Thursday, April 19, 2012

Why I am buying the pain in Spain

A couple fights and the neighbors hear every word. To outsiders, it sounds like the relationship is in shambles and on the verge of collapse. Insiders know that the couple have a long history together are deeply committed to the marriage.

That's the story of the eurozone. An underlying assumption in my last post about buying Spain when the pain is at its worse is an underlying belief in mean-reversion. That is to say, the EU will not throw a major member state to the wolves.

Not a marriage of convenience
Martin Wolf of the FT wrote a must-read article entitled "Why the eurozone may yet survive" reinforcing this idea. He said that "the centrifugal economic forces are all too painfully clear", but outsiders don't understand that the eurozone and the EU isn't just a marriage of financial and political convenience, but there is a serious political will holding the European experiment together [emphasis added]:
The principal political force is the commitment to the ideal of an integrated Europe, along with the huge investment of the elite in that project. This enormously important motivation is often underestimated by outsiders. While the eurozone is not a country, it is much more than a currency union. For Germany, much the most important member, the eurozone is the capstone of a process of integration with its neighbours that has helped bring stability and prosperity after the disasters of the first half of the 20th century. The stakes for important member countries are huge.

Thus, the big idea that brings members together is that of their place within Europe and the world. The political elites of member states and much of their population continue to believe in the postwar agenda, if not as passionately as before. In more narrowly economic terms, few believe that currency flexibility would help. Many continue to believe that devaluations would merely generate higher inflation.

If this were a mere marriage of convenience, a messy divorce would seem probable. But it is far more than such a marriage, even if it will remain far less than a federal union. Outsiders should not underestimate the strength of the will behind it.
I wrote about this theme on July 1, 2011 (see The European Experiment in context):
After the Second World War, Western Europe surveyed the wreckage and collectively decided "never again". In the 200 years preceding that war, Europe had been wracked by conflict (WW II, WW I, Franco-Prussian War, Napoleonic Wars) and the main source of conflict was between France and Germany, or the Germanic states before their unification. When Western Europe said "never again", they devised a solution that bound the French and the Germans so tightly that the devastation of war on the European Continent would be stifled, hopefully forever. That solution was the EC, which became the EEC and now the EU.

Politically, they have largely succeeded. Today, if Angela Merkel mobilized the Bundeswehr and told the troops, "We are going to war against the French", the men would all laugh and go home. Compare that result to the cost of the Battle of Verdun of 300K dead and another 500K+ wounded and you will start to understand why the EU was formed.
I agreed with Wolf that the euro is not just a marriage of convenience:
To say that the euro is at an end as a common currency is overly simplistic analysis. In many ways, the EU was paid by blood - just remember the price paid at Stalingrad, Verdun and Napoleon's retreat from Moscow, just as some examples.
The way ahead
Today, the European Elites have a Grand Plan to save the eurozone. No doubt the Grand Plan will get diluted in the normal back-and-forth negotiations and a Grand Plan 2.0 will emerge. The marriage will survive. Martin Wolf expressed a similar opinion when he wrote:
The most likely outcome – though far from a certainty – is compromise between Germanic ideas and a messy European reality. The support for countries in difficulty will grow. German inflation will rise and its external surpluses fall. Adjustment will occur. The marriage will be far too miserable. But it can endure.
For investors, the survival of the European Experiment and the eurozone means that the eurocrats will eventually take steps to take tail-risk off the table, just as the ECB did with LTRO. That's why I believe in buying Spanish equities and banks at the point of maximum pain in anticipation of a rebound.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Analytic Bastard said...

Mr. Hui, I concur with your analysis and I think that what you posted is a great contrarian strategy. However, although hyperinflation and wealth destruction may not come overnight, such risky assets will ultimately fail. One should couple your buying pain strategy with a selling calm exit.

I know the country very, very well. And I can assure that next year it will be Greece.

keithpiccirillo said...

That would put EWP very near as a bottom of the candle on a monthly chart in early 09' buy area at $24.75 and STD in the $5.25 level as buy points with 7-12% stop loss for me.
May 17th FB IPO as a possible exogenous catalyst for a top.

alexcanuck said...

I thoroughly agree with how much Europe wants the strong union to stave off the horror of modern war. The scars are strong, deep and are not fading from memory for a long time yet.
However, I'm utterly not convinced that Spanish banks and equities are safe, not to mention all other investments in the Euro zone, and even the Euro itself.
All that could explode with the chaos that ensues, yet leave the popular support for a close union intact.
It would be messy indeed, with sweeping changes to the Eurozone, yet the financial situation is so unsustainable I fail to see how the fiscal union can possibly endure. All that has been done there so far is just papering over the cracks caused by an excessive debt problem with yet more debt, and shifting the losses from banks to taxpayers via the central banks. All those institutions could vanish, with new ones rising from the ashes take their place. The debt-holders will be kind of pissed off, of course, but it just has to be pointed out to them that they still have their heads attached to convince them they got off easy.
Life for the people will go on, the food is still mostly locally produced, the cities are built to endure, and la vita will still be dolce. Once the crushing debt loads are formally defaulted public finances will be able to be balanced again, albeit with some adjustments to expectations.

WimpyInvestor said...

Which of the following would you consider the "final capitulation low" condition?

1. Spain nationalizes BBVA or STD (using C playbook or Irish/UK banks).
2. BBVA trades to $10B market cap or about value of Bancomer (Mexico) alone (Citi bought Banamex for that amount).
3. STD and BBVA raise capital by selling new shares to Singapore, UAE, Quatar, Saudi sovereign wealth funds (using C, BAC playbooks).
4. Riots in Spain and Argentina; talks of war between two countries.
5. Warren Buffet buys preferred shares in STD or BBVA.

Unknown said...

There are two ways this could break.

a) The Eurozone falls apart, to be followed shortly by the breakup of the EU itself. Markets drop 70pc, no joke.

b) Europe's new leaders finally realize that a monetary union without fiscal and real political union is untenable, so they take bold steps to unite the EU in fact. Markets have the mother of all relief rally.

I hope it goes one way or the other soon though, just dragging things out is causing too much uncertainty. It appears the ball is in Germany's court now.
real asset investment