Market Commentary
by Byron Wien
 
06/10/2013

The Smartest Man is Bullish on Europe

During the course of every year I try to meet several times with the person I refer to as “The Smartest Man in Europe.”  In my mind he earned that title by seeing major shifts in the investment landscape long before his peers on both sides of the Atlantic.  Among these were the rise and fall of the Japanese stock market in the 1980s, the end of the command economies in Russia and China, the opportunities afforded by the emerging economies, the importance of gold as an asset class and the dangers represented by the overvaluation of American technology stocks in the late 1990s.  Along the way he has accumulated some of the material rewards of success, including elegant residences, museum-quality artworks spanning many centuries and sleek means of transportation on the ground and in the air, but what moves him is identifying a major change before others recognize it.  I have often attributed at least a part of his acumen to the mercantile tradition in his family that goes back several hundred years.  His ancestors operated canteens selling food, supplies and weather protection to travelers along the Silk Road.  Dinner table conversation from the time he was a young boy centered around investment opportunities.  In his ninth decade he still derives excitement from a fresh idea, and it is inspiring to watch. 

“Everyone thinks Europe is hopeless and I can understand why.  The European Union is a flawed concept and it may not survive in the long run.  There needs to be much more convergence, both economic (which is possible) and political (which is impossible), but a major change in attitude has taken place this year.  Until recently the policy makers believed that increasing taxes and reducing spending was the way for the weaker countries to solve their deficit problems, but that was clearly the wrong idea.  From a political point of view the austerity approach was impossible because the people in these places wouldn’t accept what their governments were trying to impose on them.  Punishing the people for past economic mistakes also made no practical sense.  Europe was in a recession and the austerity policies were only going to make conditions worse.  Unemployment was becoming a serious social problem and job creation had to be a priority.  As we moved into this year the policy makers, even Angela Merkel, began to understand that austerity was the wrong course and that restoring growth had to be an objective.

“Europe is in a kind of equilibrium now which is likely to be sustained by the expansive monetary policy of the European Central Bank.  This should continue at least until the German elections in September, resulting in a definitive pullback from austerity.  Merkel can only win if she moves away from her hard-line policy stance.  Conditions are continuing to improve in Italy even though Mario Monti is no longer in charge.  The unions still have too much power in France.  François Hollande is beginning to realize that he must restore business confidence by introducing policies that take a positive view of growth.  Germany will have to be tolerant of larger budget deficits in Spain, France and Italy.

“At the beginning, as leader of France, Hollande was troubled by the huge disparity between the rich and poor and he wanted to try to correct that, but his program was too severe and he is now softening his stance.  People in finance benefited in France but prosperity didn’t filter down to ordinary citizen.  The same problem existed in Germany.  You don’t want to scare all the rich people out of the country.  Spain is recovering more slowly, but will mend itself.  I think conditions on the continent might finally drive the United Kingdom out of the European Union.  France and Germany might want more transparency on taxes.  The U.K. has the opportunity to become even more of a tax haven than it is now.  Business conditions there are not good and the prospects for major economic improvement are dim, but if the U.K. adopted a more friendly policy toward wealthy foreigners, there could be a huge boom.  There is tremendous pent-up demand in Europe and I think you could see positive growth in 2014.

“In the meantime most investors have reduced their European exposure.  Who would want to invest in a place where a recession was underway and likely to get worse?  Money managers had been so preoccupied with that idea that they failed to recognize the pullback from austerity which could lead to the restoration of growth.  During the last few years European companies, like their American counterparts, have become vastly more efficient.  Unemployment in Europe is 12% and part of the reason it is so high is that companies are getting the work done with fewer employees, so profits should improve considerably on any increase in revenues.  Stocks are priced assuming conditions will get worse and I see them getting better – not everywhere and not in every sector, but if you are a careful stock picker you can make money. 

“The most important factor is that almost no investor likes Europe now and that enhances the opportunity.  Two years ago everyone was worried that the European Union was going to break apart.  That was never going to happen over the near term because everyone had too much to lose, especially Germany, which has been the biggest beneficiary.  Now most people realize Europe is going to muddle through at least for a while, but few people are buying European stocks to take advantage of this conclusion. 

“I see a big social problem brewing in the United States.  Growth of 2% is not enough to bring down unemployment.  I actually don’t understand what’s going on because I consider the quantitative easing program the Federal Reserve is engaged in to be an enormous amount of stimulus and I would have thought growth would have been stronger.  But the Fed policy is clearly fueling the stock market’s rise and confidence is building as equities continue to move higher, so you have a problem in the making.  People working on Wall Street are doing well, but people in many other fields are not, and the disparity between haves and have nots is building in the United States as it is in Europe.  There are many factors holding back growth in the United States.  The higher taxes on higher incomes which went into effect in January dampened the enthusiasm of the better paid people.  The higher payroll taxes affected all wage earners.  Emerging market competition is slowing growth.  So is the cut in defense spending.  And demand for U.S. products in China is off its peak.  Overall demand for the U.S. products from abroad is also down because Europe is in a recession and Latin America and India are slowing.

