Focus on Europe: The Sovereign Debt Crisis, Currency Woes and Finding Quality

The flags are out as David Nadel joins Mark Rayner in London earlier this year.

How would you sum up the sovereign debt crisis in the European Union?

Mark Rayner: Quite simply it shows that the euro, as originally designed, has failed. The single currency was meant to lead to the convergence of national economies over time, but it has actually led to the opposite. The euro was from the outset as much a political project as a currency one, and such lofty ambitions proved unworkable.

Why do you think that is?

David Nadel: The economies of countries such as Germany and France are fundamentally much stronger than those of Portugal or Greece. Greece's economy, for example, is not sufficiently diversified, being based largely on tourism, shipping, olive oil, and, to a more limited degree, construction. Anyone who has travelled to both Germany and Portugal will notice vast differences between the countries. Germany is quite simply an economic powerhouse with a world-class infrastructure, a highly educated and skilled work force, world beating technology, products and industrial processes.

Mark: Before the introduction of the euro in 1999, the weaker countries would try to remain competitive with Germany by allowing their currencies to depreciate against the Deutsche Mark. In the 90's, the management of German companies would often tell investors how they had painstakingly, over many years, built competitive advantages, market share and profitability, only for the Italians or other competitor countries to regain competitiveness via currency devaluation. Typically, German management would shrug their shoulders and get on with the task of re-building their previous competitive advantage. Their hard currency meant German companies had to build competitive advantages the hard way.

With the euro, this option of competitively devaluing against Germany was taken away from the less competitive European economies, which was good news for German companies. However, it would only have been good news for the euro zone in general if, with the soft option of currency devaluation removed, it had led to structural reforms in those less competitive nations. (Not all euro zone nations use the euro.) We now know that, rather than undergo these tough and necessary reforms, the consumers and governments in peripheral nations used the lower interest rates afforded to them by use of the euro to go on a spending spree, pushing some of these countries close to bankruptcy.

David: And until the system became unglued, the euro had been treated much like a Collateralized Mortgage Obligation was before the housing market corrected here in the U.S.: both packages masked some poor-quality credits. Unfortunately, the European sovereign debt crisis laid bare the same basic fact as the housing bubble did: The total of such packages is not worth more than the sum of the parts.

So the idea of a currency union is flawed?

Mark: Yes and no. If you think about it, every country has its own currency union. For example, England has a currency union called Sterling. However, you could argue that the country actually needs two currencies, because for various reasons (economic, geographic, historical, social) northern England finds it hard to compete with the more prosperous south using the same fixed currency.

However, no one, of course, raises the topic of a second-tier Pound for northern England, because England is one country, united by a common history and language. There is, in effect, a social contract between the north and the south and an alternative route is taken. Namely southern England perpetually subsidies northern England. Taxes raised in the south are, on a net basis, transferred to the north year after year and have been for decades.

David: So currency unions can work within national borders, where you have that social contract, but are clearly more difficult to implement pan-regionally across borders and differing cultures.

Mark: On the continent, as the disparity between the strong and weak economies that use the euro was not closed through structural reforms, the Germans have to be willing to enter into a social contract with the southern countries and perpetually transfer funds from Berlin to Athens and Lisbon etc.

Logically, the Germans should be willing to put their hands in their pockets. The euro is weaker than a standalone Deutsche Mark would be. This benefits the German export machine, leading to higher employment among German consumers and higher tax revenues for the government. That some of these surpluses should be funneled back to the peripheral countries seems logical.

However, this proposition is difficult to sell to a German electorate increasingly skeptical about the euro. This is where economics meets politics. Unfortunately, the idea behind the euro was driven by a grand political ambition of European integration. Unfortunately for that agenda, the European Union (EU) is made up of 27 countries, speaking 23 different languages each with their own histories, cultures and laws. And not all of those 27 EU countries use the Euro. Creating a pan-European social contract under these circumstances was probably impossible from the outset.

So what options does Europe have in facing its sovereign debt crisis? What do you think is likely to happen?

David: I think we see four potential paths:

1. The less competitive countries default on their debts, abandon the euro and return to their own domestic currencies. These would then devalue tremendously, allowing these economies to find a floor from which they can (very slowly) recover. At the same time, the euro would likely appreciate significantly, being left with only the stronger members. Such defaults are of course politically unpalatable, but clearly cannot be ruled out in the case of Greece and perhaps other so-called PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries.

2. The less competitive countries stick with and deliver on their promises to institute sufficient austerity and structural reforms needed. Overall, we don't see this as very likely. Greece is severely limited in its ability to collect tax revenue from its citizens, let alone adhere to the sort of austerity needed, and we believe there is little reason to believe Italy or Portugal would be much more compliant or reliable.

