The last two weeks or so, I’ve been alluding to an emerging thesis I have that Europe is about to undergo a very rough repeat of what we’ve seen in the US with mortgage-based woes. I hoped to thoroughly detail my causes for concern during my presentation tonight at the BC Investment Club (BCIC), but I had a lot of topics to cover in outlining a macro investing view. The end result is that I had to gloss over much of the second order effects, in order to present some basic information – but that is what makes this site nice, because I can give myself unlimited time to construct an argument, and room to flesh it out.

Keep in mind, this kind of exercise is meant to give optimal positioning for a portfolio with some strict rules about buying and selling. BCIC can only buy and sell stocks based on a majority vote of members, and we only have so many meetings each year to accomplish those moves. This makes portfolio pruning essential, so a good thesis that generates a series of portfolio moves can quickly add a lot of value.

My current outlook through mid-year 2009 is dominated by the idea of a “Gruesome Twosome” set of economic headwinds that are going to be reaching the shores of Europe. The Gruesome Twosome leads off with the death of the global decoupling thesis and says that we’re in a global slowdown, and Europe is the next big domino to fall. In many ways, I’m looking at the posturing of European Central Bank President Jean-Claude Trichet and his “price stability first” talk and seeing a repeat of our Federal Reserve in the summer of 2007. Inflation in Europe is being driven by oil, and the ECB has no control over the price of oil. Setting monetary policy based on uncontrollable variables is simply nuts.

Now, the ECB has seen what happens when housing prices get out of line with long-term affordability and the financial system is betting on ever-rising housing prices. They’ve also seen the consequences of being stuck behind the curve and being reactionary. So when you consider the run-up in housing prices in Europe, it really makes America on the whole look rather mundane.

The major problem here is that European banks have balance sheets that are a much higher proportion of their home country’s GDP, which would make any necessary bailouts much more costly, difficult, and ultimately politically unfeasible. Also, European banks operate on a much more highly leveraged basis, and they have generally increased their leverage on a year-to-date basis… probably the exact time when they should be cutting back exposures, given how the tide looks set to go out on housing and the European economy as a whole.

This data in itself is troubling, but the effects on the next level paint an even more disturbing picture. If Europe goes through an American-style unwinding of their housing bubble, it’s going to bring with it the same destruction of the “home wealth effect” and the same situation with constrained financials causing credit to be scarce and expensive. The wounded European consumer starts to get back, just as their American counterparts have done, and that in turn spills over to the export manufacturing-driven emerging market countries. After all, with their major markets – essentially the entire “First World” undergoing a credit contraction, it’s hard to believe the developing markets be able to grow and prosper at the rates they did when their main trading partners were in the middle of the largest and most illusory wealth bubble ever.

This brings us to point two of the Gruesome Twosome thesis: deflation becomes a threat because of the destruction of wealth via declining asset values, and is exacerbated by the contraction of credit terms. But deflation is not the only problem; it’s really just a metaphor for extreme economic stagnation… although it isn’t the only thing. Deflation generally is taken to mean falling prices caused by a lack of demand. I think that’s a real possibility here, but I also think there is a threat of falling consumer prices even while we see commodity-driven inflation because no new credit is available to fund enormously expensive, capital-intensive exploration projects. Emerging markets will still be growing and increasing their demand for hard resources, just not as quickly as in the past few years – in other words, I’m saying that this recent commodities pullback is just a passing correction. This combination of high (or higher) input costs coupled with low realizable output costs would certainly put corporate profitability in a bind, but it would also go a long way toward bringing down historically high profit margins and readjusting our senses as to what activities are economic where, and under what circumstances.

If this comes across as extremely pessimistic, it is not meant to be. It’s simply meant to give the frame of mind that stockpicking has to be done from a different perspective, and oriented to pricing power and balance sheet strength, two traits which are overlooked during bull markets.
Because it’s almost obligatory, I was compelled to give my view on whether or not equity markets have bottomed. There are certainly positive signs - the degree of fear that’s out there regarding credit quality, the high level of volatility, and the $50+ billion in corporate buybacks announced just today, but the most noticeable things we don’t have yet are probably the most important - stability in real estate, and time to work excesses off.

You can see the full version of the Powerpoint I assembled (slightly longer than the version I used during my talk) here.

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