Stress Bunnies

It’s a strange thing. Most people I meet are risk averse. They don’t bet much. They don’t talk about large speculations in stocks and commodities that they have on the go. And the same for the majority of market pro’s I’ve worked with. Only a select few have made large wagers with their own money.

The Zurich Axioms, by Max Gunther, is one of the best reads on speculation you can buy. His view; because most don’t have the nerve to speculate, the payoff for those that do is considerable. From some angles, the risks of active speculation are lower than sitting on a pension. And it may raise you into the realms of genuine financial freedom. His best advice; always take profit on a big score, and buy you and your wife something nice. That’s a principle I stick to religiously.

But the Zurich Axioms don’t go into what happens when the bureaucrats get their hands on the cash money. Then you have to throw away the old rules of the risk game. The quote from Keynes sums it up – for them it is better to fail conventionally than to succeed unconventionally. So the risk for these bank apparatchiks is that they are not doing what everyone else is doing. They might get left behind. They gotta keep dancing.

And it will likely be one of the last great bank lending themes that will be the source of the next set of troubles to hit global markets; the European convergence trade.

Now I don’t intend to steal the thunder from Gavekal, who have done Sterling work on the theme, and who have recently set up a fund to trade it.

But what interests me most is how relentless the pressure is going to be – from two angles. The first is the macro divergence. Germany is going from strength to strength. The German Mittelstand – the industrial hinterland – is like a chunk of China transported into the heart of Europe. It is perfectly placed to sell into the relentless infrastructure booms in the Middle East and Asia. It’s one reason I’ve held onto GEA, the Mittelstand conglomerate, through thick and thin over the last four years, and why it’s my second biggest holding now. Contrast that to the well covered troubles in Ireland and Spain, and now increasingly Italy and Greece. Then add in a central bank determined to target inflation over growth, and a series of increasingly populist and spendthrift governments and – well – you have the makings of an investment theme. It’s a theme I’ve been playing since November 2006, when I went short the Irish Banks a painful three months too early.

But what really takes the biscuit is not the diverging macro story in Europe, which was obvious a while ago. It is the mess the banks have got themselves in. Because the banks have built up a gargantuan, decade long, convergence trade. Betting on the convergence of Italian bond yields with German, Greek property yields with French, or Hungarian property prices with those to the West. And the deeper that they got in, and the more money they made, the more conventional, the more acceptable, the trade became. You had to be on it, and the banks that were full on – like Erste Bank, Swedbank and Alphabank – they scored big wins.

And they all had the most risk on – in mid-2007- just as the risk/reward was at its worst.

I have now reinstated my shorts in all three banks. Last December, when I started getting interested in shorting the Greeks, I read a great broker report on why I should buy them on account of their defensive qualities. They had no subprime, see. What they do have is massive exposure to property lending in Eastern Europe, not to mention their own shores. If you look up the biggest lenders across Eastern Europe, you’ll find a Greek bank on the hit parade for each country.

I think the mechanism for the trade is this; as the banks pull in their Eastern European property lending on account of their own capital constraints, we’ll see fewer loans made, combined with a reduced willingness and ability of borrow to buy (on account of high European rates, the slowdown, and falling property prices in Ireland, Spain and the UK). That will threaten the funding for the currencies, which, on average, have the worst current account and budget deficits, and the worst mixture of growth and inflation, of any region in the world. When the currencies weaken, particularly against the Euro and the Swiss, mortgage costs will rise, as anything from 40-70% of mortgage loans across the region are denominated in foreign currency. That will hit consumers and investors, reducing demand, reducing the ability and willingness to borrow, and impairing the willingness and ability to lend.

And you’ve got to ask who’s there to step in to bail the banks out. Will the Hungarian central bank bail out Erste’s Hungarian operations, or should it be the Austrians who step up to the plate?

To quote the Carpenters; ‘It’s only just begun’.