3. Much closer fiscal integration, specifically via the Eurobond. A quote from George Osborne, Chancellor of the Exchequer in the UK, hits the nail on the head: "There is a remorseless logic to moving from monetary union to fiscal union."¹ Eurobonds would be issued by a central European debt agency and the proceeds would be distributed to the European countries. The Eurobond has some theoretical appeal. By creating a unified bond instrument for all 17 members of the common currency, it would effectively cut the ties between the creditworthiness of individual member countries and their borrowing rates. One can see how, in theory, this could end the successive attacks on bond markets of individual countries (Greece, then Portugal, then Italy, etc.), and effectively end the European sovereign debt crisis. And indeed, taken as a whole the finances of the euro zone are by some measures OK; for example, the euro zone's collective budget deficit would be approximately 4% of GDP, much better than America's 10% and Great Britain's 8.5%.²

But according to the IMF, cumulative, collective government debt would still amount to about 88% of GDP, admittedly still better than estimates of America's, but still problematic.³ And with the increased interest expense and inability of large parts of the euro zone to collect taxes effectively, the ratio of debts service to tax receipts would also likely be worrisome.

Overall, while the Eurobond would lower interest rates and default risk in the weaker countries , the stronger members would be saddled with paying higher interest costs; it's been estimated that for German taxpayers, these costs would amount to nearly 2% of the country's GDP.⁴

Mark: And the Eurobond would also lead to the single largest transfer of national sovereignty in the construction of the EU, meaning the centralization of the power not only to issue debt but also to set and control national budgets. In effect, civil servants from Berlin would have to oversee those in Athens. It seems implausible to us that such an arrangement would work on a sustained basis.

David: 4. Money-printing and inflation. To the extent that we accept Jim Grant's recent definition of inflation as "the over-production of money, a symptom of which is rising prices,"⁵ Europe faces the risk of rising inflation, as incidentally I believe the U.S. does. Further, we suspect that in Europe (as in the U.S.) inflation is being used as de facto policy. Put simply, inflation is the most politically tenable approach of the four possible paths towards debt relief: it is stealthy and gradual, making it a lot easier to swallow than austerity is for workers and pensioners, default is for politicians, or fiscal integration is for voters. As John Maynard Keynes said, "By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens."⁶

Money-printing has been delivered by the euro zone in a confusing array of guises since the global economic crisis of 2008; the endless bank bail-outs, interest rate cuts, quantitative easing, and now the European Stability Mechanism (ESM) underwritten by Germany and the other stronger countries, to name a few of the guises. To be sure, none of these approaches provides a cure in our opinion, but rather treats the symptoms and ‘kicks the can down the road'.

But money-printing does bring about inflation, and historically inflation has been the weapon of choice for "respectable" governments to wiggle out of the sort of debt binge engulfing Europe today. Ernest Hemingway called inflation, "the first panacea of a mismanaged nation." The ESM is scheduled to be funded initially with approximately $630 billion, but it has already committed to disperse much of this to Greece, Portugal and Ireland; were Italy, Spain or some other country to go the way of the first three, would the EU bureaucrats have the political will to stop the printing presses there? We wonder.

Given the European sovereign debt crisis, what do we think about the investment prospects for Europe?

Mark: The decline in European smaller company markets has been substantial. The HSBC European Smaller Company Index is off 31% since its May high & down 23% so far this year. This is well into bear market territory and is substantially more than the 6.54% decline year to date for the Russell 2000 Index as of August 31, 2011. Even the large- cap Euro Stoxx 50 Index, Europe's equivalent to the DJIA, was recently trading at around 7.7x forward earnings, according to Bloomberg.

In our view, this has created highly attractive valuations in a wide range of companies across many sectors. Interestingly, it seems that European executives agree with us. According to Citigroup, in August 2011 European executives bought more of their own company's shares than at any time since October 2008.

But isn't Europe something of a ‘dead-zone' in terms of growth, especially when compared with the emerging market economies?

David: To some degree, that's right. Europe still has some attractive growth pockets with legs, but there's no question that among the most important investment themes of our age is the replacement of the developed market consumer (including Europe of course, but also the U.S.) with the emerging markets consumer as the driver of the global economy. Emerging markets have been responsible for 75% of real global GDP growth in the last decade; today, they produce more than half of global exports and tend to be more fiscally sound than Europe, with 80% of the world's foreign-exchange reserves, and just 17% of its government debt.

As we have long subscribed to this mega-trend, we have for some time taken a two-pronged approach to investing in European smaller companies: 1) targeting those companies with a strong track record in exports, and a growing portion of revenues derived from emerging markets, and 2) targeting those niches even within Europe where there is still attractive structural growth.

