Louis-Vincent Gave: Greece Likely to Exit the Euro

JIM: Joining me as my special guest on the program today is Louis Gave from GaveKal Research. And Louis, I want to talk about a piece you wrote last Friday called Break Up Or Federalism And When Will We Know It. 

Last week the Bank of Greece has written to the government to warn of an unfolding run on bank deposits. Let’s begin with that. What does that portend? [00:57]

LOUIS: Well, good morning and thanks a lot for having me on the show, Jim. Look, I think it is getting to crunch time in Europe. What you’re basically starting to see now is private sector capital fleeing southern Europe in ever larger numbers. And I think this is a very important development, obviously, because an economy cannot grow without private sector capital. So you know, right now, Europe is discussing do we do, you know, a big plan to go build bridges in southern Italy or build bridges in Greece or build roads in Spain. 

The reality is Europe’s crisis has moved beyond that. It’s no longer the question of a lack of growth; it’s a question of a lack of faith of people in their own economy. And so once the private capital starts to flee, you need to rapidly put an end to it. What I’m saying is basically a bank run has started. And once a bank run has started, the logical thing to do is basically participate; right? If you walk out this morning and you see a line outside the bank, the logical thing to do is get in line. And so we are now in that situation in Europe. So that’s why I think we’re coming to the point where Europe has to decide what it wants, and that’s either Europe comes in and basically guarantees the ECB — and I think the ECB is the only one able to do it — the ECB comes in and says we guarantee bank deposits wherever they are and you stop the run on the banks, or the run on the banks continues and a country like Greece will have no choice but to leave. 

And here, I think this is the important point is that Greece has reached a point now where with all the private sector capital fleeing, it may be better off leaving. And that once Greece has left the euro, Greece has a hope of getting all the capital that it’s pledged to Germany, to Switzerland, to wherever, it has a hope of getting that capital back. 

Other than Asia through the Asian crisis and in Asia we had big devaluations — Thai baht fell 60 percent, Indonesian rupia fell 75 percent and what matters wasn’t as much the big devaluation made these countries competitive again; it wasn’t that, all of a sudden the Indonesian rupiah fell 75 percent, Toyota was going to open a plant in Indonesia. What you saw is that you start to see capital moving back; you know, people buying houses in Phuket, people buying houses in Bali because all of a sudden it has gotten so cheap. 

The big problem today for Greece is that, look, the Greek stock market is down 94 percent. So I might think, okay, you know, there’s some tremendously cheap stocks right now that I can buy in Greece. But the problem is that I’m not going to do it because if I buy a Greek stock today, if Greece leaves tomorrow, I can take a 50 to 60 percent hit in one day just on the currency. And right now, unfortunately, it’s a risk I simply cannot hedge because I can’t sell the drachma forward because the drachma does not exist. So this is a big problem all these southern European countries are confronting; private sector capital is fleeing and it’s probably not going to come back until either you get a massive blanket guarantee or you get a devaluation. And as soon as you get a devaluation, I think a lot of private sector capital comes back. It may be hedged; maybe people say, okay, I’ll invest in Greece and I’ll hedge the drachma.

We're basically at this crossroads. Now, Greece is running out of money in six weeks time, so basically Europe has six weeks to decide either we guarantee Greece or Greece walks out. [4:29]

JIM: what does it tell you when you see a bank run going on in the country because there’s one political party — and you have extremists who seem to be winning in the polls — and one says, you know what, we're just going to default, we're going to do away with all the austerity, we're going to do away with all this, and we’ll just call Europe’s bluff. But if the people in Greece were so confident, they wouldn't be taking their money out of the country or out of the bank as they’re doing now. [4:54]

LOUIS: It’s hard to fault the Greeks for voting for these extremists parties because they’re the only ones proposing a way out today. The national parties of government are basically saying let’s just do more of the same. But more of the same is 50 percent youth unemployment; it’s an economy that has already shrunk more than the US did during the Great Depression. And once you reach that stage, you have to think, okay, what we're doing is not working. And indeed, you look at this and you go, okay, what we’re doing is not working, and in the political sphere I either have some knucklehead nazi’s or knucklehead communists proposing that we do something different.  So I’ve got the parties of government telling me to do more of the same. If I were a Greek, and this was what I had to deal with, I too would be taking my money out; in fact, it’d already be out. Why would you keep your capital in such an environment. I think it’s a perfectly rational thing to do to put it outside of your country. [5:52]

