“There'll be good times again for me and you

But we just can't stay together, don't you feel it, too

Still I'm glad for what we had and how I once loved you

 

But it's too late, baby, now it's too late

Though we really did try to make it!”  - Carole King (Album “Tapestry”, 1971)

 

Carole King’s classic hit single, “It’s Too Late”, was released about 40 years ago and so it was probably not written with the European Union in mind, although the lyrics are certainly appropriate.  Ironically, the release of King’s album, “Tapestry”, featuring “It’s Too Late” in 1971 coincided with the adoption of the Werner plan by the European Parliament to strengthen coordination of economic policies.  Beginning in ’71, member states had to take measures to harmonize budgetary policies and reduce volatility between their currencies.  So, after 40 years of moving closer together, it appears that the ties binding the EU are now beginning to loosen and come apart. 

There will no doubt be “good times again” for the members of the European Union, but 2012 is likely to be a year that ushers in many changes, some expected and some not.  As investors, we must pay careful attention to the political contrivances that emerge and be prepared for any number of potential outcomes.

"History is where everything unexpected in its own time is chronicled on the page as inevitable" - Philip Roth

 

The markets are slowly backing the European sovereign nations into a corner.  Despite significant support from the European Central Bank (ECB) in the form of bond buying programs, emergency overnight funds and three-year term loans, yield differences between German and non-German debt remain near the highest levels on record.  Mr. Market is indeed telling us that it is too late to save the EU in its current flawed form.   Political and financial leaders are rushing to improve the form through greater fiscal unity but that challenge, while important to tackle, is probably the easiest and least relevant of the difficulties faced by the leaders of Europe. 

The focus of the IMF, the European Commission and the European Central Bank should be on how to best extinguish debt.  The debt loads carried by almost every member state of the European Union is crippling to economic growth, without which there is no escaping the vortex of debt deflation and the associated frailty of the financial markets.

Dealing with past sins must be dealt with first in order for structural reforms to have a chance at succeeding.  Attempting to solve existing debt problems by relying on severe austerity plans is like trying to untie a Gordian knot, which can only be undone by taking a sharp knife to it. 

“A prince (modern day Champagne Socialist) never lacks legitimate reasons to break his promise.”   -Machiavelli

 

No Roadmap 

The real problem I have with the plans and policies being floated around Europe is that none come with a clear roadmap illuminating the path toward a financially sustainable resolution.  For example, everyone agrees that European banks need more capital.  Some say a lot more capital is needed and others play down the amount to be raised.  However, no one has an actual plan for recapitalizing the banks.  The share price of Italy’s largest bank at $1.3 trillion in assets, Unicredit, fell over 70% from the start of 2010 to the end of 2011.  Shares then fell another 40% in the first days of 2012 when the bank announced it was raising just $10 billion in fresh equity to meet a portion of its capital needs.  Unicredit will decimate existing shareholders by more than double outstanding shares at the completion of this equity raise.  European banks are effectively shut out of the capital markets and unable to issue equity in any meaningful way.  Even after the massive dilution of current shareholders, Unicredit’s balance sheet is far from fixed.

Meanwhile, the sovereign nations are too indebted and overcommitted to fill the remaining hole in bank balance sheets.  Banks are therefore resorting to shrinking the asset side of the balance sheet in a deleveraging process that is being felt around the world.  As balance sheets contract, global economic activity deflates from the loss of funds and investors’ faith in the strength of bank balance sheets continues to wane.  The European Central Bank is accepting a record amount of deposits from banks too scared to lend to one another.  European depositors are fleeing banks, particularly Greek financial institutions, in droves.  Greek depositors are on pace to pull 20% of deposits from Greek banks, or about 40 billion euro, during 2011 alone.  If you were a Greek citizen, what would you do?  Italy is placing restrictions on the amount of cash depositors can withdraw. 

“Nothing weighs lighter than a promise.”   -German Proverb

 

Active Management Versus Indexing

Most of the issues and challenges facing the world are pretty well known by now, but that does not mean they are fully priced into the market.  A probabilistic approach to pricing “risk” assets in the current environment is much more difficult than at any time in the last 30 or 40 years.  Potential outcomes do not fit neatly under the traditional bell curve.  Instead, the middle, or belly, of the curve is flatter with greater weight moving out to the tails.  The tails represent the heightened potential for either inflation or deflation to take hold, depending on the type and degree of policies implemented by the world’s policymakers.  This is having a major impact on investors and made it especially difficult for “active” managers to meet, forget about beat, their benchmark indexes in 2011. 

 

According to Bloomberg, 83% of the 4,100 mutual funds that invest in large cap equities failed to beat their respective benchmarks in 2011.  Similarly, well-known bond fund companies such as PIMCO, Blackrock and Loomis Sayles were not able to keep pace with index returns north of 7% for the year.  Most bond fund managers were more focused on avoiding U.S. Treasury notes, which they believed were overpriced and risked losing value as rates increased.  Instead, they sought short duration spread product and, in some cases, bonds denominated in other currencies.  But the dollar held up well against most currencies in 2011 and yields declined sharply in the third quarter ending the year near historical lows. 

 

In an environment where the tails are “fat” (extreme outcomes are more probable), getting it wrong can be costly, as many managers learned last year.  Fortunately, we held the view early in 2011 that debt deflation would remain the dominate theme driving markets until policymakers decided it was time to take heroic steps in addressing the financial mess around the world.  This view enabled us to meet and exceed our fixed income benchmarks for the year.  The failure to keep up with respective benchmarks over a short period is not necessarily a reflection of the managers’ skill.  Rather, it illustrates the unusual complexity of inputs investors must now assimilate to come up with strategies that provide adequate returns with acceptable risk.  It also gives further credence to the necessity of taking an expanded view of the manager’s track record.

“Successful investing is anticipating the anticipations of others.” – John Maynard Keynes

 

Expectations for 2012

As we set expectations for 2012, the global financial markets are no less complicated but expected returns for most asset classes are even lower now than when we started 2011 making our jobs that much more difficult.  The margin for error has narrowed.  For fixed income investors, returns of 2 or 3% will probably look pretty good this year and next.  Equity managers will need to be focused on stock selection with an emphasis on companies that possess very strong balance sheets, stable cash flows and price valuations with low expectations built in.  While equity investors can expect to earn more than bond investors over the next 5 – 10 years (probably inflation plus 1 – 3%), equity returns will likely be volatile from year – to – year with the next couple of years being the most vulnerable.  While many will be tempted to give up on active management strategies after the dismal showing of 2011, passive investing will just sentence investors to unacceptably low returns over the intermediate-term with no hope of reaching more satisfactory rates of return.  Passive investing also locks you into asset classes and sectors that you should be avoiding now or in the future.r1`

 

 

 

(c) Sextant Investment Advisors

www.sextantinvestment.com