By: Paul Sutherland, CFP ®
The European crisis is headline news and will be for quite some time. To help you better understand the euro crisis, FIM Group will post a presentation on our website this month titled Europe Fantasy, Reality and the Euro 101. In the meantime, I’d like to answer some questions asked recently by many FIM Group clients:
Q: What is the big deal about the euro?
A: The euro is the only available currency for the eurozone countries. As part of the “deal” to be in the eurozone, these countries ceded some sovereignty to a “governing committee and a body of rules.” The main rules that are causing problems have to do with budgetary discipline, i.e., the fact that some countries are more responsible than others. Other issues involve inflation, money supply constraints, deflation, creating currency, interest rate levels, trade restrictions, etc.
From afar it appears that the euro crisis is finally being addressed. I have said in many past articles that democracies are reactive systems that fix themselves. Europe’s leaders are working to fix the problems, but until they can find a “fiscal equilibrium,” they won’t have a chance to make a significant change. One main issue, for example, is that fiscally responsible Germany refuses to bail out its undisciplined European neighbors. And it shouldn’t. The German government is planning to raise its employee retirement age from 65 to 67, while France is considering lowering it from 62 to 60. And in Greece, the pension for an assistant garbage truck driver is twice the starting salary for a teacher.
What’s most important to FIM Group’s investment team are the new investment opportunities that result from the euro uncertainty.
Q: Was the “euro” an experiment?
A: The process of integrating Europe and creating the euro was spearheaded by a small group of forward-thinking politicians/statesmen who believed in the benefits of a “united Europe.” They recognized, however, that full political and economic integration was unrealistic, so they took a small first step by creating the euro. I believe that they should have forseen (and it seems obvious now) that without regulations and political union among the different countries, the “euro experiment” would not be maintainable.
Q: Is the euro a bubble?
A: We believe that the euro could be a bubble. It has many hallmarks of a bubble in that the original idea seemed reasonable and not consequential enough to have significant impact. Its creators, like many creators of bubbles, assumed that rational human behavior, problem-solving and evolvement to correct any faults, would keep it from spiraling out of control. For most of its life, the euro appeared to be successful, but now we see it has fed on its own artificial success, very much like other financial bubbles.
Q: Will the euro crisis destroy Europe?
A: Europe and the strong corporations, well-educated workforce, sturdy infrastructure and solid democracies will still exist after the euro crisis has passed. Europe is a safe, wonderful, beautiful and historic place to visit along with providing quality of life for its citizens. If a few banks go under, property values will decrease and some people have to adjust to the new realities of the world. And in the scope of the investment world, that’s not impactful. We should give little credibility to the news-driven sensationalizing of a boring process of tinkering with agreements in conference rooms throughout Europe.
The real important changes in societies, government and politics these days are happening slowly, but they are happening nonetheless. The realities of the world are leaving political leaders no choice but to embrace the changes that will make their governments more efficient and responsible, because they know that hard-working, industrious folks and their capital will go where they are welcome. Bottom line is: If governance doesn’t change, people will vote with their feet and leave for greener pastures. People stay in a place for many reasons: family, quality of life, schools, safety, weather, jobs, etc. Europe is a great place to live – just ask the Chinese, Singaporeans and Australians buying apartments in Europe’s larger cities.
Q: How could a potential euro crash affect the world financial markets?
A: It will definitely create volatility/ fluctuation in the financial markets, which is normal. Remember 15% CDs and 17% mortgages? Everything fluctuates. Everything is cyclical. Everything is constantly changing, especially financial markets.
Q: Is this euro crisis creating great buying opportunities?
A: Yes. Without a doubt. Why should a group of countries with less than 10% of the world’s population cause markets in Asia, the Americas and Africa to lose significant value or “crash”? There are trillions of dollars just sitting in cash waiting for political and financial stability, and that cash is being invested. Corporations worldwide are sitting on trillions ready to expand and invest. Savvy Asian and many healthy cash-rich companies in the Americas are pouncing on Europe’s bargained-price real estate, shares and other investments.
In Chinese, the symbol for crisis is composed of two elements, danger and opportunity. Will investors enter the market too early? It is difficult to predict timing. We do know that history demonstrates clearly that wealth and success is not obtained by sitting on the sidelines watching opportunities go by.
By: Barry Hyman, MBA
Q: I noticed on my most recent statement there is a lot more “idle cash” in money market than normal. Why have so much cash?
