Buttonwood

A contrarian moment

Share prices in Europe may have priced in the bad news

Jun 2nd 2012



EUROPE is an ageing continent, ruled by squabbling politicians, made soft by generous welfare programmes and saddled with an unworkable currency regime. That caricature seems to fit with the general impression of international investors, who have been deserting the continent’s equity markets. Morningstar, a research firm, says that euro-zone large-stock funds have suffered 14 consecutive months of outflows. Since the start of 2010, when Greece’s debt problems started to become clear, European shares have dropped by 18% and America’s have risen by the same amount.




.But even if the European growth outlook is sluggish and no clear end to the debt crisis is in sight, there comes a point when all the bad news is reflected in the price, and contrarians should turn bullish. That point may have arrived. Matthew Wood, a hedge-fund manager at Lancaster Investment Management, regards current European share-price levels as “an extraordinary value opportunity”.



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Many investors will be reluctant to take the plunge until the outcome of the Greek election on June 17th is known, for fear that the aftermath may be complete chaos. It would be a brave man who plunged into the Athens stockmarket, even though it has fallen by 90% from its peak. You might buy a share denominated in euros and end up owning a security denominated in devalued drachmas.






This diversification is not a coincidence. European companies have already endured a decade of sluggish growth and have sought out markets elsewhere (for production as well as sales). If slow growth continues, they are likely to diversify even more. In short, buying a stake in a European multinational is not the same as making a bet on the European economy.




.What’s more, the work of Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School has shown there is no statistical link between one year’s economic growth and the next year’s stockmarket returns. For the period from 1972 to 2009, the trio ranked 83 countries by their GDP growth over the previous five years. Investors who backed the slow-growth countries earned better returns than those backing the high-growth group.



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That is because what tends to matter most for investment performance is the initial valuation. When valuations are low, the odds shift in the investor’s favour. When they are high, the odds are against.



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That is clearest in the bond market (those buying German two-year bonds on a yield of zero are assured of exactly that return) but it applies to shares as well. Everyone was enthusiastic about equities in the late 1990s, so valuations reached giddy heights; subsequent returns have been low.



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European shares are not at their cheapest ever, but they look relatively attractive. In the core markets of France, Germany and the Netherlands, the dividend yield is much higher than the yield on cash or on ten-year government bonds. The average dividend yield on European shares is 4.1%; the American market offers a yield of only 2.2%.
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Ian Harnett of Absolute Strategy Research, a consultancy, says that European equities are trading on a cyclically adjusted price-earnings ratio—a measure that averages profits over seven years—of 11, towards the bottom of its range over the past 30 years. By contrast, the ratio for American shares is 18.1 (see chart). Wall Street generally trades at a premium to Europe but the premium today is more than three times the historical average.



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Simply being cheap is no guarantee that European equities will rise in the short term. There is the risk that the euro zone will break up in chaos and that a deep recession will ensue. But if that did happen, other equity markets would be dragged lower as well. If European dividends merely keep pace with inflation, the long-term real return on equities will be 4%. In a world where the real risk-free rate in many developed markets is close to, or below, zero, that is an option worthy of serious consideration.


Here's The Thing About Deflation

June 1, 2012

by: Five Thousand Over Libor


It's as organic and natural as anything sold at Whole Foods. As anything sold at any farmer's market. It is a pure manifest of nature. We overconsumed for decades, the overconsumption primarily predicated upon the advent of consumption credit. Like financing a vacation. Or a TV. Or anything you put on your credit card and don't pay down.


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Deflation is the correction of that overconsumption. It's the pendulum swinging back on its pivot. Just like the weather you experience every day is nothing more than Mom Earth quixotically attempting to balance the permanent global heat imbalance, deflation is the rebalancing of the overconsumption imbalance.


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On net, we consumed more than our incomes amounted to, as the savings at the top of the wealth distribution worked their way down to be invested, for the first time in the history of man, in broadly available lines of credit to those who wished for more than their skills/investments brought in the door. And it all works. Until it doesn't.



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On average, over decades, an economy can only support the production and industry that it can demand through organic income. Certainly spasms of imbalance exist, but prolonged imbalances are detrimental, taking decades to accumulate.


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The global economy is set to continue its adjustment, begun over four years ago, of the overconsumption that began 60 years ago and really blossomed over the past 25-30 years. There is not much we can do about it. Debt is either paid back -- which necessitates consuming less than you earn -- or it is written off as a loss -- which contracts the available supply of savings that can be invested in future consumption credit lines -- as lenders stay lenders only by avoiding losses. Additionally, these two conditions create a business environment that is very unfavorable to investment, so credit demand among credit-worthy borrowers contracts. Worse yet, being a net debtor in a deflationary environment is paralyzing, as the principal owed is not adjusted for the deflationary developments. It's the other side of the benefit to being a net debtor in an inflationary event. All together, demand has to contract. No amount of witchcraft from the FOMC changes this outcome; it only makes that inevitable outcome more expensive.


