A Nobel Prize awaits the first person to come up with a solution to Europe’s problems. Silvio Berlusconi could be a sporting long-odds bet. And a Pulitzer Prize awaits anyone who can satirize the incompetence and collective vanity of America’s politicians in surrendering Uncle Sam’s "AAA" S&P rating, leaked after the market close on Friday (but still not up-dated on their web site as I write). One hopes that author Tom Wolfe had friends in those smoke-filled Washington rooms. But one also hopes that China’s Dagong rating agency, which beat the dithering S&P to a US downgrade by several days, did not.

Despite our cynicism, we doubt that the US downgrade is fatal, though it presents technical challenges to the ludicrous Capital Asset Pricing Model that derives global asset risk pricing off "zero-risk" treasuries. But the economic crisis may not be over. Worse, the 20% decline in European stock markets qualifies as a technical Bear Market. Much now hangs on the resilience and collective will of Europe’s political class. Their record is patchy, particularly when the sun tan oil is being passed round on the Côte d’Azur.

The market fall is an avalanche caused by the release of accumulated snow pack –Arab Spring, oil and commodity prices, Greece and Europe, US budget wrangles- built up in the commanding heights of the global economy over many years. But at its human heart is a fear that we may be plunged into a 2008 re-run, with, this time, the European banks the victims. The European banks’ recent "Stress Test" sounded like Animal Farm "Double Speak" ("All Banks are Stress-Free But Some are More Stress-Free Than Others"). The markets were in no mood to accept another "comb-over" from the Brylcreem Boy bank regulators.

Possible Euro-zone contagion via Italy, Spain etc and market damage forces us into some "back to basics" navel-gazing. But our navels seem to be in the right place. We have decided not to reduce equities, a decision that could be extremely wrong in the short-medium term as technical damage to equity markets has been severe. Please read on for why.

After checking portfolios, we find we’re as insulated from Euro-Blow Back as an equity investor could hope to be. We have no EU banks or financials. We probably won’t hold an EU bank till we retire. We have no real estate or geared or domestic European plays (OK, Tesco, but it’s 30% dominant in the UK and its ventures in Chindia and the US are where the real action is).

We have zero invested in the vague hope that somehow, someday, Europe will be a better place in the future than it is today (though we are sure it will). The Euro-companies we hold (eg Nestlé, Diageo, Unilever, BAT) do as much business as they can in places where it’s not safe to drink the tap water (sometimes, they sell the tap-water) and might even cheer if Europe’s currency fell so they can export more goods to people in faraway countries who are having a better time than they are (e.g. Swatch and the above). Read Unilever CEO’s interview last week on why 60% of sales are to come from Emergia and how this is transforming his empire. Most of the companies we own are dominant and, when the man next door to you is losing his job or trying to get yours, dominance matters.

We’re not fooling ourselves as decisions in investment are always compromises. In this age of instantaneous media over-reaction, no stock, no matter how saintly, gets out on the town with a pink ticket. So do we reduce equities and hide in cash? (The thinking goes... Is a guaranteed zero return better than a possible short-medium term negative return?... and, harder to stomach... Didn’t you learn anything from 2008?... hard questions, hard thinking). We are certain to be ambushed by bad news in the next few weeks (that’s how media work). But, as a wise man once said, news is only what’s recorded, not what happens. The good news that Mrs Manisha Mukherji has just bought her first car does not make CNN, but has more lasting investment significance than a union demo in Athens.

We think running to cash now, even in Europe, is the wrong thing to do. Put simply, "you have to invest somewhere" (by the way, cash counts as an investment). We are more than aware of the short term risks to this view; we face a potentially torrid summer. Even in Europe, equities still shine in a line-up with the other 4 major asset classes (cash, bonds, precious metals and hedge funds) and even if Euro Stoxx Q2 earnings disappoint, 2011 will produce positive single digit eps gains. A low double digit PER ratio when 10 year yields are below 3% is a suicidal level to short the equity market except on a short term basis. We have a chart. Ask if you want it.

Cash yields remain derisory in major markets (under 0.5%) and may hover around zero for several quarters, or years. Bonds (coupons of 2-4% in Europe are below inflation rates) are certain to lose money in the long term; it is no secret that inflation runs at 3%+ over time. A 30 year bond bull markets has lulled people into thinking "safe" bonds can’t lose money. Where have I heard that before? Finally, we’re known to like gold and silver. No change there. Gold shines in a fiat-currency world plagued by sovereign debt crises.

Equities still yield 10x more than cash. 10x is a lot. On weakness, we advise joining the "Dividend Aristocrat" bandwagon (high yielding Blue Chips, some above), particularly those earning more than 25% of earnings in Emergia and are skeptical of Sclerotica.

In the critical, anxious and news-ridden days ahead, we’ll be thinking of Mrs Mukherji and her new car.


This diary (the "diary") is published by Global Thematic Investors Limited, a company domiciled in Hong Kong and incorporated under the Hong Kong Companies’ Ordinance on the 15th September, 2005. The diary is not intended for private customers and is written to be read solely by sophisticated investors, such as family offices, business corporations, banks and financial intermediaries. Statements are completely personal and may change without notice, are often forward-looking and therefore subject to uncertainty and risk. The predictions and forecasts implied may not subsequently be achieved. The diary is composed of information and opinion believed to be accurate, though this information may not have been verified. Funds or collective vehicles may only be open to certain persons in certain jurisdictions and may follow strategies that are speculative and involve a high risk of loss and may go up as well as down (a favorable performance record is no indication of future performance).