Mark: Still, we think it's important to appreciate that economic activity or demand for a company's products is a necessary, but not sufficient, requirement to create shareholder value. If supply can simply follow demand, the returns on capital of those companies operating in the market will eventually become unattractive and such companies will fail to create value for shareholders. For example, there is a huge demand for air travel, but the profitability of the airline industry is poor. There is likewise a huge demand for cars, but the profitability of the car industry is also poor.

We believe, therefore, that it is critical to understand that competitive differentiation (i.e., company quality) is at least as important as the growth in demand when determining corporate profitability. In Europe, we find an excellent pond from which to fish for the corporate quality we require (as well as exposure to structural growth). In fact, we believe our high-quality European exporters are better positioned than most companies to benefit from the new normal, which is a fast-changing global landscape led by the emerging markets.

David: We like companies with long operating histories who use their strong balance sheets to take market share in tough times, and many of our European holdings are battle-tested in this way. They have not had the luxury of serving one unified 300-million person market as American smaller companies have. Whereas fewer than 1% of American companies today have any foreign operations, our typical European holding has been forced to compete pan-regionally, and even globally, for decades.⁷ This gives them a leg up, in our view, whether they are finding growth in those pockets across Europe, or selling to the emerging markets.

So given the sovereign debt crisis how are you positioning your European investments?

Mark: It's important to emphasize that while macro considerations like the sovereign debt crisis influence our portfolio construction, they do not drive it. This is not only because the outcome of the sovereign debt crisis is hard to predict (though we do feel that is the case), but also because we prefer to stick to our tried and tested methods of bottom-up stock picking –buying what we believe to be competitively positioned companies operating in attractive markets or niches, generating superior returns on invested capital, possessing strong balance sheets and run by credible and honest management.

As a by-product of our long established investment process, we do consider our investments to be well positioned in both their country exposure as well as sector exposure. We have comparatively few investments in Europe's peripheral countries; we currently have none in Portugal, just a handful in Spain, Greece and Ireland, and a somewhat higher number in Italy. This positioning is the result of our focus on strong balance sheets. It is perhaps not a surprise that those countries that have governments and consumers with the highest levels of financial leverage in Europe also have the most indebted corporates.

We have, in contrast, substantially larger investments in Germany, Austria, Switzerland, France, the Nordics, and the UK. Again, not primarily because of macroeconomic or political views, but more because these are the countries where we have been finding the highest concentration of high-quality companies for years.

Neither Switzerland nor the UK is, of course, in the euro; nor for that matter is Norway or Sweden. As Switzerland has sailed through the crisis since 2008 rather serenely, the Swiss Franc has appreciated against the U.S. dollar markedly over the last 12 months. Although this is beginning to hurt Swiss corporate earnings, as a dollar-based investor we have benefited from the rise of the Swiss Franc in our investments. If a core euro were to emerge from the crisis, we believe a similar scenario would likely play out for our investments in Germany, Austria, etc.

The UK has a substantial budget deficit. However, it also has a freely floating exchange rate, and we believe a credible government to enact budget cuts and tax raising initiatives that over time will move it back to a more stable fiscal footing.

David: We currently own no European banks due to our insistence on strong balance sheets. We own very few European retailers, as we find few companies in that industry can match our competitive quality hurdles. We therefore have little direct exposure to the indebted European consumer.

In contrast, our search for companies operating in well-structured markets, with strong market shares and strong balance sheets has led us much more often to niche European exporters, healthcare companies, focused asset managers, oil service companies, agricultural companies and precious-metals mining companies. The latter three sectors, incidentally, provide a natural hedge against the inflation which we think is a likely outcome of the policy response to the European sovereign debt crisis, as we discussed earlier. Each of these three sectors deals with commodities that are in finite supply (oil, gold, silver etc.) in a world where, by contrast, the euro and other developed-world currencies appear to be in more-or-less infinite supply, thanks to the printing presses. Gold- and silver-mining companies, in particular, appear to be on the same cusp as oil companies were on in early 2003 before oil prices reset themselves upward: they are transforming themselves from "asset plays" to real earnings-producing, dividend-paying companies with high returns on capital.

So to sum up, we do believe that sticking to our knitting has allowed us to be well positioned with our European investments for the medium to long term.

¹ "Eurozone will not be saved by logic, however remorseless," The Guardian, July 23, 2011
² The Economist, August 20, 2011
³ Ibid.
⁴ Ibid.
⁵ Quoted at Bloomberg Inflation Forum, September 8, 2011
⁶ Keynes, John Maynard, The Economic Consequences of the Peace.
⁷ The Economist, "The Case Against Globaloney," April 20, 2011