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Vol. X No.18 - December 1 - December 31, 2011


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Stephen Tierney MBMG International Ltd.

 

Why the Euro is where it is

More than a few readers have recently requested a guide to the EuroZone problem and to the recent manoeuvrings. Here goes:

Post 1945 Europe had to rebuild after the devastation of two world wars that straddled the Great Depression. Capital wealthy America funded the recovery of Europe and Japan plus the emergence of newly independent countries in Asia and Africa.

The universal mood focused on desperately avoiding further wars at all costs. Allied to the distribution of the prosperity dividend this helped bring about a collaborative Federal Europe. At the core of this federation was Germany, with France attached at the hip to its erstwhile adversary. This symbiosis reflected French deeply embedded suspicions and German war guilt. In both countries the ravages of war dominated the thinking of successive generations.

Ironically, Germany’s engine of growth, which drove much of the post-war prosperity, dated back to the 19th century harnessing of phenomenal natural and human resources in a powerful and energetic young country and fuelled the over-exuberant economic development and ambitions that ultimately caused World War I.

The EU grew out of a primarily Franco-German trade and tariff organization for the steel industry that expanded to include the whole manufacturing sector in the post-war era. Harmony and homogeneity were initially and subsequently far from universal - military regimes prevailed at various times in Spain, Portugal and Greece whilst the Iron Curtain cut a line between central and Eastern Europe that provided the starkest aftermath of WW II long after Western Europe had rebuilt, with Germany itself once again divided and a small corridor providing the only access to the western sector of Berlin.

The same urge that eventually unified Germany also drove forward the creation of a federal bloc that ultimately became the largest economic entity on the planet, despite a bureaucratic administrative system that famously interfered in every aspect of life.

Pythagoras’ theorem   24 words

Lord’s Prayer  66 words

Archimedes’ Principle 67 words

Ten commandments    179 words

Gettysburg address     286 words

US constitution           7,818 words

EU rules on cabbage sales       26,911 words

To serve its relative prosperity this Franco-German alliance sought the continuing evolution of the fragile Federation, which remained divided by national borders, languages and currencies. A single currency was conceived twenty years ago and introduced a decade ago as a way of keeping alike the twin dream of a perpetually fast growing federation bounded by homogeneous fiscal, monetary, political and social standards. This is where the wheels started to come off. In fact, there had been clear warnings when the likes of the UK had shown themselves unable to operate within the structures of the Exchange Rate Mechanism (ERM) that had preceded the currency itself.

Stark national and regional differences continued in many ways to grow ever wider. Giving previously unimagined access to cheap and easy capital to those EU members whose economies featured a structural lack of competitiveness merely facilitated a transfer of wealth to the more productive core and a transfer of debt to the less competitive periphery.

Borrowing was suddenly so cheap and so easy for countries that had previously experienced difficulties raising capital because the myth was propagated that lending to all EuroZone members was the same. Basically, when the bonds of the GIPSI countries (Greece, Ireland, Spain, Portugal and Italy) were each rated as being similar to German or French bonds, institutional buyers such as banks and pension funds bought the higher yielding but apparently equivalent risk GIPSI bonds in preference to lower yielding Teutonic ones. This caused the market price differential (the spread) between them to narrow to the point that it virtually disappeared altogether, further embellishing the myth that leverage had created uniform prosperity across the EuroZone, whereas for the periphery the leverage had really only begat a series of bubbles.

Like all bubbles, these fed in a virtuous cycle: spiralling asset prices fuelled high growth rates. However, like all leveraged bubbles, the debt levels eventually started to impact on growth and asset values when slowdown set in. The process of deleveraging caused these bubble economies to slow even further. This coincided with the bursting of America’s bubble, further showing European growth, further exacerbating the debt burden and suddenly leaving Ireland, Greece and Portugal struggling to service their existing debts in an environment where capital became much more difficult to access.

Shackled by a currency whose strength was far more to do with Germany’s positive current account than the budget deficits of the smaller, weaker economies, it was impossible for these economies to grow their way out of trouble.

The heart of the federation’s economic system, the European Central Bank (ECB) began providing short-term solutions to immediate cash flow deficiencies in 2008 whilst failing to address the structural imbalances. Despite astonishing endeavours by the likes of Ireland to cut spending, the shortfalls have persisted strangling these economies into the recessions that persist today. Less imbalanced larger economies, such as Spain and Italy, took a little longer to reach the same point.

