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Marcuard's Market update by GaveKal Dragonomics
By Charles Gave
As regular Gavekal readers may remember, I have always maintained that over the long run the returns delivered by two different stock markets — adjusted for exchange rate fluctuations and differences in pay-outs — must be the same. This is just another way of saying that in an open economy the returns on invested capital generated by well diversified stock markets have to be the same.
It follows from this that investors should buy one stock market of a pair when it is cheap relative to the other. And more often than not, the reason for this cheapness is political. Politics has always been one of the main reasons investors buy high and sell low.
If you doubt that the returns generated by different stock markets really do converge over time, please take a look at the chart, which shows the ratio between the total returns of the French and the German stock markets in a common currency since 1988.
Clearly, there is no overall trend in the ratio. But in the intervening years investors have had a couple of compelling opportunities to sell France and buy Germany, and a couple of handsome opportunities to sell Germany and buy France. And most of these “buy France” opportunities have corresponded with political crises in France.
Now the ratio is issuing a new “buy France, sell Germany” signal. And sure enough, the French political situation right now could indeed turn out to be highly favourable for investors. Consider the following:
– First, let us assume that François Fillon, candidate of the traditional right wing Les Républicains party is elected president. With a reformer in the Élysée Palace there would be a very good chance of a handsome rally, at least in relative terms of French versus German assets.
– Second, if by chance the French electorate chooses an extremist, whether of the far right or the far left, as the next president—a probability of at least 50% in my view—then the euro will head rapidly towards break-up. In that case, the newly-reintroduced franc will depreciate massively. This will be great news for local currency-funded investors, because the French CAC 40 index consists largely of big French multinationals. Big oil, big pharma, big FMCG, big luxury, big chemicals, big tourism, big electricals, and big aerospace, all of which generate most of their sales and profits outside France, will benefit splendidly from the demise of Jean-Claude Trichet’s financial Frankenstein followed by a big fall in the value of the franc. The result will be a fabulous bull market in local currency terms.
– Finally, the break-up of the euro will lead to a big appreciation of the German currency, which currently looks deeply undervalued. With German companies generating much of their sales from exports, and more than 50% of Germany’s trade surplus attributable to the automotive sector, the German stock market would take the mother of all beatings, again in local currency terms.
So, being long the French stock market and short the German stock market looks like a marvellous “heads I win, tails I don’t lose” investment strategy, and a cheap hedge against the demise of the euro.
Investors unwilling to commit too much capital to the trade might consider buying call options on the French stock market, balanced with puts on the German market. The beauty of using calls and puts in this fashion is that the return from the strategy will not be greatly impacted by the post-break-up emergence of variations in the exchange rate.
Of course, this strategy would work best for big, international companies. Small and mid-caps stocks are another matter…
