Euros And Gyros: Greece's Decision And Your Exposure

Includes: EFA, JPM
by: Alan Hartley, CFA

Fear has reentered markets, due to a string of weaker-than-expected economic data as well as worries over Greek elections and the country's possible exit from the Euro. Two prominent firms, the Hussman Funds and the ECRI, both recently reiterated their forecasts for an "imminent" U.S. recession. Economic growth is certainly slowing, but by no means are we seeing the early signs of recession that have been apparent in our macro-economic model at other business cycle inflection points.

Average weekly hours worked continue to rise, initial claims are at multi-year lows, housing starts and building permits are growing, corporate profits are still expanding, and the Federal Reserve is extremely accommodative. All this may change in the months ahead, but for now, an imminent recession seems improbable. A credit crisis in the Eurozone could potentially change that.

Greece's economy is mired in recession, high unemployment, and declining standards of living. Will the country abandon the Euro? Will the country stay in the currency union? Either path will be rife with challenge.

If Greece leaves the Euro, its banking deposit base would convert to a greatly devalued drachma and much of its citizen's wealth would be decimated. Its pensions and promises would not be honored, at least in their current form, its banks would be insolvent and would likely be nationalized, the government would default on all Euro-based debt, import prices would surge and the country would be on the brink of utter collapse.

For a time, things would be far, far worse than they are today. However, over time, the country's competitiveness would be restored. Its exports would be much cheaper to the rest of the world, its domestic companies' products would be affordable to its people, the government's budget could be properly sized, and its trade balance would become a very large surplus. The rest of the Eurozone would have to be ring-fenced, however, and substantial monetary and fiscal support would be required to prevent more countries from leaving the Euro.

If, on the other hand, Greece remains in the currency union, a much larger backstop must be created for not only the troubled nation's existing debt and future funding needs, but for the other periphery countries as well. While the Greek economy's lack of competitiveness would remain and its path to sustainability would be further drawn-out, the adjustment process would be much less severe on the Greek people than an outright exit.

The region desperately needs growth, but thus far Euro countries have been required to be austere. Fortunately, that seems to be changing. Growth in the region, particularly in the periphery, will require much more monetary and fiscal involvement as well as German-approved inflation. A Euro-wide bond is also likely necessary to stem the tide.

In either event, some perspective is due for internationally diversified investors. If you hold a well-diversified basket of foreign stocks, what direct exposure do you likely have to the Greek equity market? Less than 9 basis points. For instance, if you held the iShares MSCI EAFE Index (NYSEARCA:EFA) exchange-traded fund, the overwhelming majority of your current positioning consists of 22% in the United Kingdom, 21.5% in Japan, and 8% to 9% in each of France, Switzerland, Germany, and Australia.

While contagion is certainly possible, it is still unlikely, considering the accommodative stances of the Federal Reserve, the Bank of England, the ECB, and other central banks. Our reasoning for holding international equities remains (improved diversification through differing correlations, varying currency exposure, and ownership in well-run global companies), despite current turmoil. Unless and until we see a high likelihood of a global recession, our positioning will remain. For now, the data just says otherwise.

While our portfolios beat their benchmarks in April, there were a handful of disappointments, one of which deserves mention. JPMorgan (NYSE:JPM) declined 6.5% in April. The firm's well-publicized second quarter trading debacle has wiped out an additional 22% of market capitalization during the month of May. Whether the trading loss ultimately amounts to $2 billion or $10 billion, it is unfortunate, but it is by no means unrecoverable.

JPMorgan earned nearly $18 billion in a very challenging 2011 and should deliver similar figures in the years ahead. The stock now trades for $32.51 per share, or roughly 7x earnings, a slight discount to tangible common equity, and 75% of book value. This extremely low valuation co-exists with the firm being well-capitalized: It has the highest ratio of deposits to loans in the last decade and the highest allowance for credit loss coverage in seven years, while having already charged off over 12% of its five-year average loan balance. The loan portfolio is being rebuilt with superior credit standards and lower collateral risk (housing for instance, now has far less downside risk).

Simply put, JPMorgan - and the other banks we own for that matter - is in better financial shape than ever. We believe we will be duly compensated by these companies in the years ahead. In our opinion, resolve, patience, and time are all that are needed.

Disclosure: We hold JPM and EFA in client portfolios.

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