Having now reached that point, the crisis is of such a scale that the entire EuroZone is in recession, the Euro banking system appears grid-locked by mistrust and on the back of a liquidity crisis where the ECB seems to be the primary source of bank funding and the domino ripple of sovereign defaults still appears imminent, despite the agreement that each country can now work around the EU’s own founding treaties and constitution to do whatever bilateral deals are necessary to secure short and medium term funding requirements.

Ultimately, capital is still available from the ECB via the core, from America (whose own financial system might not be able to withstand Euro defaults) or possibly from Asia, where neither Japan nor China want to see Europe slow down any further. However, neither big bazookas nor tiny pea-shooters of short-term liquidity will fix structural insolvency and imbalances. It will merely delay the inevitable.

Beyond short term remedies, there are 2 structural solutions:

1. Countries revert to appropriate national currency policies. ASEAN 1997 is the playbook for this - Europe 2011 faces the added headache of a world that, except Asia, may well already be in recession (and Asia may not be so far behind). GIPSIs can, however, choose to debts in Drachma, Lira, Peseta, Escudo and Punt allowing for a much quicker healing after a period of initial extreme volatility.

2. The core countries, primarily Germany, can point enough Euros to plug the EUR5 trillion holes in Europe’s financial system, investing this as permanent capital in assets that will depreciate sharply in value, along with a much weaker currency. This might work. However, to create a sustainable solution, it requires a homogeneous EuroZone to be created.

To create equivalence across the EuroZone may well be possible especially after the monetization of the German balance sheet by printing an unprecedented amount of currency to swap back some of the core’s ill-gotten gains from the Euro experiment back to the periphery.

But to my mind it is far likelier to result in equivalence being achieved by reducing the competitiveness and standards of Germany down to the levels of Greece than by improving the standards and competitiveness of the GIPSIs in line with the core. To that end the recent agreements amount to little more than further kicking the can down the road with the added caveat that in recent weeks the EU has supplanted democratic processes in Greece and Italy (in the words of Eric Rosenkranz “Germany’s just chosen a new Prime Minister…for Greece”) and abrogated its own constitution. This “democratic deficit” to use Nouriel Roubini’s description, may well be a long-lasting problem, well after the warm glow of the short term fix has worn off. Caveat emptor!
 

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 [email protected]


Allocations within allocations

A successful asset allocation strategy goes further than just allocating assets to broad asset classes. Allocation within these classes is also vitally important. Unfortunately this is not as simple as following a quantitative model. It is of great importance to have a fundamental understanding of the current situation to start with in order to structure each component of the broader allocation correctly.

To illustrate this, we look at a common perception within currencies and commodities that some investors hold without assessing the fundamental backdrop, namely the “flight to safety” premise, where they believe Gold and the US Dollar gain in ‘risk off’ periods.  The chart shows the Japanese Yen relative to US D over eight bear markets since the mid 1980’s. The Japanese Yen provides positive returns in these periods, which shows that it offered better protection than the USD. However, the Yen is not a perfect hedge, as when the IT bubble burst, it did not offer much, if any, protection at all. Gold also only offered positive returns in 10 out of the 13 US bear markets since 1970.

The asset class where most investors attempt to get exposure to high Beta during periods of ‘risk on’ and low Beta during periods of ‘risk off’ is equity. Within this asset class there is the perception that some sectors clearly do the trick better than others. As above, this holds true to an extent on average, but the results of this strategy can be vastly improved with a deeper understanding of whatever the current market is at the time.

The bar charts here depict the average return (middle bar) of each sector during all ‘risk off’ (bear) and ‘risk on’ (bull) markets over the past 20 years as a ratio to the general market as a proxy for its Beta. To give a sense of the reliability of this relationship we plot plus (back bar) and minus (front bar) one standard deviation from the average. The smaller the range, the more reliable the average will be as a guide to action.

Reading from left to right the columns are: Technology, Financials, Energy, Healthcare, Staples, Consumer Discretionary, Industrials, Utilities, Materials, Telecoms.

Whilst some average results are hardly surprising (such as staples, healthcare and energy offering downside protection), dispersion on many is quite wide. Tech stocks would have been a leveraged play on the downside at some stages, whilst being negatively correlated when markets rallied at other times. Also the consumer discretionary sector underperformed on the down and the up side at different periods. Industrials and materials are not biased one way or the other on average and financials does offer a leveraged play in general as anticipated, but this does not always work and disparities are large.