JIM: You know, as you look at how this crisis has unfolded when it first began, the first crisis was sustainability of the budget deficits, which triggered the acronyms EFSS, EFSM. The second one dealt with liquidity; we got the LTRO program. But the fact is, you write, when it gets down to the stage of a bank run and private sector fleeing, you’re almost in the terminal phase here. [6:20]

LOUIS: I think that’s right. And frankly, you’re at the stage where either you have to say, look, we’re guaranteeing the banks and once that’s done maybe have a chance to stop the hemorrhaging, although you’re still left with the structural problem of Greek competitiveness, or you let it go. Now, if you guarantee the banks, it also means of course the ECB isn't going to guarantee Greek banks or Italian banks without having regulatory powers over them, without having the ability to tell the banks, look, you can’t do that. And so invariably it’s forcibly, it takes a lot of powers out of the individual countries and centralizes it within the ECB. So it’s undeniably a move towards federalism. And you know, all this has to happen in a fairly short period of time. So right now it doesn't seem that European leaders are even talking with one another. I think right now the higher up scenario is that in the next six weeks Greece leaves. [7:22]

JIM: As you look at this debate, whether it ends up in federalism or it’s in break up, even within your own organization you have two different views on this, you believe that it ends up in a break up. State your case and why you think you’re going to be right on this. [7:36]

LOUIS: You’re absolutely right we have different views on this, partly because at the end of the day it becomes a political decision. And as a result it’s far murkier. I think it ends up in a break up because of a number reasons. The first, I think there is an overall fatigue amongst European policy makers; if you’re Angela Merkel and you've spent the past three years in summits discussing Greece, and you’re probably tired of it; you’re probably sick of it. Just like Hank Paulson, I think, having tried to rescue Lehman two or three times and organized different deals, it wants to be taken over by Barclays, it wants to be taken over by Daewoo, and each time seeing Dick Fuld say, no, I don’t like the price. By the end of it all, you know, Hank Paulson felt like, I’m not taking Dick Fuld’s phone calls anymore. I don’t care. 

And I think for a lot of European policy makers we've reached that point with Greece; definitely for Angela Merkel. You know, if she never has probably to see another Greek again she will be happy. What I’m trying to say, I guess, is that you can’t underestimate the human factor in all these decisions because, you know, it is now a political decision.

The other reason I think a solution — a federalist solution is unlikely is at the end of the day, for everything to happen right, you need to get 17 different countries to sign off on a plan and 17 countries representing 25 different political parties — 17 different governments representing 25 different political parties, with different constitutions, different timeframes in getting legislatures through and pretty much you’re asking everyone in parliament — or everyone of these civil services to give up a lot of power to a central authority. Now, parliaments and civil services tend to be very jealous of their power; they don’t like giving it up. And that’s why it seems to me unlikely that you could get all this done in the six weeks before Greece runs out of money. [9:32]

JIM: Let’s say, Louis, that you’re right. Come January 17^th, they exit. Europe does nothing before that. Describe what it would look like if this event unfolds in the way you think it is, which is an exit of the euro. What happens next? [9:49]

LOUIS: So Greece — I think Greece leaves the euro and obviously you have a few weeks of chaos for Greece, but for Greece actually it seems to me the most likely scenario you have a few weeks of chaos. And then, unless Greece goes completely communist and basically turns into Albania, unless that happens, I think a lot of capital, that is, Greek capital sitting outside of Greece today, starts coming back and saying, oh, I can pay off my mortgage on the cheap or with all the money I stocked away; I can all of a sudden buy a house in the center of Corfu for half the price. So money starts coming back. That’s for Greece. 

The big question of course, is with Greece leaving, does that trigger a massive bank run in Portugal, Spain and Italy and possibly France. This is the big risk and I think this is what, obviously, European policy makers are most scared of, otherwise it would have let Greece go long ago. But that’s the big unknown.

