By Joseph Hogue, CFA
The director of France’s Institute for Economic and Fiscal Research, Nicolas Lecaussin, appears in an interview with an anonymous executive at French bank BNP Paribas (OTCQX:BNPQY) this morning in the Wall Street Journal. The first paragraph is particularly surprising and really says it all.
"We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore ... We hope it will work, otherwise the downward spiral will be hell.”
When lending to banks gets cut off and bankers start using words like, “We hope it will work,” I start to get a little nervous. Investors in the three largest French banks should be nervous as well. The three banks - BNP, Societe Generale (OTCPK:SCGLY) and Credit Agricole (OTCPK:CRARY) - hold about $57 billion of total Greek debt. That’s 67% more than what was held at the largest German banks and more than four times the amount held in British banks. As of December, French banks also held more than €140 billion in Spanish debt and €400 billion in Italian debt. As these countries get incrementally worse, the French banking system, the euro and the eurozone look like an investor’s nightmare.
An article I wrote in July titled, “Why Banks Should be on Your Radar,” outlined several reasons why the U.S. banking system may not be as weak as many expect and that investors could start laddering their investments in the sector. The article received more comments than any of my other articles. Some readers commented in support, many emphatically opposed. I agree that the largest U.S. banks may have farther to fall and we’ll probably see real estate go down further before it goes up. To put it in perspective, however, the three largest U.S. banks - Bank of America (BAC), JP Morgan (JPM) and Citigroup (C) - hold about $5.9 trillion in debt (about 39% of GDP), while the three largest French banks hold €4.7 trillion (about 250% of GDP). The systemic risks to Europe and its financial system are astounding.
Many of the French banks have been state-owned as recently as the ‘80s and Mr. Lecaussin writes that this may be on the horizon once again. Within the banking article, I suggested a hedged approach to investing in the financials. There are certainly risks out there, too many to name here, but I believe they will be borne more by the European system than the American system. I suggested a long position in the Financials Select SPDR (XLF) with a commensurate short position in the SPDR S&P International Fianncial Sector ETF (IPF). The XLF is exclusively invested in U.S. financials, while the IPF holds more than half of its assets in European banks. Since July 15, the XLF is down -16.7% while the IPF is down -19.4% for a net gain of 2.7%. It won’t make you rich, but it is a good way of laying off weakness across the Atlantic.
For investors looking to short exposure to the euro, the CurrencyShares Euro Trust (FXE) provides a cost-effective way. A long position in the dollar may be warranted as a hedge. The PowerShares DB U.S. Dollar Index Bullish (UUP) holds dollar futures bets against a basket of currencies including the euro. For those looking to protect themselves from dollar and euro weakness, the WisdomTree Dreyfuss Emerging Currency Fund (CEW) provides exposure to currencies in emerging markets although the currencies in these countries might not have as much upward pressure as their central banks hold steady on rates.
As problems unfold in Europe and the possibility of some form of contagion spreads to other markets, investors should reassess their time horizons and risk tolerance. For those with a shorter 2-5 year time horizon, it may be time to think about capital preservation. For those with longer horizons, there may still be market opportunities and the ability to wait out the storm.
Disclosure: I am long XLF.