In a nutshell, this analysis suggests that quantitative analysis is not effective if not backed by fundamental reasoning, which can be different every time the wheel comes around. Therefore, whilst diversification is very important, it is how it is allocated that will bring you in the extra comfort and reward.
 

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 [email protected]


We’re forever blowing bubbles…

A bubble is created when more money flows into an asset than is commercially or structurally feasible or sustainable.

An example of this was the US property market being driven to extreme highs by the radical trick of making mortgages available to those who could not actually afford them. This appeared to suddenly drive the demand for properties to new exponential high levels - but, of course, the people who were not able to afford the mortgages defaulted. The newly found new demand dried up and, to make matters worse, tens of millions of repossessions are now flooding US project markets, simultaneously increasing supply while demand continues to fall.

The most comparable bubble right now may well be in high yielding stocks - a distorted interest rate curve, manipulated by central banks, has forced investors who need yield to take exposure to inappropriate levels of risk.

Like the property bust, this will also end in tears.

High yield stocks (the VHDYX) fell by over 50% during the Global Financial Crisis. That is looking odds-on favourite again now.

You know it is a bubble when every news article, or sell-side research or advert or financial channel on TV or every fund manager touting his wares talks about high yield equities as the latest and greatest on the basis that they pay better yield than bonds, have upside potential and great balance sheets.

Yes, they do pay better yield - but then they would need to if we are in the kinds of waters where a risk of 50% fall is more likely than any upside. Cash on balance sheets is not always a sign of a healthy economy. Many Japanese companies have more cash on their balance sheets than the value of their capitalization.

These waters are shock-infested!

At least fund manager Jesper Madsen admits that the real reason for investing in dividend stocks is the higher quantum and the smoother delivery of returns over the cycle. It is not the argument that high dividends are the bargain of the century right now. Jesper is right about high dividend stocks over the cycle. However, at the height of a bubble, it is not the right time to buy any asset.

MBMG Group’s latest research analyses the problems, risks and challenges facing investors who need yield right now. Guess what? We think it is the best to avoid high yield stocks and we will leave ‘Forever Blowing Bubbles’ to the West Ham fans.
 

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 [email protected]


China

Some hard (for some people to swallow) facts on China today

With less than 20% of the world’s population, China consumes:
... 53% of the world's cement
... 48% of the world's iron ore
... 47% of the world's coal
... and the majority of just about every major commodity
To continue:
- In 2010, China produced 11 times more steel than the United States and achieved a New World Record by making and selling 18 million vehicles in 2010
- There are more pigs in China than in the next 43 pork producing nations combined
- China is currently the number one producer in the world of wind and solar power (although they don’t use it themselves)
- China currently controls more than 90% of the total global supply of rare earth elements
- China is the world’s largest gold producer
- In the past 15 years, China has moved from 14th place to 2nd place in the world in published scientific research articles
- China now possesses the fastest supercomputer on the entire globe
- China has accumulated over USD3 trillion in foreign currency reserves - the largest stockpile on the entire globe and is the largest external foreign creditor of the US Government (second only to the biggest single creditor of the US Government which is in fact the USG itself as it issues around one quarter of its debt in internal IOUs to itself!)
- The Chinese consume 50,000 cigarettes every second …
Yet Scott Paul, the executive lobbyist for the Alliance for American Manufacturing, a labour-management partnership, says a 28.5 percent appreciation in the Yuan would create 2.25 million American jobs and reduce the annual trade deficit by USD190.5 billion. He believes that China has declared trade war on the USA and that legislation is needed to protect poor little America against the new bully kid on the block.

This has been greeted with much incomprehension by those who believe that economies develop and markets adjust factors like currencies and interest rates accordingly. Yes, Central Banks like the PBoC and The Fed push back against those responses of the market that they do not like. The PBoC has focused on targeting and setting the CNY exchange rates whilst The Fed has used money supply to undermine their own Forex rates through QE, The Twist and two year interest-free teaser rates on short term money.
Scott Paul refuses to see this, preferring to believe that China’s economic success story is a mere reflection of the competitive advantage obtained by China in the currency debasement wars with American manufacturing and jobs the innocent victims of a brutal trade war. This conveniently forgets the fact that when the Bretton Woods agreement installed America as the global supplier of capital, America’s consumption-driven economy quite rightly developed itself and moved up the value chain into highly skilled services and value added manufacturing, dominating high-tech and finance globally. Scott now wants to drag America back down to complete with third world manufacturing labour.
Forgetting that the RMB has appreciated since the Global Financial Crisis and is one of the few currencies year to date to have strengthened relative to USD, Scott now wants to see markets manipulated in the AAM’s favour to help, artificially, US job creation at this difficult time.

