Mid Quarter Update from South Shore Capital Advisors Newport

September 1, 2011

Given the volatility and related uncertainty in the market I felt it might be worthwhile to provide an update. I send out quarterly letters to this end, but with the recent turmoil in the markets a mid-quarter update seems appropriate.

Recession in the US The global economy is clearly slowing down. Worried about inflation, China in particular has stated a desire to put a brake on growth, and that seems to be working. Governments in the US and Europe would like to speed things up but have few tools at their disposal. France reported zero GDP growth for the second quarter, and the slowdown in China has been noted by exporters in Germany. Closer to home, estimates for US year over year GDP growth have been reduced to around 2% for 2011. Economists are now saying there is a 30% or 50% chance of a recession. That seems a bit too exact for a profession that got the last recession exactly wrong and brings to mind John Kenneth Galbraith’s comment that “the function of economic forecasting is to make astrology look respectable”, but let’s just assumes there is a chance of a recession. Accepting the probabilities above we can then assume there is also a 50% to 70% chance that we avoid a recession. In the summer economic activity slows and it may be that is all that we are experiencing right now. We could see a reacceleration come September, helped by lower interest rates and oil prices, especially if China backs off some of its recent tightening moves.

Financial Crisis in Europe
Concern about where the US economy is headed is clearly influencing stocks prices. However, the 4% and 5% swings in the market witnessed over the last few weeks suggest that something more is at play than the risk we slip from low growth into recession. And these swings have little to do with the S&P downgrade of the US, Treasury bonds actually rallied on the downgrade news. It appears to me that the bigger issue is fear that the world is headed for another financial crisis, one similar to what we saw in 2008, but this time sourced out of Europe. As discussed extensively during the last recession, and best described in the book “It’s Different this Time”, recessions caused by the failure of the financial system are much deeper than ones caused by other forces, say the Fed tightening (1991) to slow inflation, or a period of overinvestment (2001) that needs to be digested. A financial crisis is when banks stop doing business with each other, and because of the interlinked nature of the global financial system, a financial meltdown in Europe would be felt elsewhere. Just two examples, US money market funds are major lenders to European banks, and Deutsche Bank and Soceite Generale of France are two of the biggest counterparties behind the derivatives contracts found in many ETF’s.

Europe’s banks face a situation that is similar to what the US banks experienced three years ago. Too much money has been lent to too many people who can’t possibly pay it back. In this case the loans went to subprime countries and not subprime homebuyers. At some point this debt will have to be written down to reflect reality, or assumed by some other entity. Financial Crisis II begins if the banks can’t offload their sovereign debt or have to write it down without an injection of capital. Pressure is building on the banks, today’s newspapers carried the story that authorities are questioning why some banks value their Greek debt at 85 cents to the dollar while that same debt trades in the market at 50 cents. The International Monetary Fund estimates that marking European sovereign debt to market would put a $287 bn hole in Europeans banks’ balance sheets.

After Sixty-Five Years Germany Wins by Default
Europe as a whole has the resources to deal with the crisis. The problem is they do not have a central government, or a powerful central bank that can step into the breach in the same way the Fed and the US Treasury did. All the Europeans have right now is the Germans – with an economy one-third bigger than the next largest economy in Europe and possessing the largest pool of savings. Europe will avoid crisis if the government in Berlin decides to end it, a fact that has created political paralysis across Europe. Of course the US suffers from political paralysis too, but perhaps only from the waist down relative to the full body paralysis of the Europeans. There is at least vigorous debate in this country, and TARP and the auto bailouts got done despite distaste for both from all involved. In Europe there is denial and silence. No one wants to see German Finance Ministry officials arriving in the capitals of southern Europe with detailed plans about how these countries will pay them back.

However, something not too far from the scenario above might happen. Consensus seems to forming around the idea that to prevent a financial crisis and to keep the euro as the common currency for all 17 countries that currently use it, requires the creation of “Eurobonds”. Bonds that would not be guaranteed by the individual countries that issues them, but instead jointly guaranteed by all euro-zone members. No fools, the German tax payers know this means the burden of the guarantee falls on them. Without a Eurobond some unknown number of countries will default. More than likely Greece and Portugal would be the first to go. When they need to refinance maturing debt they will find no buyers for their bonds. In fact there haven’t been buyers for their bonds since the start of the year. To date the European Central Bank has filled the void, but at some point they will run out of capacity. Default would ultimately lead to a country abandoning the euro. Newly printed drachmas, escudos, and punts would be issued and would devalue instantaneously against the euro, allowing these countries to become more competitive again. This is how it used to work pre the 1993 introduction of the euro when the drachma, lira, peseta, escudo and punt devalued annually vs. the Deutsche mark.

What is particularly concerning about one country leaving the euro is that you do not know what will follow. If Greece and Portugal go are they followed by Ireland? Can it stop there, or do big countries like Spain and Italy go? Will we see the return of the lira and peseta? Together Spain and Italy are the same size as Germany in terms of GDP, and their combined debt is much higher. There are no good options. No one wants the Germans to bail out the rest of Europe, especially the Germans, and no one wants to see the end of the euro. Expect inaction for some time.

Conclusion – Defending the Indefensible before giving up to the Inevitable
Because of the uncertainty of what would happen if the Euro zone crumbled, I place a higher probability that the Germans will step up than on the return of the drachma. The Germans also understand that they have been beneficiaries of the Euro. Many more BMWs were sold in Greece, Italy and Spain after the introduction of the Euro than before it. But it could take a long time for German politicians to lead their country in that direction. In the meantime I expect financial markets will remain volatile.

At SSCA Newport cash levels right now are high, and bonds are 15% to 25% of portfolios. I have incorrectly been negative on bonds, particularly US Treasuries, but believe it is important to have some exposure, and that exposure has been beneficial. Stocks still look like very good value.

As noted in my last letter, there are companies that have better balance sheets and growth outlooks than most western governments. They also pay you in dividends more than what the US, German, British or Japanese governments are willing to pay you to buy their debt. I would use rallies to lower bank stock positions, and selloffs to buy high quality global consumer brand companies. These are companies that can maintain/ grow earnings in a low growth environment and maybe through a recession. Non-life insurance stocks which have their own cycle look attractive. Some healthcare stocks offer good earnings growth in a slowing economy. Investing in pipelines that bring newly discovered shale gas to market also seems like a winner.

As always, if you have any questions please call or email.

Lowell Thomas