The € is Becoming a Funding Currency
I spent a few days in London last week, meeting with investors and discussing my book. I also managed three separate TV appearances. I can tell you that if the € sovereign debt crisis appears to dominate the news in the U.S., it is an all-consuming obsession for the financial media in the UK. It is naturally more impactful on Britain, and the jingoistic response of the popular media to Prime Minister Cameron’s exercise of his veto over Treaty changes showed how shallow is the support in Britain for the European project. I’m sure if there was a way to shift Britain 1,500 miles to the west it would more accurately reflect the country’s center of gravity between European liberalism and U.S. mercantilism.
But wherever you sit, Friday’s EU summit was yet another all-too-small step towards finding solutions to the problems of too much European sovereign debt. The markets are now left to wait and see if the ECB will find enough to like in the commitments of the other 26 nations towards fiscal discipline so that it can become a significant buyer of high yielding sovereign debt. One has to assume they will do so if needed – sufficient private buyers are not yet there, although over the next 2-3 years the Carry Trade could become a source of recapitalization for European banks desperately in need of such. 7% Italian yields funded at 1% could replenish the retained equity of banks for a considerable time. It’s not a trade we would do ourselves, but it could plausibly draw substantial capital in the months ahead.
Indeed, the growing differential in Real GDP between the U.S. and the € zone looks set to be 2.5% in 2012 and could easily reach 3% if Europeans follow through on promised austerity while the U.S. delays such and extends the payroll tax deduction. The € is becoming a “funding currency”, the disrespectful moniker attached to a currency facing an extended period of low rates and little prospect of moving higher. Borrowing in € is looking increasingly like a cheap source of funding – after all, European sovereigns have been doing so for years with reckless abandon (hence the present crisis). The ECB is likely to keep rates low and in considering the solutions, whether they stay on the present course of employing fiscal drag, utilize an increase in inflation or stumble into a disaster, it would seem that most plausible paths for the € are lower. It’s frankly part of the solution, to further stimulate exports and devalue the real value of debt owned by non-€ investors.
We think it’s one of the better trades available, but in combination with a long equities portfolio is becomes quite compelling. Stocks are reasonable long-term value and are compelling versus fixed income. A higher € would almost certainly be accompanied by higher equities and an altogether more friendly investment outlook. It’s not obvious how we’ll get there, but it’s certainly possible. The big issue restraining equities is the €. So borrow the € and buy US stocks.
As a result we remain invested in U.S. equities. Our biggest position is Kraft (KFT) an attractively priced name that provide exposure to global GDP in combination with their own positive story. KFT has seen almost 7% organic revenue growth through the first 9 months of 2011 and more than 5% of that has come from pricing, so they’re clearly able to push increases through the pipeline. They continue to enjoy operating margins of 12-14%. The Cadbury synergies are coming through, both in sales of Oreo cookies in India across Cadbury’s existing distribution infrastructure and through sales of Cadbury’s chocolate in South America where it had relatively small penetration. KFT’s break-up next year into a global snack business and U.S. grocery business should unlock additional value for investors, and at 14X next year’s consensus earnings with 11% YOY EPS growth we think valuation is not excessive.
We continue to like Aspen Insurance (AHL), trading at 60% of book value in an industry with reduced capacity given a series of reinsurance payouts over the past year (Japanese earthquake and so on).
We are long stocks such as these in our Deep Value Equity strategy, and in our hedge fund maintain long equities with a short € (long EUO).
Disclosure: Author is Long KFT, AHL, EUO
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