A: The current higher than normal cash levels in portfolios we manage is an intentional but temporary condition. We are not using cash passively as an asset class allocation decision. That is not always the case but it is now. When money markets are paying rates well above the rate of inflation plus the cost of management fees, we may hold money market cash as a strategic investment. But currently at zero percent interest rates holding cash is not an effective use of assets. There are several reasons we have more cash than normal currently including 1) having sold some positions recently that reached our sell targets, 2) having sold one or two whose fundamentals and outlook no longer warrant their imbedded risks, 3) to deploy in assets we are planning to purchase imminently after having completed due diligence, especially several Asia based securities with whose management we have recently met.
Q: Why have there been several sells in the past few months but few “new” buys?
A: See 3) above. We have several planned investments in our sights but after completing our “in office” homework on these investments we want to do additional due diligence on all of them. In the mean time, we do not wait to sell investments that warrant being sold.
Q: Why has the yield declined in my portfolio?
A: Again this is related to the prior questions. With cash (money market) yielding zero and the vast majority of the investments we own yielding 3-8% in dividends and/or interest, each time we sell an income producing investment and temporarily leave the money in cash, the dividend yield of the portfolio declines. But rest assured this will be temporary. It is likely overall portfolio income yields will rise back to or above their yields of a few months ago because almost all of the positions we are exploring are high income producers.
Q: Why are there so few bonds and Treasuries in my portfolio?
A: Short answer: at current yields bonds in general are very risky. They present the worst risk/return ratio in history. In technical terms, long term returns on bonds have a 95% correlation with their interest rates and in the long term their downside risk is inversely correlated with their yields. In other words, with yields under 2% on 10-year US Treasuries, after fees these bonds should earn less than 1% annually over the next 10 years. After inflation that means they will generate negative real returns. Yet if interest rates rise, the market prices of such bonds have the potential of falling dramatically. It is important to understand why bonds have done so well during the past 20-30 years, to understand why they are likely to perform poorly from this point forward. With the starting points for interest rates at much higher levels in past years, followed by falling rates, bonds paid high levels of income and generated additional capital gains as their prices rose as a result of falling rates. With starting rates now at very low levels with the distinct possibility of them rising in the future, the higher than average returns of recent decades will likely “revert to the mean” providing extremely low returns going forward with very high potential for downside shocks. Unfortunately many investors look backwards to estimate future returns. As a result buy moving out of global stocks and into bonds, they are taking on excessive risk thinking they are decreasing their risk exposure. The measure of risk in bonds is called “duration”. A shorthand definition of duration is the number of percentage points the price of a stock moves in response to a 1% move in interest rates in the opposite direction. For example a bond with a duration of 15 will move down in price by approximately 15% for each 1% increase in yields. So if interest rates on such a bond move from 2% up to 4%, the market value of that bond would drop by 30%. It is very doubtful that most investors are aware bonds possess this much risk.
Q: Why sell some of the high income yielding investments that have recently been sold.
A: Yield is only half of the story in investment returns. Very seldom do we make an investment only for its dividend or interest yield. In addition to yield, we typically intend to earn some growth as well. This holds for so-called “fixed income” investments as well! A simple example would be to buy bonds selling at prices below their maturity values due to various market factors. Because the purchase price is below the face value of the bonds, but the coupon payment is still the stated coupon, the yield is higher than its stated yield. In addition, if the market price of the bond price moves back toward (or in some cases above) its maturity value, investors also get growth from that bond. For example take a BB rated corporate bond with a 7% coupon (i.e. pays $7 per year for each $100 of face value) selling at $90 that matures in 10 years at $100. The current yield is $7 / $90 = 7.78%. If the issuer of the bond pays down some other debt and/or improves its financial condition for other reasons such as an increase in profits, the ratings agencies might upgrade the bond from a rating of BB to BBB or even to A. When that happens the market price for that bond increases. In that example above, let’s say the market price of that bond jumps to $100. If we were to sell it a year after purchasing it, the total return over that year would have been 7.78% in interest plus 10% in growth for a total return of 17.78% in a year. Of course this will not happen with every investment but the point is we do not hold most investments just for the income they generate. There is also a price component. Remember the potential downside volatility in the price explained above as duration. So when the price reaches a point where the total expected future return doesn’t warrant our estimate of its price risk, we will sell despite passing up what appears to be a decent yield, in favor of owning other investments we determine to offer better risk adjusted opportunity.
There is no Spotlight for this issue.