Is European Union support still available?

One of the key attractions of a European Union (EU) membership (and one of the top reasons to invest in the region’s markets) is not only the amount of foreign direct investment member countries attract, but also funds from the EU itself. The general purpose of these funds (known as Structural and Cohesion funds) is to help speed along the convergence process among EU members by investing in key initiatives that create jobs and boost growth.

With lower per-capita GDP and higher unemployment, Emerging Europe’s newly-accepted EU country-members are significant beneficiaries of the almost EUR 350 billion collection of funds. In fact, ten countries are slated to receive over EUR 150 billion by 2013. This is a significant investment. In terms of contribution to GDP, this sum represents 2-4% of additional GDP growth per country per annum. The amount of funds available is also impressive in absolute terms. Poland, for example, should receive almost EUR 60 billion, while Hungary, the Czech Republic, and Romania are getting almost EUR 75 billion between the three countries. At a time when fiscal austerity is on the agenda, the effect of such investments cannot be underestimated.

After the financial and economic crisis of 2008-2009, European states were among the hardest-hit by the recession and the ensuing concerns over the ability of a number of Western European countries to service their growing pile of sovereign debt. As can be expected, monetary support from the EU also slowed down, as countries (and the union itself) were focusing their efforts elsewhere. Since then, however, EU transfers and remittances have strongly recovered, as virtually all countries slated to receive funds have seen a recovery to or above pre-crisis levels.

Are valuations attractive?

2009 was an extremely successful year for equities in Emerging Europe, as the broad market rallied over 60%.  Valuations, an area of possible concern when such a rally occurs, have remained at cheap levels, however, thanks to strong earnings growth after a disastrous 2008. In fact, the region’s markets are currently trading at low (and often single-digit) price-to-earnings ratios across the board, including Russia at 5.9x, Hungary at 9x, Poland at 11.2x, the Czech Republic at 10.2x, and Turkey at 8.8x. What makes them ever more appealing is the fact that their relative “cheapness” also holds true when looking at their valuations over time; in other words, markets in the region are trading at or below their long-run historic medians.

Globally, Emerging Europe also appears attractive. In fact, five of the six cheapest emerging equity markets are in Emerging Europe.

What will be the source of growth in Emerging Europe?

Consumers—the all-ruling (and currently missing in the developed world) part of the equation. Even though investors tend to think of emerging markets as places where markets are commodity-driven (Russia, Brazil) or export-driven (China), private consumption in Emerging Europe actually accounts for a low of 40% to a high of 80% of the average growth of GDP in the last ten years.  Unlike the majority of the developed world, where consumers are facing a protracted period of deleveraging, consumer fundamentals are much healthier in Emerging Europe. Household savings as a percentage of disposable income range from 6.5% in Poland to about 18% in Turkey. Consumers in Emerging Europe are also much less leveraged compared to consumers in the eurozone. The highest leveraged consumers in the region are in Hungary, where household debt expressed as a percentage of disposable income is at about 65%. Russia’s is at a low 17% (the figure is over 80% for the EU and over 130% for the U.S.) As a result, the real growth rate for private consumption is expected to continue to be a major contributing factor to GDP growth.

Is government debt in Emerging Europe sustainable?

The debt situation in Emerging Europe stands in stark contrast with the troubled European periphery. In nominal terms, the size of public debt in the Czech Republic, Hungary, and Poland (EUR ~280 billion) combined is less than that of Greece (EUR~300 billion) alone! As a percentage of GDP, public debt in the Czech Republic stands at a low 31%, Poland is at 51%, while Hungary is the only country even coming close to the eurozone average, which currently stands at 80%. Also notable is that Russia’s public debt stands somewhere around 10% of GDP, in contrast with the EU average of 80% and Greece/Italy’s over-100%.

Much like economies elsewhere, budget deficits could be a potential future trouble spot. Budgets consistently in the red may lead to accumulation of unsustainable public debt and bear the risk of breaching the 60% limit of the Stability and Growth Pact (SGP). Prior to the crisis, the countries in the region were well within the 3% SGP upper limit required of eurozone members (Hungary was the notable exception). In the last couple of years, however, governments have been slow to adjust to new economic realities of lower revenues, and some are only now starting to raise taxes and reign in expenditures to avoid a second “Greek” situation.

