Investor

5 Things You Need To Know To Profit In Europe

Published on CNBC.com and broadcast on Squawk Box and Fast Money Halftime Report.

As an investor, misunderstandings and overreaction can offer some of the best opportunities to profit. Here 5 widely held beliefs are challenged and attractive investment strategies revealed: There is no need to fear deflation; The stock market trade has reversed; It’s not too late to join the (small cap) party; Central Bank action will not achieve its goal; Turmoil in Ukraine unlikely to directly impact earnings…

FMHR april

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How to Navigate Markets through the Euro-Zone Turmoil…

As the Euro zone crisis intensifies and global markets reflect investor concerns, we ask ourselves, is a Greek exit from the euro on its way? Crucially, preparations have already begun to protect shareholder interest, companies are robust and policy in the US and China aims to maintain the upward momentum. To protect capital, proactively positioning portfolios has been key. International exposure and dividend yields offer attractive opportunities..

A ‘Grexit’ on its way?

All eyes once again are focused on Greece. An inability to form a government has led to a renewed fear that the country could exit the Euro and the wider European Union. Although only a small contributor to European economic output as a whole, contagion is the real risk. Concerns of further losses for external holders of Greek debt and a more widespread break-up of the euro have driven equity market weakness.

A self-perpetuating situation, investors are demanding more to lend to the likes of Spain and Portugal, driving their debt burdens to unsustainable levels. Furthermore, disappointing data from the US and China over the last few days have further added to the uncertainty.

 

…but preparations are underway

However, preparations have already begun to protect shareholder interest. German and French banks, which were the largest holders of Greek debt, have been aggressively reducing their positions. Some, for example, have cut periphery debt exposure by as much as half since 2010. Banks in the UK have been making provisions since at least November when the Financial Services Authority’s top regulator, Andrew Bailey, told banks: “We must not ignore the prospect of the disorderly departure of some countries from the eurozone.”

On the corporate side, interesting anecdotes have highlighted the proactive nature of company management in the face of this turmoil. Last year, for example, Tui, one of Europe’s largest travel companies, was reported to have requested to reserve the right to pay in a new Greek currency should the country exit from the euro.  Corporate balance sheets are robust, holding more cash than long term averages, dividend yields and the potential for merger and acquisition activity once the macro outlook starts to improve can offer an attractive upside.

Finally, although wavering slightly, the US still successfully avoided falling back into recession. Keenly aware of both external and internal risks to growth, Chairman of the Federal Reserve, Ben Bernanke has made it clear he is not afraid to utilise further tools to protect economic growth. Especially with an election this year, policy is likely to remain accommodative. With respect to Emerging Markets, despite the recent wobble and an inevitable cooling of economic growth, with an estimated 1 billion of the population to join the consumer class by 2030, the long-term case remains strong.

Proactive portfolio positioning prudent

To protect capital, proactively positioning portfolios has been key. Reducing direct European exposure as Europe’s southern members showed severe signs of economic stress from an asset allocation perspective and via underlying fund managers has proved prudent. Fund managers have been able to maintain a zero weighting to Greece and a substantial underweight to the likes of Portugal and Spain relative to benchmark.

As equity markets reached new highs in the first quarter of this year, the substantial rally in share prices in the face of continued structural problems within the Euro zone, was a sign that the risk of a downward correction had increased in the short term. Caution was of course well-founded. A move to lock-in profits and redeploy capital to alternatives and property for a more attractive risk/return potential and hedge against inflation has been supported.

Assets which will help portfolio performance during these volatile market times are good quality companies with strong balance sheets paying an attractive level of dividends.  Furthermore, in times of slow economic growth and persistent inflation, strong franchises with pricing power for protected market share and the ability to pass on increases in supply costs to the customer are very desirable attributes.

 

International exposure and dividend yields offer attractive opportunities

Looking forward, a resolution of key issues in Europe is required to gain confidence to add to equity exposure. Structural reform, greater fiscal consolidation, a focus on growth and long term support are required for stability in the region. At the same time, with a medium to long-term time horizon, it is more important to focus on the geographical location of a company’s revenue streams than where it is headquartered. Investor overreaction can offer buying opportunities with share price corrections providing attractive, cheaper entry points to high quality firms. Furthermore, the yield from dividends these companies pay out can provide a valuable income stream. With many investors holding back capital, the flow of money back into markets, buying into sell-offs at lower levels, could dampen these downward moves and provide a level of support. Therefore, although volatility could continue and market direction remains difficult to determine, it is possible to navigate the turmoil.