Ignoring that the failure to address American structural lack of competitiveness will only make matters worse and that the US has tried to mask this through QE-driven stimulus and currency depreciation, Scott’s view is that QE is acceptable because it was conducted through American capital markets whereas the CNY rates were set by a Cabal in Beijing.
Conveniently forgetting that FDR, and his Cabal in the ‘30s, sat in the White House setting US exchange rates in the same way that the PBoC do now, Scott who, it has to be said, seems to be a thoroughly likeable chap with a highly polished grin, is very articulate as he rewrites history for a desperate gallery.

However, American voters, American businesses and American workers deserve better than this, used as mere pawns in a game of party politics. They deserve to be able to pin the blame on those responsible for the job losses in America’s high-skilled, high-tech, high value economy and not just on a soft target like a Chinese Bogeyman!
Long-term China observers have often remarked that threats and public intimidation are the worst possible way to try to get the Chinese government to do what you want them to, especially in the name of American party politics which Chinese officials tend to view with great disdain.

Enzio von Pfeil of Commercial Economics Asia is decidedly sceptical: "I'm just not sure revaluing Yuan will necessarily create a Chinese trade deficit because U.S. multinationals account for a trade surplus of USD3 trillion in America's global trade…China is for free on the hill… anybody gets to beat up on China and you get free election points off China when you are out there campaigning in Oregon or Seattle."

Robert Roche, vice chairman of the American Chamber of Commerce in Shanghai, says that there are bigger issues: “We really don't feel that the currency is the big issue… Market access is higher up on the list, national treatment is higher on the list, intellectual property rights (IPR) is higher on the list. This is somewhat of a hollow gesture… By going off on the currency bandwagon, it can get a little bit... off track. We don't evaluate the China risk every time something changes in China. We made the risk, we're here, and we're willing to do what it takes to succeed here, and we react to the different changes in the environment. We don't do a whole another risk analysis."
Maybe the self-appointed foot soldiers in the trade war need to do a risk analysis of the damage that could be done if Beijing reacts too strongly to all this. At a time when China is taking some key decisions about its economic future, loose words can cost billions of dollars in a trade war and provoke catastrophic effects for the entire global economy. China is at quite a fragile developmental stage - it is vital for everyone that China avoids repeating the serious policy mistakes that the west has made. This would be easier without such noise and distraction and without such idiotic politics.

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 [email protected]


