6 May 2010

Global Strategy
Alternative view
www.sgresearch.com

Popular Delusions
Crisis investing in the eurozone? The vain search for distressed value

Who knows, maybe the latest Greek bailout and the ECB’s decision to relax collateral
Dylan Grice
(44) 20 7762 5872 requirements will succeed in containing the eurozone’s crisis. I certainly hope so, but I doubt
dylan.grice@sgcib.com
it. Mr Market’s mood swings are now more important than pleas for respite on grounds of
better Portuguese and Spanish fiscal metrics. More important though, apart from a Greek
bond market that is now pricing in default, where are the distressed valuations? There may
well come a time to fill your boots with eurozone stocks and bonds, but it’s probably not now.

Q At last weekend’s Berkshire Hathaway meeting, a shareholder asked Warren Buffett what
he thought about the developing situation in Europe. He replied that he wasn’t sure how this
movie ends, “and I don’t like going to movies like that.” I think he’s spot on, as usual. Albert
and I have both been pretty clear in past work that the strain on government balance sheets
will ultimately place a fatal strain on the single currency, but who honestly knows what the
end game is here?

Q ‘Logic’ says that once we’re over Greece, we’re over the worst since the other ‘problem’
economies are in better fiscal shape: Portugal and Italy have significantly lower deficits,
Spain a lower debt to GDP ratio and Ireland is aggressively consolidating. It seems these
governments are ‘structurally sounder’. But this is to apply ‘logic’ to a situation which is now
primarily about Mr Market’s mood swings. After all, according to such ‘logic’ Greece should
never have happened because its government balance sheet was never as stretched as
Japan’s, which has had no crisis. So much for such ‘logic’ ...

Q Actually, Reinhart and Rogoff’s work shows there is no ‘threshold’ beyond which markets
refuse to finance government deficits (see chart below). So we should be wary of
confidence that the crisis will be contained to Greece, just because other crisis candidate
countries have better debt metrics. We just don’t know how much debt is too much …

Global Strategy Team A comparison of public debt to revenue ratios during past crises with some of those today
Albert Edwards Historical public debt/revenue ratios during selected defaults Selected ratios today
18
(44) 20 7762 5890
albert.edwards@sgcib.com 16
14
Dylan Grice
(44) 20 7762 5872 12
dylan.grice@sgcib.com 10
8
6
4
2
0
Germany, 1932

Pakistan, 1998
Turkey, 1978
Mexico, 1827

China, 1939

Greece, 2009

Japan, 2009

US, 2009
Mexico, 1982

Russia, 1998
Philippines, 1983
Spain, 1877

Spain, 2009
Brazil, 1983
Argentina, 1890

Argentina, 2001
South Africa, 1985

Source: SG Cross Asset Research; Reinhart and Rogoff (2009)

Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document
 Popular Delusions

One thing we do know though is that crises like these move sequentially. Mr Market turns into
one of those outsized monsters in the Hollywood movies, hunting its cowering victims down
one by one, picking up the cars or buses or buildings in which they might be hiding and
violently shaking them until someone falls out, or the thing is smashed. Only then does it move
onto the next target. We saw this during the crash of 2008 when the epicentre of the crisis
moved from one weak financial institution to the next, busting some and nearly busting others.

We also saw it during the Asian crisis of 1997. The following chart shows how the key Asian
exchange rates broke as the crisis unfolded. What’s important to understand is how
confident the world was at the time that Korea was not Thailand or Indonesia (or
Malaysia, which also lost its peg, though it is not shown on the chart). Korea was deemed
more ‘structurally sound’.

Mr Market picked off

… bef ore
100 'structurally sound'
Korea w ent too

90 Thailand w as f irst ...

… Philippines w as next ...

80
… Indonesia f ollow ed

70

60

50
28/02/97 28/03/97 28/04/97 28/05/97 28/06/97 28/07/97 28/08/97 28/09/97 28/10/97 28/11/97
Korean w on Thai Baht Philippino peso Indonesia Rupiah

Source: SG Cross Asset Research

In many ways Korea was more structurally sound than the other economies. Unfortunately it
was similar in one way that counted, which was that a debt load which was sustainable at one
exchange rate was unsustainable at another (Korea, like most of its Asian neighbours, had
borrowed heavily in dollars during its lengthy fixed exchange rate period, so when Mr Market
repriced those exchange rates its real foreign debt burdens exploded, unmasking the
previously hidden structural problems). In that respect today’s problem in the eurozone isn’t
that different: deficits and debt loads which work fine at a 4% interest rate no longer work
when Mr Market prices them higher. During these halcyon days of worldwide low ‘risk-free’
yields, the rest of the world’s indebted governments should be paying attention ...

Another thing we know which suggests the crisis isn’t over is that, at the nadir, valuations
become distressed. Yet, with the exception of Greek bonds (now pricing in default) I’m
struggling to find such distressed pricing: Greek, Portuguese and Spanish equity markets
have fallen heavily but none of them yet trade below my estimates of intrinsic value. Indeed,
looking at the intrinsic value estimates for each of the stocks in my universe, there are no
stocks from Greece or Portugal trading below intrinsic value, and Repsol and Gas Natural are
the only Spanish names.

As for markets overall, only the UK and Norway have IVP ratios (intrinsic value to price) greater
than 1.0 (i.e. intrinsic value > price). These markets simply offer much better value and Norway
in particular – unfortunately small though it is – remains to my mind as sound a destination for
your capital as any.

2 6 May 2010
 Popular Delusions

Equity valuations in the ‘problem’ countries don’t appear obviously distressed

1.20
Equities attractive

1.00
Equities unattractive

0.80

0.60

0.40

0.20

0.00
United Kingdom

Norway

Italy

Spain

Eurozone

Germany

France

Greece

Portugal

Ireland

Canada

United States

Japan

Australia

Hong Kong

China
Source: SG Cross Asset Research

That better value is available outside the eurozone is equally true of bond markets. According
to Datastream, Greece’s 10y benchmark series yields 9%, which, to my mind, compares
unfavourably with, say, Indonesian 10y government bonds, which yield 8.85%. Admittedly,
Indonesia has a higher inflation rate (3.9%), but it has better public finance prospects (despite
declining oil production), a lower probability of default and its citizens have about the same
tendency to riot. Less exotically, Australia’s 10y government bonds yield nearly 6%, higher
than Portugal’s and significantly higher than Spain’s (chart below). I’m no bond expert, but it
would be hard to convince me that Australia deserves this discount.

Portuguese and Spanish debt rated more highly than Australian?

11

10

9
Portugal Australia Greece Spain
8

2
04/05/09 04/07/09 04/09/09 04/11/09 04/01/10 04/03/10 04/05/10

Source: SG Cross Asset Research, Datastream

None of this is to say that we’re not over the worst. The ECB now accepts junk bonds as
collateral provided they’ve been issued by a eurozone government. From the perspective of
saving the euro in its current form and lowering the systemic risk building in the zone’s
financial system, this is an excellent decision. But only a few months ago the ECB was talking
about restoring its collateral standards to pre-credit crunch levels! I expect to see it
compromise more of its hard money principles before this particular crisis has played out.

But what do I know? Maybe we are over the worst and maybe the markets will rally hard from
here. But one thing I wish I’d known before my drunken line dancing with the locals of Omaha,
Nebraska last weekend is that if you don’t understand the music you shouldn’t be on the
dance floor. At these valuations I’m happier letting others show off their moves.

6 May 2010 3
 Popular Delusions

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4 6 May 2010