The Smartest Man in Europe Is Very Cautious
July 2011
Every year I try to spend time with the person I have come to think of as The Smartest Man in Europe. I met him almost thirty years ago when he encouraged me to think about the investment implications of the end of communism in the Soviet Union. He later saw opportunities developing in the emerging markets of Asia. Over the years he has been early to see important changes in trends across the world. He is descended from a mercantile family that has been involved in trade for hundreds of years, going back to the operation of canteens for travelers along the Silk Road. Fluent in many languages, he trained in the United States after World War II, but returned to Europe to take advantage of the recovery taking place there.
Usually we have our discussions in hotels or offices, but this year I spent a weekend with him at his summer home on the Mediterranean in France. There, surrounded by his impressive paintings and sculpture, we talked about the current outlook for global investors. I wrote my first essay about these meetings in 2001 and it was called “The Smartest Man in Europe Is Upbeat.” His mood was very different this year.
“It’s very hard to make money in stocks. Earnings growth is the key to equity market performance and with the heavy debt burdens of the developed economies of the United States and Europe, growth is likely to be slow. I know earnings are going to be good this year but profit margins are high and it will be hard for earnings to exceed the nominal growth rate of the economy on a sustained basis. The developed economies don’t have the resources to stimulate to grow faster even though that is what their people want. Unemployment is high in the United States and many parts of Europe, and this will dampen consumer spending. Politicians are in a difficult position. They would have to spend more money to create jobs and they need the money to service and draw down the debt in the United States and to deal with the credit crisis in Greece and Portugal in Europe.
“Ironically, the big beneficiary of the financial problems in the weaker European countries has been Germany. The credit crisis has kept the euro cheap. I know it doesn’t look that way to you Americans because your currency has deteriorated significantly, but to many others around the world German goods are very attractively priced, making their exports strong. That’s why it is in Germany’s interest to keep the European Union intact. If Greece and Portugal were thrown out because of their poor financial management, the euro would appreciate and the German economy would suffer. The current solution that allows Greece to roll over its maturing debt into new longer-dated, lower-interest obligations avoids default and is very elegant. It doesn’t solve any of the long-term problems, but it does get Europe through the current crisis. Greece will have to undergo severe austerity and the people will react badly to that, but they have no other choice. The hope would be that they could grow their way out of the problem, but that’s hard to do if your economy is based on tourism and olive oil.
“Over the next few years the banks in the stronger countries – Germany, France and the Netherlands – will try to become less exposed to the sovereign debt of the weaker countries. In a few years, if the situation has not improved, the European Union may have to be restructured. While the Germans believe that the people in the weaker countries should go through a period of hardship as Germany itself did when the East and West parts of the country were combined, they have come around to the view that they have more to lose than to gain if the euro collapses, and so they are supporting the program to help the weaker countries get through the crisis. Ultimately the Greek banks will have to be nationalized. They have already lost most of their deposits. The government has tried to solve part of the problem by raising taxes, but 30% of the economy is underground and there is no record of income. If Greece defaulted, the whole European banking system would be in trouble.
“The United States is destroying its currency. You cannot keep borrowing from abroad at the rate you are doing it and expect the dollar to maintain its value. America has been living beyond its means for a long time. Most people think that means that consumers have been spending too much and borrowing to do it, but that’s not what bothers me. The government has been spending seriously beyond its means. It has 150 military bases around the world and is involved in three wars. How does that make sense when you are running a deficit of $1.5 trillion?
“Right now my portfolio is invested in gold and Swiss francs. Every once in a while a special situation appears that interests me. Last year I made a real estate investment in Baghdad. I remember the look in your face when I told you about it. After I had owned the property for less than a year, the Iraqi government wanted to buy it and I got out with almost a 100% profit. I like to seek opportunity in places everyone else is avoiding.
“The central bankers throughout the world have lost touch with reality. They did not recognize that the liquidity they were creating would produce excesses in the housing industry. This was particularly true in the United States and Spain. Housing is no longer attracting capital, but there is still plenty of liquidity out there. I know you have been expecting interest rates to rise, but all this liquidity looking for a place to rest has to go somewhere. That’s why interest rates are so low in the United States, and if I am right and it will be hard to get a satisfactory return in risk assets, U.S. Treasury yields will stay low.