What effects will eurozone slowdown have on Emerging Europe?

Even though the European periphery is expected to go through a rather major recession, it is important to keep in mind that, much like the states in the U.S., eurozone countries face different challenges and will grow at different speeds for the foreseeable future. Germany and France make up Europe’s economic “core” and are expected to both grow at 1.4% in 2010 and 1.6% in 20111. Demand from fast-growing emerging markets in Asia and Latin America is expected to continue to support the economies in Europe’s core.

With the eurozone being Emerging Europe’s main trading partner, slower eurozone growth will likely translate into lower demand for goods (exports) produced in Emerging Europe. The contribution of exports to GDP varies widely within the region, from over 75% in Hungary to as little as 25% in Turkey.

It is important to keep in mind that even though Hungary is the most trade-exposed country in the region, over a third of its exports are going to Germany and France, where growth is expected to be robust. In fact, Germany is the top trading partner for virtually all of Emerging Europe outside of Russia and the Baltic States. Slow-growing countries, like Europe’s periphery, do not make up a substantial destination for Emerging Europe exports.

By all accounts now, not only is the market currently flooded with a number of properties that will keep values in the doldrums for the foreseeable future, but that number will absolutely continue to grow; while many dispute the likelihood of the broad economy entering a second recessionary dip, that eventuality is all but certain within the real estate market itself.  Prices are expected to drop another 5 percent over the next year and a half, and even if they stayed flat, they certainly wouldn’t be going up.

According to the National Association of Realtors (NAR), only 4 percent of real estate transactions this summer are for homes with title seasoning (i.e., owned) of less than a year.  In other words, the process of short-cycled buying and subsequent selling is now so rare that it’s practically statistically insignificant.  In our opinion, anyone seeking to enter a real estate transaction on that basis would have to be, well, out of his mind.

Complicating matters are the infectious problems associated with the meltdown that have made the buying process infinitely more difficult, even for investors with a lot of cash.  The vastly-tightened underwriting standards, particularly for Non-Owner Occupied (NOO) residences, have become all but prohibitive for the vast majority of borrowers out there right now, even for those with a pile of cash to put down.  Banks, despite what we have all been told and supposedly “know,” seem just fine with vastly-growing Real Estate Owned departments.  Even title issues, once regarded as incidental to the buying process, have become major factors in transactions; many investors are finding that, other than in the case of an all-cash deal, lenders will not touch properties with title seasoning of less than a year.    

So where does this leave the prospective real estate investor?  In a good position, or in a bad one?  Well, it depends.  For the RE investor with a pile of cash on hand to make the lender happy (or preclude the need for a lender outright), as well as to put into the property in an effort to add value, along with a willingness to deal with people (renters) in the way we need not when trading stocks, it is a fine time to consider the portfolio addition.  For those on behalf of whom that profile does not fit?  Stay away.

Stunningly, at least to those of us that haven’t been so infected with an insane sense of entitlement that it prevents us from actually seeing the difference between up and down, the pushback against this bill and reforms is still very strong.  Protesters continue to take to the streets on a regular basis, and the vote count by which the package itself passed…157-134…is hardly suggestive of unanimity on the matter. 

The irony of the fierceness with which so many are trying to repel these reforms is that these benefits, all couched as “workers’ rights,” are a lot more about the rights of people to refrain from working.  Pensions at 50?  Even younger than 50?  Per the new bill, pension payments will be reduced, and the average retirement age will begin a gradual climb to 65.  Those who are protesting with such virulence represent the mindset of many who stand in the way of meaningful economic reform across the globe.  The Greece pension system was absolutely headed for collapse without these changes, and the masses about whom socialists ostensibly care so much would ultimately be pulverized by the event…and yet…too few of the caring souls seem to want to live in that economic reality; instead, they have been guided by a single-minded pursuit of preserving the goodies in the present day, a pursuit that has gone a long way to paralyzing the mother country.

