“Investment is an activity of forecasting the yield on assets over the life of the asset… speculation is the activity of forecasting the psychology of the market.” – John Maynard Keynes
After stealing the headlines last fall, it seems most people became exhausted with Europe’s debt problems. The European Central Bank’s (ECB) Long Term Refinancing Operation (LTRO) provided a strong helping of liquidity to the sovereign debt markets, giving global markets a sigh of relief, and alleviating some risk of a disorderly default by countries. The ECB is catching up to the Fed’s and Bank of England’s balance sheet expansion, thanks to the LTRO program.
Unfortunately, this does not address the solvency issues, i.e., the fact that peripheral European countries like Greece and Italy simply are not able to meet the debt obligations over the long-term without a reduction in the amount owed. This is why creditors of Greece agreed to give them a 70% haircut on their bonds, in exchange for a longer maturity period.
The problem is that if you are going to bring a treat to class, you better bring enough for everyone. It sets a poor precedent for Portugal and other countries seeing Greece given a break on some debt, as those countries will probably want some debt relief too.
Well the break comes at a cost, and that is austerity (a policy of deficit-cutting, lower spending, and reduction in benefits and services provided). This in turn lowers growth. The formula most cite for problem debt issues is:
Gross Domestic Product
Lowering growth (GDP) only makes the debt as a % of GDP ratio increase, and deficits worse over time. Thus austerity is not a road to improvement for the people of these countries or the creditors who hope to be repaid.
One of the best leading indicators for the broader economy is the Purchasing Manufacturing Index (PMI). When above 50 it indicates expansion from the previous month, and below 50, contraction.
Germany and France continue to be the biggest benefactor of the Euro currency union. Both have very low unemployment and decent growth projections, despite stumbling to a negative GDP in the 4th quarter.
The peripheral countries though, including the usual suspects of Greece, Portugal, etc. continue to show a contraction in manufacturing, albeit at a slower rate as the PMI data improved to the best levels in the past sixth months in January.
The MSCI Europe (proxy for European stocks) rose 18% over the past five months as the LTRO program and better than expected growth data (or a lower contraction than expected) came through. This has made investors giddy across asset classes. Below is a chart showing net speculative positions across equities, bonds, and oil. The grey lines show time periods over the last 13 years when all three had net bullish positions (all three above the zero horizontal axis).
This typically led to disappointing results over the following 6 months, as MSCI Europe was up only 19% of the time.
Still, European equities remain about fair value and attractive for those with a long time horizon. From 1970 to 2011, the MSCI Europe price returned 5.7% while dividends provided 3.9% for a total return of 9.6%, as studied by Ned Davis Research.[i] Interestingly, the average historical dividend ratio of 3.9% is right where the MSCI Europe sits today.
Private equity firms and hedge funds discussed the European opportunities at the 2012 Wharton Restructuring conference earlier this month. One analyst summarized, “It is likely that the assets may turn out to be long-term good investments, while those looking to trade in the securities of those assets may not fair nearly as well. Asian investors, particularly China and India are pouring money into European assets as a long term investment and as a hedge against their investments in the US.”[i]
The risks are certainly out there, as we see over-bullish sentiment and a still yet unresolved sovereign debt situation. Investing over speculating looks likes the best approach when it comes to Europe today.
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[i] Aranda-Hassel, Christel. “European Economics and Strategy: ECB – It’s raining Euros!” February 29 2012. Credit Suisse.
 Secker, Graham. “This Much Cross Asset Optimism Is Usually A Bad Sign.” February 20 2012. Morgan Stanley Research, European Strategy.
 Secker, Graham. “Strategy Data Gallery.” March 2 2012. Morgan Stanley Research, European Strategy.