE valuations are 20-48 times ten year average earnings you can expect 2% per annum real returns as against 10% per annum real returns if you buy on PE multiples of 5-13 times etc.

For Government Bonds, if you buy at a starting yield of 2.8% on 10 year US T Bond you get 0% real return on a 10 year view versus buying at 7.6% yield equals 4% real returns for the next 10 years. Go figure.

Whilst global earnings still reflect the highest profit margins in multiple decades, and the European Debt crisis is far from solved, we believe the ten year expected real returns are very close to the left hand axis in each chart above and a Strategic Asset Allocation shift is required.

In conclusion, global equities are much better value than they were ten years ago, government bonds offer terrible value with zero real return, if not negative on a 10 year view and gold has nearly achieved its valuation target but is probably not quite there.

For our cautious to balanced portfolio to have had the same benchmark asset allocation to any of these asset classes over the past twenty years is ludicrous, but that is what most efficient frontiers produce. The standard deviation remains the same but the returns vary wildly. As stated before, no further explanation is required. Basically, when it comes to funds there are lies, damned lies and statistics. Rather than drown yourself in figures that are produced by the people who want you to buy their fund, look at independent research and select the funds you feel comfortable with and match your own investment requirements - especially when it comes to risk/reward ratio.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Stephen Tierney on stephen@mbmg-international.com