Papandreou said it pretty well on this past Wednesday night before the vote when he proclaimed that “the challenge is whether we have the courage to take decisions that will benefit society, especially its weaker members, in the longer term.”

Indeed.  Righting the ship in Greece and elsewhere depends on the willingness of many to work more and receive less, so that debt at all levels can be paid down and we can resume a high-functioning marketplace.  How hard is this to understand, anyway?

Even though the RMB revaluation is not expected to be significant in magnitude and/or abrupt in its timing, the move is generally positive for the region and also for the world.  A stronger Yuan is likely to allow China’s global relative purchasing power to increase, driving the price of dollar-based assets up.  Countries like Russia, where the stock market is generally dominated by oil & gas stocks, are likely to benefit through stronger demand for (dollar-priced) commodities. High-beta Central European and commodity currencies (such as the Ruble) should also benefit.

The bigger picture outcome from this policy decision is also important for the region, at least for sentiment reasons: a more flexible Chinese currency policy may help alleviate some of the pressure the country is facing domestically (i.e. overheating housing market), thus alleviating concerns over an abrupt growth decline in economic growth, as well as internationally (from its US/EU trading partners).

Make no mistake about it, the decision to move towards a true floating rate currency will slow the Chinese economy as a stronger currency will make Chinese goods and services more expensive for outside countries.  Yet, if the Chinese move towards a true floating rate currency “correctly”, it will pay big dividends down the road.  From the outside world, the Yuan is considered a second class currency.  How could it not be if you are pegging your currency to an outside country.  That said, China is experiencing massive growth.  But, if it wants to be considered a global economic power longer-term, it needs to promote a more free currency.

Far be it for us to argue that Hungary’s fiscal situation is rosy: the country’s 80 % debt/GDP ratio, for example, is on par with the Euro Zone and the highest among the Emerging European countries; the budget deficit is also relatively high. The longstanding inability of Hungary’s governments to tackle the country’s fiscal vulnerability (i.e. twin current account and budget deficits) made it susceptible to problems even before the global crisis, and the problems have only gotten worse since then, despite an (initially) credible fiscal austerity program and an agreement with the IMF in 2008.

Hungary, however, is not Greece for a bevy of reasons: better fiscal situation, currency flexibility, small absolute size of debt outstanding at about 70 billion euro, ongoing relationship with the IMF. The local politicians’ comments are better understood given the leading party’s recent landslide election victory and their desire to blame any and all problems in the economy on the previous government.  Much like we saw in the US when our new administration took hold, political commentaries are not always tied to economic realities.   

In the end, the market weakness we have seen may create a long-term buying opportunity in Hungary.  But, as with Greece, the jury is out.

Sound familiar?

In what some are regarding as the possibility of a real estate bubble that could be as impactful as that which crippled Japan for more than a decade, or which keeps much of the U.S. on its knees presently, the rapid rise of real estate values is getting the attention of many within and without China.  Many of the common denominators for a bubble are in place: low interest rates, lots of speculation, rapidly-climbing prices, and even the inflating of income documents by prospective buyers who wish to get every bit of house they can (not an entirely American habit, apparently).

Certainly there is cause for concern, or at least increased awareness of the transient condition.  That said, there are some key differences between what we’re seeing now in China and what we’ve seen in other, more storied real estate bubbles-turned-meltdowns, and the differences are pointed enough that investors should discard the bubble talk (for now) as they consider opportunities in China.

For one thing, there is a simple housing shortage in many urban areas of China.  As modernization continues to permeate the economic landscape in China and more of the country’s citizens concentrate themselves around the cities, the shortage becomes even more prominent.  This is a key difference from other bubbles, where prices skyrocket in the face of great supply; at least an increase in prices on the back of a unit shortage is something that stays consistent with the laws of economics. 

(As an aside, this is something that makes the efforts at inflating income for the purpose of securing mortgages a little less insidious than that which was taking place in the U.S.  For so many years, U.S. consumers were trying to grab as much excess as they could; the Chinese, noted for their parsimony by comparison, simply want a place to live.)