What to watch this week: Policy drives market direction (Prezi slideshow)

With political pitfalls possible, eyes on Chinese easing, and a flight to quality by investors, policy is driving market direction. This week, the minutes from the latest Federal Reserve meeting will be scoured for signs of further fiscal support. Moreover, the Bank of England’s inflation report will be reviewed for changes to the outlook for growth and inflation. Central bank rhetoric will determine how investors trade. (Watch this as a slide show…)

Political Pitfalls Possible

France’s new President will meet German Chancellor Merkel today with opposing views on the fiscal treaty (see previous post). Furthermore, until a Greek coalition is formed, turmoil there will continue.

Eyes on China Easing

After data disappointed last week, the Bank of China cut the reserve requirement ratio by 50 basis points on Saturday. This is the equivalent to injecting around $64 billion into the banks. Investors remain watchful on Chinese policy, hoping it remains accommodative as the economy cools, to protect global growth.

Flight to Quality

Unsurprisingly, with the climate uncertain, investors have rushed into perceived safe havens. With much money still on the sidelines, a reversal of this trend could provide a hefty boost to markets. Appetite for risk is a crucial current driver.

QE3 Back on the Table?

The Federal Open Market Committee (FOMC) minutes will be scoured for signs of fiscal support. Housing market weakness and elevated unemployment has caused Bernanke to leave the door open for further stimulus. Any indication of inflation easing could put the possibility of QE3 back on the table. Although still unlikely, with elections due this year, the pressure is on for policy to remain accommodative.

A Worse Outlook for UK Inflation and Growth?

The Bank of England’s inflation report will give investors colour on the headwinds for consumption and the economy as a whole, as growth and inflation forecasts may be amended. Plunging purchasing power will keep consumer spending stifled. As rising inflation data calls an end to a 5 month easing trend and continues to surprise on the upside, investors will be watching for an increase in the inflation forecast. Higher energy prices and lending rates have kept the risk to the upside and as we dip back into recession, businesses are unlikely to boost hiring. Investors will therefore focus on whether the growth outlook is downgraded. Headwinds are severe and sentiment remains depressed.

Libya – Oil, Water, Gold – The Real Issues

The oil price has sky rocketed over the past few months. The finger has been pointed at the troubles in Libya and claims of supply disruptions have dominated the press. However, are these claims grounded in fact or are we watching yet another sentiment driven bubble? What are the issues we should be aware of and how should we best invest in the face of such turmoil?

Expectations are often more damaging than reality

Libya’s contribution to global oil production is in stark contrast to the column inches it has been awarded in the press. As quoted by the National Journal, the country produces around 2% of the world’s oil. OPEC (Organization of the Petroleum Exporting Countries) has claimed that they have managed to “accommodate most of the shortfall” and instead attribute the rise in the oil price to fears of a shortage rather than any genuine supply issues. Oil reached a 2.5 year high last Friday. This is against a flattish demand side dynamic. Paris-based International Energy Agency and the U.S. government’s Energy Information Administration left fuel demand growth for this year unchanged and OPEC only raised their forecast by a relatively small amount (to 87.9m b/d from 87.8m b/d).

Note - this chart also highlights the Crude vs. Brent trade with the discount at record levels. Source: http://www.tradingnrg.com/crude-oil-price-forecast-recap-for-march-and-outlook-for-april-2011/

EU Sanction: A further boost for the oil bulls

On Tuesday, the EU extended sanctions against Libya to include energy companies, freezing assets in an attempt to force leader Muammar Gaddafi to relinquish power. Phrased another way, by the German Foreign Minister, this is a “de facto embargo on oil and gas”. Approximately 85% of exports are for delivery to Europe and importers will now have the task of finding potentially more distant and/or expensive alternative sources.

The pent-up downside risk

Nevertheless, many are not paying attention to the downside risk to the oil price as we move forward. Libya has Africa’s largest proven oil reserves but 75% of the country’s petrol needs are met with imports because of limited refinery capacity. Any improvement on this front, if a regime change is eventually secured, could significantly reduce imports and boost global supplies.