Creative Destruction at Play

The technology sector has come a long way since the heady market highs of 2000 and yet many investors still treat it with circumspection, thanks to the bursting of the internet bubble and crazy dot com valuations. We believe that the sector has evolved and that much of what was promised in 2000 is now becoming reality.
Looking back, the 1980‘s was all about the migration to the PC, followed by the rise of the Internet in the 1990‘s and culminating in the NASDAQ bubble of 2000. To illustrate how far the industry has come, I thought this quote from Computerworld magazine summed it up rather nicely: "If the auto industry had done what the computer industry has done in the last 30 years, a Rolls-Royce would cost $2.50 and get 2,000,000 miles to the gallon.”
It is our view that we are at the forefront of the third wave of a disruptive new cycle - namely that of connected computing. This has been made possible thanks to three key drivers - cloud computing, broadband applications and the growing ubiquity and mobility of computing. The glue that keeps all of this together is the affordability and speed of broadband. To illustrate this point, NTT Japan has successfully tested fibre optic cable that pushes 14 trillion bits per second down a single strand of fibre, which in plain language is equivalent to 2660 CDS or 210 million phone calls every second!
Ironically, it was the cheap capital of 2000 that allowed broadband to become so pervasive, as companies had so much money thrown at them that it allowed telecom operators to create broadband virtually for free.
To digress for a moment for those of you who are not tech savvy, I‘ll explain what cloud computing is all about. It means that instead of all the computer hardware and software you're using sitting on your desktop, or somewhere inside your company's network, it's provided for you as a service by another company and accessed over the Internet, usually in a completely seamless way. Exactly where the hardware and software is located and how it all works doesn't matter to you, the user - it's just somewhere up in the nebulous "cloud" that the Internet represents. This is exciting because it allows companies to make savings and to boost efficiency. It also allows smaller companies to become more competitive, without being forced to spend a huge amount of capital on IT infrastructure. Furthermore, it’s changing the way the world works as your competitors aren't just in the next town or the next country, they could be eight time-zones away and you probably have never heard of them.
As the third wave plays out there are going to be winners and losers in technology, as new entrants take over from the old stalwarts. Driving the change is the rise of the mobile internet device or smart phone / tablet. Previously the preserve of early adopters and enterprise, 2010 was the year when smart phones became mass market products as volumes grew 80% year over year. Penetration rose from 18% to 27% by the first quarter of 2011. The key winner in this space has been Apple, now the largest market capitalisation stock in the world.
This is unleashing wide ranging forces across the capital equipment, software, hardware, telecoms and consumer electronics sectors. The potential losers in this revolution are easily identified. They are the technologies and companies that shaped the PC era over three decades: Intel and Microsoft, other PC makers as well as hard drive vendors and original design manufacturers that produce over 80% of PC notebook components.
Take Microsoft, for example. With a price/earnings ratio of around 10 the software giant is a value play for some hedge fund managers, including Greenlight Capital‘s David Einhorn. Even Warren Buffet has recently called Microsoft - cheap. But the likes of Ben Rogoff of Polar Capital believe that Microsoft and most other stocks in the PC camp will provide disappointing returns to investors. GLG’S Technology Fund team says, “To discuss one year’s P/E is flawed. It is not that valuation is unimportant. It is instead important to look at an addressable market and how it will evolve over four or five years. Apple and ARM, and others, are slowly destroying the business models of Intel even though they are still making decent profits.”
However, the GLG team doesn’t expect the losers to blow up as connected computing continues to evolve and grow. Instead, their sense is that the stocks of earlier tech eras will behave like IBM, which in the 1990s fell slowly but relentlessly until the company had lost 80% of its market value. We are not arguing that Microsoft or Intel will disappear. What we are saying is that they will be affected for maybe 10 years or more as the market they address gets smaller and they operate at lower (profit) margins.
Companies which we believe are on the cutting edge of innovations have to be the likes of Apple. Thanks to the popularity of the iPhone, Apple has managed to capture over 17% of the global smart phone market in less than 36 months. Apple’s cash reserves exceed $34 billion, enough to buy the world’s leading PC vendor, Dell, and still leave change. It also has more cash on its balance sheet than the entire market capitalisation of Nokia. Apple’s flagship store in Regent Street is the most profitable for its size in London, earning twice as much per square foot as Harrods. Apple is not alone in having lots of cash on its balance sheet and this cash, which is burning a hole in many legacy companies’ pockets, should be supportive of the small and mid cap technology shares today.
Developments in the technology space are changing so quickly that one needs the steady hand of fund managers who really understand the space. For every 60-fold gainer like Autonomy there are equally spectacular examples of capital destruction. Nortel Networks, worth $250 billion in 2000, crashed from $83 per share to under $1 in just two years! It is important to learn from history and the lessons show that the winners typically win for longer than people think while the losers always look cheap and present dangerous value traps.
To end off, it would be remiss of us not to comment on the rise of Social media aka Facebook, Twitter and the like. Some info:
▪ With over 500 million users, Facebook is now used by 1 in every 13 people on earth, with over 250 million of them (over 50%) logging in every day.
▪ To reach 50 million users took Radio 38 years, TV 13 years, Internet 4 years and Facebook 9 months.
▪ 48% of 18-34 year olds check Facebook when they wake up, with 28% doing so before even getting out of bed.
▪ Almost 72% of all US internet users are now on Facebook, while 70% of the entire user base is located outside of the US.
▪ Over 700 billion minutes a month are spent on Facebook, 20 million applications are installed per day and over 250 million people interact with Facebook from outside the official website on a monthly basis, across 2 million websites.
▪ Over 200 million people access Facebook via their mobile phones.
▪ 1 in 8 people married in the US last year met via social media.
▪ Social media has now overtaken pornography as the number one activity on the web.
▪ 48% of young people said they now get their news through Facebook.
▪ 14% of people believe adverts, 78% of people believe peer reviews.
▪ If Facebook was a country it would be the world’s fourth largest.
We are not alone in being nervous of their valuations and to date none of the funds that we invest in hold these companies, largely due to the fact that the real winners have not yet listed! When they do list, their valuations are bound to be on the high side and many will talk about bubble valuations, but as the following example shows, social media companies march to a different drum. The traditional methodologies of one year forward P/Es for companies that show exponential growth are not necessarily appropriate.

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 [email protected]

 


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