There are some other important differences, as well.  Overall, Chinese consumers are much less debt-laden than their counterparts in the U.S. and elsewhere, which means they have room for greater levels of mortgage debt.  Additionally, the steady and continuing increase in prosperity in China means wages will continue to increase.  This reality tends to mute the significance of the notation by Goldman Sachs that the increases in the prices of houses in Shanghai and Beijing are outpacing wage increases by about 30 percent and 80 percent, respectively.  Unlike in the U.S., there is still plenty of room for growth in many a Chinese paycheck, which is something of acute interest to the general investor looking to China as a big component of his portfolio “engine” for the foreseeable future.

Also, it should be noted that banks in China are much less exposed to real estate than those in the U.S. and elsewhere.  Residential mortgages are not securitized by banks in China, so that alone constitutes a huge difference between the potential threat offered up by a U.S. bubble (historically) and a China bubble, where developers stand to lose more than do lenders and homeowners.

It’s important to note, too, that during classic bubbles, real estate prices in nearly every corner of a country see considerable appreciation.  According to the Chinese government, real estate prices rose only about 6 percent nationwide in 2009.  Certainly the situation in the larger cities is noteworthy, but for the global investor concerned about the nationwide temperament of real estate in China, there may not be so much to worry about.

For now, although there has been talk of raising rates in a proactive effort to keep housing prices and inflation in check, the government’s fear of a backlash from homebuyers already at their wits’ end trying to get into a house is great enough to keep that from happening.  As a result, the viability of the Chinese real estate market and the Chinese consumer should remain intact, which is good news for the investor in China.

Without getting into the gory details, Greece simply took on too much borrowing, most of which was sanctioned by the implicit strength of their participation in the Euro.  These borrowings were not used intelligently to build valuable and long lasting infrastructure, or to increase their global industrial competitiveness, but rather to spend on transfer payments to their local governments and citizens in a highly inefficient and corrupt manner. Their debts are now over 110% of GDP (the red flags start going up around 90%) and the debt to GDP ratio is headed to 140% because the new IMF bailout does not require immediate austerity measures.  To appease the Greek citizenry, the bailout plan requires only a gradual phase in of sternness measures. On the matter of whether the Greek citizens will actually go along with the imposed measures that are a condition of the IMF bailout package, well we will see what these people have to say about that. The Greek are a fickle, funny, self-centered bunch.

 In what is being interpreted by Germany, as well as much of the rest of the European community, as a most unfortunate reaction to the EU/IMF bailout of spendthrift Greece, protests, some of which have morphed into deadly riots, have been the response of many of Greece’s rank-and-file citizens to the austerity measures that represent the engine of the plan.  How nice; while much of financially-sober Western Europe is going to bat for an economy that is in shambles, its citizenry can think only to spit in the faces of its benefactors.  The German people, long-abhorrent of debt and financial imprudence since the days that saw the rise of Der Fuhrer, will not take kindly to a response predicated on a juvenile unwillingness to go along with the cuts in pensions and wages… as well as the increases in taxes…that provide at least a prayer of this all turning out OK at some point.  German chancellor Angela Merkel has her hands full right now; there remains a good chance the German parliament won’t approve the $150 billion bailout deal that’s on the table, and elections in Germany this coming weekend may well prove to be a referendum on the inclination of the German people to prop up their Hellenic neighbors.

The reaction in Greece, along with the growing concern that the package may not ultimately fix the nation’s woes anyway, continues to pound the world’s markets on a daily basis.  The reactions in Spain and Portugal are especially noteworthy; both nations are in the batter’s box of grossly-indebted European nations, and the lack of a consensus resolution has the debt-laden particularly worried.

On the table presently is much that was regarded as unthinkable just a little while ago, including the dissolution of the euro.  The bottom line is that public sector spending…anywhere…that is out of touch with economic reality ultimately ends only one way:

With the gold bugs making a killing.

In our estimation, there are four legs holding up this bull, or Tiger, market:

1.  Improving fundamentals: “V-Shaped Recovery” – The global economy shows signs of the beginning of a V-shaped recovery. Locally, you can see this in the leading indicators, the Purchasing Managers Surveys, and a host of other indicators such as credit spreads and industrial commodities. Further, it’s not just the U.S. economy. We are seeing  improvement across the global economic landscape, especially in the Far East. Inventories have been depleted, workers have been laid off, but now orders are returning.