 Is water the next oil?

In addition to oil reserves, one asset belonging to the Libyan government which is rarely mentioned is an ability to bring water to the desert. With the largest and most expensive irrigation project in history, the $33bn GMMR (Great Man-Made River) project, Libya is able to provide 70% of the population with water for drinking and irrigation. The United Nations estimates that by 2050 more than two billion people in 48 countries will lack sufficient water, making this an enviable asset indeed.

How can the US pay for the Libya intervention?

It is interesting to note, with all the claims being made that the intervention is oil motivated that, Libya has another form of ‘liquidity’.  According to the International Monetary Fund (IMF), the country’s central bank has nearly 144 tonnes of gold in its vaults…

How to best invest: Retain context

The tide is starting to turn, Goldman Sachs has called the top for commodities in the near-term and oil fell by 4.5% on Monday and Tuesday alone (Source Bloomberg) . With this amount of volatility, short term noise can sometimes overwhelm. For a long term investor, looking for steady and stable returns, an ability to cut through the sentiment (whilst acknowledging it’s importance in driving returns in the shorter term) is valuable. Often many factors are at play and it will ‘pay dividends’ to be well-informed as they become wider known and priced in by the markets. Knowledge may be king but preparation will come up trumps.

European “Financial Mechanisms” – Can they solve the EU’s problems? And how can I make money from the concern?

World unity is the wish of the hopeful, the goal of the idealist and the dream of the romantic. Yet it is folly to the realist and a lie to the innocent – Don Williams, Jr  (American , b.1968)

There has been much in the news lately on the outlook for the European Union. In May, Greece was offered €120bn in EU government and IMF loans over 3 years to replace the need for new borrowing at exorbitant market rates – the “first bailout of a Eurozone country and the biggest bailout of any country”.  Just last month Ireland joined the queue and received a €85bn injection plan. The flame of contagion was burning bright as investors worried Spain, Portugal and Italy were to follow suit quickly (The other members of the PIIGS acronym – and we’ve been advised what risks lie in an acronym!). Then just as markets calmed after the ECB staged their largest intervention and purchased mainly Portuguese and Irish bonds on Friday, the rating agency Moody’s announced it was downgrading Hungary’s debt by not one but two notches!  This country isn’t even in the periphery of the EU, it’s outside of it entirely… and so the contagion spreads….

Source: Bloomberg. The premium investors demand for investing in Irish government bonds over German bunds remains elevated (indicating a perceived heightened risk)

Why won’t the EU bailouts solve everything?

1. FLAWED LOGIC: attempting to solve the problem of debt with more debt

2. NOT SOLVING PROBLEM: without growth, the debt burden as a share of GDP will continue to rise. The latest European Financial Mechanism only covers maters until 2013,  if Debt/GDP has not reduced significantly then bond holders start sharing the pain

3. UNCERTAINTY: ministers keep changing their minds! (“no bail out” to “bailout”, “no pain for creditors” to “sharing the burden”) – markets don’t like uncertainty!

The key discrepancy –

What the ECB wants EU countries to do: Be prepared to increase the size of emergency bailouts, consolidate budgets and reform (implement austerity measures and assume national responsibility so the ECB can avoid being a bailout tool)

What EU country economies need: COMPETITIVENESS AND GROWTH

Market Impacts

  • YIELDS may have fallen sharply for some periphery debt but as the chart before shows, they remain at elevated levels.
  • FORCED SELLING – Pension funds, insurance cos and ETFs which are focused on matching the liabilities to their assets may have to sell certain debt when its credit rating is cut

How can you exploit this?

“Europe is difficult to understand for markets. They work in an irrational way sometimes,” Christine Lagarde, French economy minister

  1. Companies located in an EU periphery country, with strong balance sheets and demand insulated from worries about their homeland (i.e. international exposure and demand for their products from the east etc) making it a sound investment choice, may suffer from illogical moves in the markets that punish anything connected to the country regardless. This debt can be picked up cheaply.
  2. In addition, a downgrade in a country’s government debt may trigger a wave of forced sellers (the pension funds etc. mentioned above) that are restricted in holding this level of debt. If this is just an automatic trade, these distressed sellers may be exploited with the purchasing power in your hands