I think basically my belief is they let Greece go; partly, Greece has been too egregious and just lying too much about its numbers, et cetera. They let them go and should a bank run get started in France, Italy and Spain, the ECB will come in and give the bank guarantee they refuse to give to Greece. And what you will thus see is a massive new wave of liquidity from central banks. While the ECB does this, you’ll probably be getting at the same time QE3 from the Fed, you’ll probably be getting some printing from the BOJ and the PBOC here in China and you know, I think the markets may find their footing much, much faster than people expect. Undeniably, Greece coming out will create a wave of great uncertainty; that’s what we’re partially — that’s one of the reasons markets are struggling today. And then, but on the back side of that, with a bank guarantee — assuming you get bank guarantees from the ECB — and then at that point I think you’re off to the races. [11:50]

JIM: You know, it almost reminds me just before a war, leading up to the war, the market is filled with uncertainty; the market declines because there is this event out there and then all of a sudden when the bombs start dropping, the markets take off. And then essentially, you have another crisis here, as you just described going on in Europe; there all of this uncertainty and anxiety as to what may happen. Once the event happens and you get the response, in this case QE from the Fed, from the Bank of England, Japan, Europe, and that response comes back in, then the crisis eases and the markets can say, okay, it’s happened, we know what’s being done. There’s a little bit more clarity than there is now. [12:37]

LOUIS: I couldn't agree more. And I think, you know, today the big analogy, the big fear in people’s minds is that this is another Lehman. And I think that just like generals, investors are often too prone to fight the last war. So you know, Lehman was such a traumatic event for everybody that everybody’s mind immediately comes back to that; like Greece hitting the wall would be like Lehman hitting the wall. The reality is the situation could be extremely different.

Because of Lehman, the policy response is likely to be far more proactive than it was back then, number one. But more importantly, Lehman occurred at a time when financial market participants were massively geared. Eventually hedge fund was running maximum net and gross positions. Up to the summer before Lehman’s, private equity funds were raising billions and billions and doing deals for hundreds of billions of dollars on massive leverage; commercial and investment banks were geared at least 50 times, if not more. And in the past four or five years we've seen a degearing of the entire financial industry. You know, banks that used to be 50-times geared are now 12-times geared. 

And so Lehman happened, everybody had to deleverage extremely rapidly at the same time: hedge funds, investment banks, private equity firms. Everybody reduced their leverage in a market with no buyers. Today, this crisis is able to be telegraphed and it’s happening at a time when the leverage just isn’t as high. So you know, it’s going to happen, but it doesn't mean everybody is going to get a margin call first thing on Monday morning. [14:11]

JIM: You know, something we've been spending the first part of this discussion talking about Greece, in the bigger picture, bigger scheme of things, maybe a $400 billion economy. I want to talk about something else not enough attention has been paid to, which is the bigger picture, is I think right now it matters more what’s going on in the US economy because it’s a $15 trillion economy. And while we're watching this sort of slow motion chain of events unfold in Europe, in the bigger picture there’s something else going on in this country. Let’s talk about that and what happens here may matter more than what happens in Greece. [14:53]

LOUIS: Look, I fully agree. Judging the overall relevance of Greece, I have a simple stat for you, that China adds a Greek economy to its own economy every 11 weeks. So every 11 weeks you have a new Greek economy added to the Chinese economy. To help keep things in perspective. And China is only the second largest economy in the world. Obviously, the largest economy is your own. 

Now, I think this latest bout of weakness in equity markets, sure, it’s coincided with the new fears on Europe, but to a large degree investors now, for the last two years, have known Europe was a write-off, you know. For the past two years, investors have come to know that Europe is going through a double-dip recession for the first time since World War II. So it’s not that much of a surprise. Who today is waking up and picking up his Wall Street Journal and saying, “oh wow, Greece is in trouble. I didn’t realize that.”? You know, this is a well known fact. 

So I think part of the pull back we're seeing in the markets isn't as much linked to the fact that Greece is hitting the wall — everybody knows that — but the fact the US data, which had been looking very, very strong, at least private sector data over the past month has started to look maybe not as strong as one might have hoped. Now, it’s our belief that actually the data that’s going to come out in the coming weeks is going to show once again the US economy is actually holding its own when you look at the PMI surveys, when you look at some of the OECD leading indicators for the US, you know, they’re all pointing to an economy that is on the mend. And so it seems to me that all you would need is, for example, a strong job number, I think the next important jobs number is on June 1^st, not this Friday but the following Friday, when you get a strong jobs number there I think the markets may rip again, very, very equally. And bonds — and bonds sell off. 

So it seems to me that given all this today, being in the bond space, being long dated bonds is a very dangerous proposition. [17:04]

JIM: I want to talk about this issue too because as the economy has slowed down — it’s probably equivalent to a soft patch — we have seen, at least in the US, since the beginning of the year, record out-flows out of equity funds. In fact, if we take a look at April and May, we're on record to set a new pace of inflows into bond funds at a time that let’s say the 10 year Treasury note is around 1.7 and we’re about 2.8 on the 30-year Treasury bond. It’s this kind of safety — as you alluded to — where everybody thinks, “Oh my goodness, Greece is going to lead to another Lehman event; this is going to be 2008 all over again.”