2.  Unprecedented stimulus: “Don’t Fight Central Banks” – The second leg is the Fed’s and other central banks “Quantitative Easing” mode. Quantitative Easing is a fancy way of saying “printing money.” Central banks rarely print money because they are usually fighting inflation, which requires the opposite approach (i.e., raising interest rates and shrinking the money supply). The banks resort to money printing when they have to fight deflation, as we see now. If you read the papers and watch TV, you will see the “talking heads” screaming about the potential for huge inflation.  However, most central banks around the world are not focused on inflation, they are worried about deflation.  They will eventually raise rates to combat  inflation (see Australia), but deflation is the “kiss of death” for an economy and much harder to fix once it’s taken hold. 

3.  Strong technicals: “Don’t Fight the Tape” – The old saying “don’t fight the tape” is very much in force today.  Market breadth, the relationship between advancing and declining stocks, has confirmed new price highs for the major averages. Often at price tops there will be a breadth divergence, but this hasn’t happened yet.  That said, most global markets have not hit new highs while the US has, probably a reaction to our more stable economy.  But, internals have been strong across the board and most global markets should hit fresh highs before it’s all said and done.  . 

4.  Favorable sentiment: “The Rally Everyone Loves to Hate” – There are just so few signs of bullish capitulation .  Investors who have not wanted to buy stocks are finally caving in and buying at high prices.  Normally everyone is bullish at the top. At the March bottom everyone was bearish and no one was bullish. That’s no longer the case. There are very few bears left, but that doesn’t mean that the majority is now bullish. Sentiment in general seems to be “skeptical” for lack of a better word.

Everything is not rosy with our economy.  But, things are certainly better than what is represented by most news services.  For now, are holding our cash levels in expectation of a normal short-term market correction.  We think any correction in this time frame will provide us a great opportunity to reposition into some new sectors and set the portfolios up for the next market run.  We’re not expecting a huge selloff, but feel if we’re patient, we can use market volatility to our advantage.

In the world of the hedge fund, the concept of the sophisticated investor is just about as important as anything else.  Investment professionals, from money managers to brokerages, and every sort of “financial guy” in between, rely on the sophisticated investor in order to be able to chart courses to wealth that involve greater risk and complexity-of-instrument structure than that able to be withstood by Mr. and Mrs. 401(k) Investor.  It is, in truth, the very existence of the sophisticated investor that fuels much of what goes on in the global investment market.

We all know by now about the civil suit with which the SEC is attempting to use like a club and smack Goldman Sachs in the head.  While my naturally suspicious nature causes me to look for political underpinnings to the action (at least with respect to its timing), and sees some curious coincidence with the suit and the Obama administration’s efforts at financial regulatory reform, let’s leave a more in-depth examination of that angle (there are angles aplenty here) for another piece, and look at the idea that brokerages invoking the sophisticated investor should be tantamount to pulling out a “Get Out of Jail Free” card.

The key to every action like this lies in the level of transactional transparency that can be proved.  “Sophisticated investor” should not be an excuse to capture funds for a transaction that is manipulated in a way to the detriment of the investor participants, but if it becomes clear that the (ostensibly) aggrieved parties, ABN Amro and IKB, really did know what was going on, their obvious experience in the realm of complicated mortgage securities structures will work against the SEC’s portrayal of them as victims (indeed, we have learned that the SEC itself was divided on bringing these charges in the first place); the aforementioned firms know full well, among many other things, that a synthetic CDO transaction has to have both short and long positions, so the “shocking” short interest of Paulson and Co. may ultimately prove to be of little judicial consequence.

We’ll see.  In the end, few of the reasonable among us quibble with the idea of risk as long as appropriately-qualified principals are all on the same sheet of music.  The opportunity to step outside the box is part of the global wealth building effort, and the embrace of free market philosophy is the platform on which that opportunity sits.  However, the greatest of those opportunities remains reserved for the sophisticated investor, and so, assuming, appropriate foreknowledge, it is only reasonable that “he” bears the associated, unusual level of risk that always tags along for the ride.