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We are over four years into this, and right back where we started, only far worse for the wear. Stop the Keynesian attempts. They've never worked. Which is likely why Keynes himself came to understand this in the week or two prior to his death in 1946, explaining to Henry Clay of the Bank of England: "I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking 20 years ago."


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Deflation is eventually good. It's the only thing that will allow us to enter into a new era of economic expansion. But the poor spending decisions, both public and private, have to experience their natural consequence. If that entails suffering, it isn't ultimately avoidable just because it's undesirable.


May 31, 2012 7:57 pm

Oil, blood and the west’s double standards

By Philip Stephens

The Middle East is a graveyard for ethical foreign policies. Whenever American and European leaders speak in lofty tones of an unflinching commitment to political pluralism, the rule of law or human dignity, this benighted region turns around to shame them.






Local people habitually talk of the west’s double standards. This is not new. Even if one puts aside colonisation, recent history has been littered with grim examples of the elevation of selfish interests above declared values.


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One good starting point is 1953 and the toppling by the US – at British incitement – of Mohammed Mossadegh. The then Iranian prime minister’s embrace of economic modernisation and social reform promised a shining model for the region. He made the mistake of thinking Iran rather than Britain should own its oil industry.



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The archives of western foreign ministries bulge with evidence of the contradictions and hypocrisies. Diplomats stationed in the regionAmerican and European – have for decades crafted eloquent dispatches questioning whether support for Arab autocrats sat easily with the espousal of universal values; or if one-sided support for Israel did not ignore the legitimate rights of Palestinians. The telegrams went unread. The tyrants had the oil and the Palestinians were powerless.





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More than half a century later the tensions have surfaced again in the reaction to the Arab spring. After some hesitation, western leaders have decided that popular demand for representative government is by and large a good thing. Listening to some of these politicians one could almost imagine that they had always carried a torch for Arab democracy.



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That’s until you get to the caveats. Democracy is all very well as long as it does not threaten western interests.

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Elections are fine except when voters seem likely to embrace Islamists. Support for the uprisings has been selective and conditional.



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Sure, Nato lent its military to the overthrow of Libya’s Muammer Gaddafi. But mention repression of the Shia majority in Bahrain and silence descends. Privately, policy makers criticise the kingdom’s ruling al-Khalifa family for resisting reform. Privately.
As I have heard one European diplomat observe, much of the world’s oil passes through Bahraini waters; and Shia Iran sits menacingly across the Gulf.




.Saudi Arabia is a no-go area. Much of the Islamist extremism within and without the Middle East has its roots in the Wahhabi fundamentalism that flourishes under the House of Saud. But Saudi Arabia is the world’s largest oil exporter. The Saudis also buy hugely expensive military kit and, since the war in Iraq, serve as a vital Sunni counterweight to Iran.




.I recall a conversation with Tony Blair during George W. Bush’s ill-fated campaign to bomb the Middle East into democracy. The march of freedom, the then British prime minister said, was unstoppable. So why had he just returned from a mission to sell advanced fighter jets to the Saudi regime? For once Mr Blair seemed lost for words.




.Governments are not alone in their double standards. The other day Mr Blair was confronted in London by a demonstrator calling him a war criminal. It has become an article of faith among the liberal intelligentsia that Mr Blair’s support for Mr Bush’s war in Iraq was at very best an act of vainglorious imperialism and more likely a criminal conspiracy.




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Yet as Syria descends into ever more bloody civil war, critics of the toppling of Saddam Hussein are among those complaining that the international community is standing idly by while Bashar al-Assad continues to slaughter his people. Never mind that Saddam had massacred the Shia of southern Iraq and used chemical weapons to murder Kurds in the north.




.As it happens, the carnage in Syria throws up a dilemma that reaches beyond the familiar cynical choices between realism and idealism. Western leaders share international outrage at the wanton killing of civilians by Mr Assad’s regime. They want to see him removed from office. But to suggest that there is an easy option by way of military intervention is to abandon intelligent analysis to understandable anger.



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Syria is not Libya. Mr Assad’s military is armed with sophisticated Russian weaponry and large stocks of chemical weapons.


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Would bombing save Syrian lives? I suspect that the combination of the particularly brutal killings in Houla and Russian intransigence at the UN will eventually push the west into arming the insurgents. But no one should suppose that this will bring a happy ending.




.Confronted with charges of double standards, western policy makers tend to shrug their shoulders and reply this is the world as it is. As far as, say, Bahrain and Saudi Arabia are concerned, they will take the criticism on the chin. What the realpolitik misses, I think, is the deeply corrosive effect of the accumulated hypocrisies on the west’s standing and influence.




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During the cold war, the US and its allies could cite the need to fight against Soviet communism. They could make a cold calculation that for all the occasional agitation, the Arab street was not a threat to the status quo. Satellite television, the web and social networking lay somewhere in a deep distant future.




.Now Barack Obama, François Hollande, David Cameron and the rest confront a painful paradox. The wars in Iraq and Afghanistan and the political awakening in the Arab world have greatly weakened their capacity to effect change in the Middle East.