I’ve looked at investor sentiment, it’s at levels that we haven't seen since the market bottomed in 2009; investment strategists have turned negative; investor sentiment — I don’t care where you look — it’s down at levels that you would think we're heading into another Lehman fall like we did in 2008. I have trouble with that because I don’t think that things as we have just been discussing here, what’s going on here has a lot more relevancy. 

And you know what, I’m looking at corporate earnings that have come in much better than expected; I’m looking at companies saying, you know what, things are looking pretty good right now; and companies are raising dividends. That doesn't describe, for me, an economy that’s about ready to fall off a cliff or private capital is about ready to recede and go hide in a cave. [18:36]

LOUIS: I couldn't agree more. And frankly, I think all this is tremendous news because it provides investors with tremendous buying opportunities. The reality is the kind of sentiment indicators that you've just mentioned, you know, the investor surveys, the put to call ratios, all these indicators that you might use, are immensely relevant in a bull market but become irrelevant in a bear market. So as you get a big pullback, the question every investor has to confront is, okay, is this the start of a bear market or is this a pullback in a bull market. If it’s a pullback in a bull market, today all these indicators, the funds flows, the surveys, the put to call ratios, et cetera, they’re all telling you you have to buy; if it’s the start of a bear market, of course, you can discard those. 

Now, the bet we're making as a firm is that we are still in a bull market; we are still in a bull market for the very reasons you highlighted: the earnings being strong; the fact that global growth, yes, European growth stinks, but global growth is still above average. And if you think like I do, that bull markets rest on three pillars, you need three things for a bull market to take off: you need attractive valuations; you need decent economic growth; and you need excess liquidity. Excess liquidity more often than not provided by central banks. 

Today we have all three. We have all three in spades. Central banks are providing a lot of liquidity; the growth is there. Now, I know the growth numbers in the US, the headline print has been somewhat lackluster, but that’s because you've had government retrenchment during that period. That’s because you've seen no growth whatsoever in government. So what the US in now doing is you have a private sector GDP that’s growing at 3 ½ to 3.6 percent, and a government that’s growing at zero, which gives a total growth of 2.4, 2.2, 2.5, which might look somewhat, basically not good enough. But really, that’s exactly what the US needs. The US needs five years of private sector growing at 3 ½ while the government’s been flat. The US can do that. We are starting a structural bull market. For me, that’s very much where we are today. 

I’ll add one last thing if I may on this point. If you look at the internals of the market, it seems to me as if the situation today is very different than the situation that prevailed in 2008. You know, we manage several funds here in Asia. We manage a global equity fund out of our Denver office. And in all of our funds we tend have a growth bias; we tend to like stocks with strong earnings price momentum, strong share price momentum and basically high quality growth companies. Now, in 2008, these names were getting crushed and we were having a tough time staying ahead of our benchmarks. 

This time around what we’re finding is the high quality names in Asia, the high quality names in the US, even the high quality names in Europe, even in this fairly brutal pullback that we've had in the past six weeks or so, they’ve held up not badly at all. They’ve held up very, very decently. And that tells me that the kind of sell-off we're seeing isn't as indiscriminate as we had in 2008. There’s not as much throwing in of the towel. And it tells me that for a lot of names, you know, the weak hands are gone; you know, the guys who aren’t really committed and buy for the easy money and as soon as it doesn't look it, they quit. A lot of these guys have already left the equity markets. Maybe they all went into the Facebook IPO. And that was maybe the last burning of the weak hands. [22:06]

JIM: You and I are seeing a lot of things because I look at not just what the market indexes are doing, but I’m looking at what companies are saying and what companies are doing. I mean if you take a company like IBM, a big tech behemoth, they just announced in their last earnings call that they expect cash flow to grow by $100 billion in the next five years; 50 billion they’re going to use to buy back stock and 20 billion to pay investors dividends, which have been growing at 20 percent a year. That’s a growth story I can get my hands around. That doesn't tell me that this is a company, which operates globally, that says, you know, we're down in the bunker right here and just hoping that things come out okay, we're getting ready for the Mayan calendar. This is a company that sees great things ahead. [22:54]

LOUIS: Absolutely. And that 100 billion, just to put things in perspective, is 25 percent of Greek GDP. So just the increase in the IBM cash flow is 25 percent of Greek GDP. So, yeah, just to put things in perspective about what we should worry about because at the end of the day, when you are an investor, you buy companies; you buy a stream of cash flows. And today, that stream of cash flow, as you point out, in a number of companies that we're seeing around the world is massively undervalued. And I think the reason so much cash flow is undervalued is that people underestimate — investors underestimate the amount that has been invested, especially in the western world by companies over the past decade or two decades. 

