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Feb. 10, 2012
Europe’s debt problem
A crisis or an opportunity for Canadian investors?
ARI SHIFF
Depending on the day on which you are reading this article, the European debt crisis will either have been declared to be “contained” or “renewed” in the daily papers. In fact, the worldwide de-leveraging process has years ahead of it, and we should all prepare for a long, perhaps uncomfortable, ride. Canadians will not be immune to the impact of decisions made in Europe, but the impact on individual investors will depend on how well they have prepared their portfolios for some of the more likely scenarios.
While the crisis will eventually be resolved, the pervasive uncertainty leaves various markets here, as well as in Europe, vulnerable to what are being referred to as “sugar rushes” and “air pockets” – sudden updrafts and downdrafts, respectively, of positive or negative sentiment coming out of any one of many, many sources.
The three main problems in Europe are: 1) massive sovereign (i.e. country-backed) debt; 2) a banking sector overly invested in that massive sovereign debt; and 3) a unified currency that no longer allows weaker countries to devalue their currency to escape their debts.
Reams have already been written on the crisis, but suffice it to say that the primary source of the debt is an unaffordable culture of entitlement in many European countries. That explains both the daily protests among various European labor groups outraged at cuts to their standard of living and our own prime minister’s recent musings about throttling back some of Canada’s own entitlement programs, such as Old Age Security.
What makes the situation so much worse in Europe is the extremely cozy relationship between governments and their bankers. Even today, the European Central Bank continues to print money, which is distributed to banks, which in turn purchase ... you guessed it, more sovereign debt, to the tune of 30 times their invested capital. Beware, this is a house of cards in danger of collapsing!
When it does, it may make 2008 look like a mild tremor by comparison. As the United States has shown in the last four years, you can’t have a debt-issuing binge without eventually paying for it via bankruptcies, downgrades, write-offs, cram-downs, and various other unappetizing scenarios. Although there has been much to criticize in the United States’ response to its own crisis, the inherent competition and transparency of U.S. markets have forced both governments and companies to deal with their messes in plain sight. By contrast, Europe is a club where the release of difficult news is negotiated behind closed doors. While Europe is unequivocally on sale right now, it may be more prudent to wait for the “going out of business sale,” before going shopping.
In the meantime, investors would do well to know the risks to which their portfolios are already exposed. For the near-term, European stocks may be an investing arena best left for prophets and the very brave. Closer to home, a wobbling Europe will destabilize global companies with subsidiaries around the world. And while we can hope that precautions have been taken, Canadian banks will inevitably be somewhat exposed in their relationships with European banks.
There will also be second-order risks, follow-on effects triggered by the unfolding primary events. A vivid example is the volatility we’ve been seeing in North American markets due to the upheavals in Europe. While this past January was relatively placid, the second half of 2011 saw many companies and, indeed, whole markets valued more on their European exposures than on their fundamental ability to produce profits for investors.
That same instability has been a damper on certain forms of economic activity, like initial public offerings, and mergers and acquisitions. Perhaps more importantly, the uncertain economic environment has forced banks to keep interest rates at historic lows. While low rates have been great for those with the ability and boldness to borrow, it creates further risk of inflating the debt bubble we’ve been trying to deflate since 2008. Hence, the warnings from the Bank of Canada not to be too eager to take advantage of the all-time low mortgage rates being offered by banks.
It is also important to note that our low rates will be a significant drag on the performance of more conservative investments like GICs, bonds and, perhaps most worryingly, pensions and insurance products. Investors would do well to double check with their advisors on the protections in place to ensure anticipated payouts on term products over the next decade or two.
It won’t, however, all be discouraging news. The contrast in monetary policy between Canada, the United States and European Union member countries will likely be a continuing source of dislocations in monetary and business cycle dynamics. While dislocations are often bad for long-only equity investors, they can be very, very good for tactical investment managers who invest both long and short and who try to reduce their risk by matching winners and losers. Such managers have the potential to make money when equities trade both higher and lower and, indeed, benefit from improved dispersion, or divergence of quality and performance.
The tough times ahead in Europe will also likely be a profitable opportunity for private equity and hedge fund investors who have the ability to scoop up substantial assets when borrowers and banks are forced to sell even good credits indiscriminately. Such was the case in 2009 and 2010, when many funds reported healthy double-digit returns on assets they picked up in 2008.
While the next few years may present Canadians with a new paradigm for investing, one thing is for sure: they certainly won’t be boring.
Alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. Past performance is not necessarily indicative of future results. Consult with your professional advisor before making any investment.
Ari Shiff is the founder and head of research at Inflection Management Inc., and the manager of the Inflection Strategic Opportunities Fund. He has more than 15 years experience in hedge funds and can be reached at [email protected] or 604-730-9147.
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