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Yet the instant transmission around the world of images of bloody repression demands that they act. The west cannot win. Given the sorry record of the past half-century, it hardly deserves to.



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Copyright The Financial Times Limited 2012.


France’s new president

The first steps of St François

It has been a popular if easy start for François Hollande—but he faces far more testing battles ahead

Jun 2nd 2012 | PARIS                   





TWO weeks, three continents, two world summits and one European Union gathering later, François Hollande, France’s new president, looks almost like a practised old-timer. Laurent Fabius, his foreign minister and a former foe, called his performance at the G8 and NATO meetings in Americafaultless”.


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His fight for growth over austerity in the EU has won him friends and praise. He claimed after the G8 summit that his electoral mandate had been “honoured”. “Hollande the conqueror” cooed Le Nouvel Observateur on its cover. “St François walking on water,” said Le Point in an editorial tinged with irony.



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Polls suggest that Mr Hollande is one of the most popular newly elected presidents of the Fifth Republic. With an approval rating of 61%, he trails only Charles de Gaulle (67%)—and Nicolas Sarkozy, his defeated predecessor (65%). Mr Hollande’s new prime minister, the little-known Jean-Marc Ayrault, has soared even higher: 65% of the French think he is doing a good job, more than for any modern predecessor.
What the French like most, after the flashy Sarkozy years, is the new style: conspicuous modesty. Mr Hollande has decreed a 30% pay cut for himself and his cabinet.


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Ministers must refuse expensive gifts and hospitality, they must travel by train when possible (as he did to Brussels on May 23rd) and their cars must respect traffic lights (a novelty for ministerial motorcades). Half his ministers are female, many are young and some are both, including Najat Vallaud-Belkacem, the 34-year-old Moroccan-born minister for women and government spokesman, and Aurélie Filippetti, the 38-year-old culture minister, a novelist and daughter of a Lorraine miner.






So far, so good—but also, so easy. Mr Hollande has taken largely uncontroversial decisions. His promise to withdraw combat troops from Afghanistan by the end of 2012, a year early, may have irritated the Americans, but it met with French approval. He has talked tough on Syria, saying that military intervention cannot be ruled out, but has done little. He promises to raise the minimum wage, which is hardly unpopular.
Even his decision to reverse by decree Mr Sarkozy’s raising of the retirement age from 60 to 62 for those who started work young has gone unchallenged, since he campaigned for it.



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The main reason why Mr Hollande is in no mood for immediate controversy is that he faces legislative elections on June 10th and 17th. Most polls put the Socialists and their Green friends—the two have an electoral pactwell ahead of the centre-right UMP. A divided right helps.



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Not only is Marine Le Pen’s far-right National Front likely to get the 12.5% of votes needed to make it into the run-off in nearly a fifth of the 577 constituencies, but a leadership battle has broken out within the UMP. Jean-François Copé, the party leader, faces a strong challenge from François Fillon, the popular former prime minister, who this week said that the right had “no natural leader”.






Yet Mr Hollande cannot afford to be complacent, given worries about turnout and the potential for unpredictable three-way run-offs. Some local Socialist dissidents are running outside the party, in protest at the parachuting in of Green candidates (the Greens’ Eva Joly got just 2.3% in the first round of the presidential election). And the Socialists have no pact with the Front de Gauche, the radical left-wing party led by Jean-Luc Mélenchon, even though he backed Mr Hollande in the run-off.



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The National Front may do better than either left party in some places, including Hénin-Beaumont, the mining town where Ms Le Pen is standing—and where Mr Mélenchon has decided to oppose her. For the left to win, one or other left-wing candidate would have to stand down ahead of the run-off.





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Mr Hollande has to steer clear of painful decisions until after the election, as well as to keep up the anti-austerity pressure on Germany. But time is against him. He has promised to reduce the budget deficit to 3% of GDP next year. Yet the IMF says it is more likely to be 3.9%. Moody’s has restated its negative outlook on France’s AAA credit rating, pending Mr Hollande’s first policy decisions. This week’s economic report from the European Commission (see Charlemagne) warns France that the deficit is too high, the debt is growing and extra efforts may be needed. The commission also expresses concerns about the competitiveness of French business and of exports, which shrank by almost 20% as a share of global exports between 2005 and 2010.




.Mr Hollande must make some hard budget choices. His new finance minister, Pierre Moscovici, formerly close to Dominique Strauss-Kahn, the ex-IMF boss, has begun to prepare the ground.


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During the campaign, Mr Hollande called the “world of finance” his main adversary; now Mr Moscovici has said that “debt is our enemy”. An audit of the public finances by the national accounting office is due next month, conveniently after the elections. The new government may use this as a pretext to junk promises and cut spending, even if this is not what voters want.



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All this will happen against a backdrop of rising unemployment. In talks between the government and unions this week, the communist-supported CGT complained that 46 firms were planning 45,000 lay-offs. Mr Hollande has put Arnaud Montebourg, author of a bestseller on “deglobalisation”, in charge of preventing such industrial closures. But his job looks as challenging as the economic outlook. Mr Hollande’s halo may soon start to slip.