And the reasons the amounts of investments are underestimated is that most of the investments that have taken place in the past couple of decades have been in things like house brand, staff training and development, but most importantly in R&D and the like. And the problem with all of these expenses, whether branding, training, brand development, R&D is that you have to expense it immediately and you don’t accrue it as if it was capital. Basically, intellectual capital cannot be found anywhere on the balance sheet. Take Apple as an example. Apple developed in house the iTunes system, which is how pretty much everybody I know buys music, but look for the iTunes system on the Apple balance sheet and you can’t find it. Or think of Amazon. I sometimes feel like Amazon knows me better than my wife because every week I get an email from Amazon saying, oh, you’re going to like this new book. And invariably they’re right. And when it comes to Christmas, invariably my presents are never quite what I want! You know, Amazon has a database out there on people with you know, matching — Amazon knows more about me than probably most of my friends. And yet, none of this intellectual property is on balance sheets. 

You could tell me, well, for Apple or for Amazon it’s already reflected in their valuation. That’s undeniably true, but there’s hundreds of companies out there where the investments they’ve made in intellectual property are simply not reflected in their balance sheets. And now what’s happening are these investments are starting to generate massive cash flows. And that’s how the re-rating is going to happen and that’s how you have to look at the companies. Look through their cash flows, assuming some of them are generating bigger and bigger cash flows and you’re seeing it in of course as [inaudible] profit margins of the US, that I think you can look at the next few years with excitement. And for me, pullbacks such as the one we're seeing are tremendous opportunities to buy quality companies on the cheap, when we can’t let go of them. [25:40]

JIM: You know, I couldn't agree with you more, Louis, because we notice it just in the QLine calls we get here on the program and emails that we get and also articles that we write on our website. If I write something positive — I wrote a piece a couple of months ago, The Story That Nobody Wants To Hear — it’s that stocks were cheap, that the economy was growing, we have plenty of liquidity — the three conditions that you talked about in a bull market, hardly any response, but if I were to put something like crisis, Armageddon or throw some kind of word like “Mayan calendar” behind it, I’d get five times the readership. [26:18]

LOUIS: Yep. No, look, I think there is a natural inclination to feel scared. There is a natural inclination to want to go hide in a hole because the world is getting more and more complicated because the transmission mechanisms are harder and harder to understand. I mean look at it this way. As an investor of mine put it a couple of years ago, up until two years ago he thought Greece was the name of a musical. Now, all of a sudden, he’s got to find out about Greek politics, he’s got to — it’s a massive headache. And he thinks, you know what, write it off. 

But I think you can also go the other way and say, you know what, I’m not going to pay attention to that; I’m going to pay attention to my companies, talk to them, see how they’re doing, see what their plans are. And when you do that, you come to the conclusion, as your IBM example shows, that you have a lot of companies generating tremendous amounts of cash flows and these cash flows, one way or the other, either through share buybacks or through dividends will be coming back to investors. [27:23]

JIM: Well, I think you said it very aptly when you said, you know, IBM’s $100 billion, that’s 25 percent of Greek GDP. What should we focus on, the 100 billion generated by IBM or a 400 billion dollar economy? I think I’m going to stick with IBM. [27:38]

LOUIS: That’s right.

JIM: Well, listen, Louis, as we go close, why don’t you give out your website. You guys publish some phenomenal stuff. I love the way you guys think.

LOUIS: Well, thank you. That’s very kind of you. Our website is at www.gavekal.com. [28:02]

JIM: All right. We've been speaking with Louis Gave of GaveKal Research. If you’d like to find out more about the work they do at GaveKal: www.gavekal.com.

Louis, I want to wish you a good morning and thanks for joining us on the Financial Sense Newshour. It’s always a pleasure speaking with you.

LOUIS: Thanks a lot, Jim. Take care. [28:23]