Monday, November 21, 2011

Eurozone Issues

It seems increasingly likely that there will be at least one sovereign debt default in the Eurozone over the next several weeks and that, as a result, there will likely be some change in the composition of the 17 Eurozone countries using the euro as their common currency.

These Reuters quotes from the last week seem indicative:

Angela Merkel told her Christian Democrat party that: “Europe is in one of its toughest hours, perhaps its toughest hour since World War Two.” She said further that she feared Europe would fail if the euro failed and vowed to do anything to stop this from happening.

"In another conference, Merkel said “Europe's plight was now so ‘unpleasant’ that deep structural reforms were needed quickly, warning the rest of the world would not wait.”

"She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stayed more loosely connected -- a signal that some members may have to quit the euro if the entire structure is not to crumble.”

Also, European Central Bank (ECB) board member Peter Praet said it is not the role of the ECB to intervene “when there are fundamental doubts about the sustainability of some countries”, and outgoing ECB chief economist Juergen Stark rejected calls for the ECB to act as lender of last resort like the U.S. Federal Reserve or the Bank of England.

If the ECB is not to be the lender of last resort, such as our Fed, and the German people are to be heard politically, it seems clear that a Greek default is virtually inevitable, and that Italy and Spain, which are much too large to be saved by intervention, could easily follow, creating a severe crisis in the European banking system, which holds the greatest percentage of Eurozone sovereign debt.

How Does That Affect Us?

We can see day-to-day what Eurozone machinations do to our stock markets, which are acting a lot like they did in the 1930s, except that this time they are mostly reacting to the Eurozone’s problems (and now the failure of our own “supercommittee”). That raises the question of just how big a problem a major financial crisis in Europe is for U.S. businesses. Without a doubt, major U.S. banking institutions would be directly affected, depending on their actual exposure to European sovereign debt and the extent of their role as counterparties in derivative transactions. This would likely be quite large, but not nearly as big an issue as our own sub-prime mortgage scandal, which came close to burying several of our big financial institutions in 2008 and 2009, and has still not been resolved. Nonetheless, added to the problems these financial companies already have, it is likely to produce losses in the billions, but probably would not present existential issues (such as Lehman and AIG in 2008).

There is also recent concern that several large money market funds in the U.S., which hold significant amounts of Eurozone sovereign debt, could suffer losses, which would result in the “breaking the buck” scenario, which we wrote about in 2008. What this means is that investors in these funds would find that, not only do these funds cease to produce any current yield, but actually would become worth less than the dollars invested in them. All of our client cash has been invested in U.S. Treasury money market funds since 2008, in order to protect ourselves from this scenario, which begins to look more likely in 2012 than it did in 2008.


As for multinational U.S. manufacturing companies, a crisis in the Eurozone creates the potential for reductions in sales and earnings. Companies with extensive sales in Europe, such as consumer and auto companies, can be expected to suffer earnings reductions and possible foreign exchange losses, depending on the relative strength of the euro vs. the dollar. For example, a weak euro would result in European goods becoming less expensive in dollars (e.g. European cars) and vice versa, which would be negative for the U.S. balance of payments and companies manufacturing goods for export to Europe. Again, these potential losses would not threaten the survival of the kind of manufacturing companies that interest us, i.e. EVA companies that generate internal rates of return on capital that exceed their costs of capital (but they could create interesting buying opportunities).

Because of the Eurozone threat and the yet to be fully resolved mortgage crisis in the U.S., we have continued to steer clear of owning large banks and investment banking institutions in our client portfolios. Our financial exposures are with Berkshire Hathaway through their insurance businesses, and with General Electric, through their GE Capital subsidiary, which, while still suffering from loan losses incurred in the last several years, is a relatively healthy company overall.

FalkerInvestments’ equity portfolios are largely invested in U.S. multinational consumer non-durable, energy, and technology companies, most of which pay good dividends. Plus, we have significant holdings of strong electric and natural gas utilities, all of which pay good dividends. We also have a small automotive holding, Ford, with the expectation that they should benefit more than any other world auto company in an economic recovery, when it comes. Before the U.S. financial crisis, Ford was the only U.S. auto company producing EVA and, of course did not require a government bail-out or bankruptcy.

Because of our belief that Europe’s problems and the obvious fiscal challenges here at home will keep market volatility high, we still maintain significant holdings of bonds and U.S. Treasury money market funds, which provide our clients with good insulation from most world events. These funds are ear-marked for investments in equities, when we believe the opportunities are right.

As we constantly review our portfolios in light of what is happening in the world around us, we continue to conclude that we are comfortable being positioned as we are. Our equity holdings have outperformed the market this year as investors have sought safety in the type of conservative, dividend paying stocks we hold. That could change, of course, if everything gets better all at once, but somehow we don’t think that’s going to happen right away.

As always, we value your observations and questions.

Thank you for your continued trust.

Jack and Peter Falker

November 21, 2011