The Italy Crisis Is A Buying Opportunity

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Includes: DBIT, DEUR, DRR, ERO, EUFX, EUO, EWI, FLIY, FXE, HEWI, UEUR, ULE, URR
by: J.G. Collins

Summary

Italy and the other PIGS.have kept the Euro below what the national currencies of northern European countries would otherwise be.

If Italy and/or the other PIGS leave the Eurozone, the Euro would appreciate.

The fear that the PIGS will be unable to repay their debts to the ECB and the Bundesbank are overblown.  Those loans should have been written off long ago.

Events this weekend in Italy triggered a potential buying opportunity for investors willing to take risk over the long term. We recommend long positions on Euro-denominated bonds and equities for investors with a medium to high risk threshold.

Background

The inability of the newly elected Five Star and Lega parties to form a coalition government, and their nomination of a eurosceptic finance minister (now rejected), have created concerns that Italy may have snap elections that could trigger its departure from the Eurozone or that the two parties - led by rightists and anti-establishment politicians - might leave the Eurozone in any event.

As we and others have said for some time, Italy and the rest of the PIGS (Portugal, Italy, Greece, and Spain) in southern Europe are part of the Eurozone by design. Their economies, relatively weak relative to their northern European counterparts, keep the Euro weak relative to the Dollar, Yen, and Renminbi and aid northern European exporters, particularly Germany. (Germany now has the world's largest current account surplus for the second year running.

Diagram: Italian Senate


Image source: Wikimedia

Diagram: Italian Chamber of Deputies










Source: Wikimedia

If the Deutsche Mark and the Franc still existed, they would be much stronger then the Euro. Monetary integration with weaker economies cause the euro to be undervalued relative to the underlying currencies of strong northern European economies.

Germany and the ECB have been doing so-called "extend and pretend" loans to the PIGS for years, to keep the Euro undervalued relative to what Eurozone member currencies would have been had the Euro not been created. Northern European Finance ministers, particularly Wolfgang Schauble, the former finance minister of Germany, made sure to play this element of monetary integration to their implicit advantage to benefit their export economies.

It stands to reason, therefore, that the departure of Italy or any of the PIGS from the Eurozone would actually boost the euro and cause it to appreciate relative to its current market level.

While certainly the ECB and the Bundesbank would take a significant markdown of their loans to the PIGS , the write down would effectively be an accounting entry to acknowledge what most of us who watch such things already knew: that the extend and pretend loans were no good in the first place. (Hence the name: you "extend" the terms of credit on non-performing loans; then, you "pretend" you will be repaid. Doing so avoids having to face the hard fact you will never see your principal again.)

We think investors with a higher than average tolerance for risk and a three to seven year investment horizon should go long the euro, and high quality northern European bonds and equities in the consumer staple and export Industries.

Companies we like include Daimler AG (DAI), Mercedes-Benz, BMW (BMW) Bayer AG (OTCPK:BAYN), Airbus SE (AIR), HENKEL AG & Co/S (OTCPK:HENOY).

Author's note: Our commentaries most often tend to be event-driven. They are mostly written from a public policy, economic, or political/geopolitical perspective. Some are written from a management consulting perspective for companies that we believe to be under-performing and include strategies that we would recommend were the companies our clients. Others discuss new management strategies we believe will fail. This approach lends special value to contrarian investors to uncover potential opportunities in companies that are otherwise in downturn. (Opinions with respect to such companies here, however, assume the company will not change).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The foregoing is only the author's opinion about a company and its operations, market, and management. It is not intended as investment advice, and you should not use it for that purpose. You should consult your own personal financial adviser before undertaking any changes to your investment portfolio.

Foreign-based companies have their own set of currency and political risk that you should consider.

The author may have indirect interests, through international mutual funds, in the stocks mentioned, but none of those stocks mentioned make up an substantial portion of his portfolio.