“I am not particularly positive on emerging markets.  Their exports are lower because of reduced demand from Europe and the United States but the standard of living in these countries is still rising.  The only country in Latin America worth considering is Brazil, but the political situation there is not good.  There is a window of opportunity in Japan that could last a year or two.  The monetary and fiscal policies of Shinzo Abe are clearly having a positive effect on the economy.  Next year Japan should show some growth and some inflation.  The value of the yen has declined considerably and probably has further to go, helping exports.  The deflationary recession that the country went through for two decades is over for the moment.  I don’t know if Japan can begin a sustained period of growth but right now you can make money there.

“The charm that gold held over investors is clearly broken.  I was surprised by the huge liquidation of gold Exchange Traded Funds because the fundamental problems that caused the rise in the price of gold are still there.  Central banks in the developed world – the United States, Europe and Japan – are still printing money and demeaning their currencies so you would expect that something real, as gold is perceived to be, would increase in value.  You have to ask yourself the question:  Where did all the gold that was sold this year go?  The answer is Asia, primarily India and China.  The people who bought it are going to hold it, not trade it.  Next year, when interest in gold picks up again because of the continued expansive policies of the major central banks, gold will be in short supply and the price will rise, perhaps as sharply as it fell.  I am not much interested in other commodities.  On currencies I expect the Swiss franc to stabilize around current levels and the euro to strengthen against the dollar.

“The situation in the Middle East is very troubling from a humanitarian standpoint.  People are dying and the whole area is unstable.  Bashar al-Assad will probably endure.  Most Westerners thought he would not last as long as this, but he has the support of the Christian population, the Alawites, business, the army and Iran.  The rebels are getting help from Sunnis in the region who view Syria as a buffer against Shiite Iran.  I think Iran will eventually have a nuclear weapon.  Israel will not bomb the country because Iran is in a position to send too many missiles in retaliation and the destruction and loss of life would be devastating.  The United States policy toward Iran is more unpredictable in my opinion.

“The major geopolitical problem in the world today is that the United States doesn’t have a coherent foreign policy.  It has the most powerful military force in the world but it cannot decide whether to use it.  Does it want to be the leader of the free world or not?  How does it define its self-interest?  Some crowd in the White House will probably convince Obama to bomb Iran without considering all its implications.  I think the wars with Iraq and Afghanistan were lost before they began.  It is naïve to think you can bring democracies into these countries when they have been torn by tribal factions for centuries.  You need a powerful leader, a dictator if you will, to run these places and the United States cannot bring itself to support that.  Americans have to ask themselves whether they are in a better position since the Arab Spring came to Egypt than they were when it was under Mubarak’s rule. 

“The United States cannot simply walk away from the Middle East because if it does, the Russians will step in and become the dominant western power.  The region is likely to remain volatile and in continued conflict, much like Europe in the Middle Ages when there were wars going on all the time.  In the Middle East power is not hamstrung by humanitarian considerations.  Maliki is a de facto dictator and Iraq is thriving economically.  Karzai is another example of a powerful leader who has built a supportive cadre around him.  The United States has pursued policies in the region based on its need for an assured supply of oil, but now that America is headed toward energy self-sufficiency, its strategy in the region may change.  In any case, don’t worry about Iran having the bomb.  Mutually assured destruction is an important deterrent.  They may scare people with it, but they won’t use it.

“The real problem in the United States is that Obama is an intellectual president and he doesn’t seem to understand the importance and usage of power.  He thinks if he has a good idea, everyone should recognize it and follow him by bringing the idea into reality.  But the world doesn’t work that way and if he is going to get anything done in his second term, he has got to get together with the opposition and sell them on his views.  In foreign policy he has to be willing to use American power more forcefully.  Once he starts something he has to finish it.  He didn’t do that in Iraq and Afghanistan and that is why he failed.

“I know you want to make some money so let me tell you what I am buying.  I like social media companies like Yahoo and Google.  Generally I like technology because it is open-ended.  If you buy DuPont you have to worry about whether the economy will be strong enough to enable the earnings to grow.  In technology the power of the idea can drive the stocks higher.  I also think the U.S. banks are cheap.  I see the Standard & Poor’s 500 going higher.”

As usual I didn’t find myself in agreement with all of his ideas, but the discussion was wide-ranging and his positions were clear.  I vowed to myself that I would take a hard look at European equities before the summer began.  Year after year he always has something provocative and important to say.

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