This note was originally published at 8am on June 27, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“Call it what you will, incentives are what get people to work harder.”
Nikita Sergeyevich Khruschchev served as Premier of the Communist Party of Russia from 1958 to 1964. In Russian Communist Party terms, Khrushchev was considered a liberal reformer, especially vis-à-vis his predecessor Stalin. Although to be fair, a comparison to Stalin is a relatively easy comp in that regard.
The irony of using a quote on incentives from a prominent Communist leader is not lost on me. Obviously, most attempts at Communism, with China currently being a slight exception, have failed to actually provide the incentives to create economies that are sustainable, flexible, and adaptive. The root of this is that the actual individuals who underscore any economy do not have the correct incentives in a communist society.
Just imagine, if you will, an economic system in which the harder you work and the more you make, the more the government takes from you. Sounds crazy, no? Or perhaps it just sounds a little like the escalated taxation system that we have also developed in the West in which the more you make the more the government takes and then the more they spend. And then when they can’t take anymore from you without the risk of popular unrest, they just borrow. Then the governments default and feel shame.
But I digress.
Contemplating incentives are critical when considering the investment landscape. As it relates to Europe, one of the more interesting charts I’ve seen recently is that of real euro exchange rates. The chart was produced by the Peterson Institute for International Economics. The chart, which is highlighted in the Chart of the Day, indexes real effective exchange rates based on relative labor costs.
This chart shows Germany versus the so called PIIGS – Portugal, Ireland, Italy, Greece, and Spain. The analysis is staggering in that it emphasizes the massive advantage that Germany gets from having a fixed currency, the euro, across the Euro-zone. Instead of the currency market acting rational and increasing the value of the German currency, the Germans are given a long term relative advantage by being part of the Euro-zone.
So, on one hand, despite domestic political pressure, Germany is clearly at least somewhat incentivized to protect and sustain the euro. That said, while the euro does provide Germany with a long term and sustainable economic advantage, the Germans are not incentivized to protect the euro at all costs. Germany will exist just fine if the euro failed, while for many nations – Italy, Spain, Portugal, Greece, and so on, it will be an unmitigated disaster. Those nations would effectively be shut out of the international debt markets and would likely experience massive inflation.
Arguable Ray Dalio said this best, when he wrote in a recent note:
“For this reason, we think the popular assumption that the Germans and the ECB (which requires agreement of the key factions within it) will come through with the money to make all these debts good should not be taken for granted. Said differently, we think there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a Plan B in place. This "fat tail" event must be considered a significant possibility.”
As I interpret it, his point is primarily that incentives are not fully in place for Germany and the ECB to provide a carte blanche bailout of Europe. Therefore, the more likely scenario is that sovereign debt debacle continues in Europe.
And if you don’t want to believe me or Ray Dalio, then take Angela Merkel at her words. According to reports from last night:
“The chancellor told lawmakers a quick move to eurobonds or other forms of joint liability would be constitutionally impossible in Germany and insisted that "supervision and liability must go hand in hand." She said they could only be considered if and when "sufficient supervision is ensured."
Changing topics slightly, this morning we will be launching coverage of the Industrials Sector with Jay Van Sciver. Hopefully, you won’t hold the fact that he has a Yale degree against him (we certainly don’t). In addition, he also has over a decade of experience covering Industrials from the buy-side. Like many of our Sector Heads, he will cover a broad universe and go to where the action is in terms of investable ideas. In the call today, he is going to discuss some of his investment ideas as well a deep dive on airlines. Email email@example.com if you are institutional investor and would like to participate.
Not to totally steal Jay’s thunder, but his initial view of the airlines is not overly positive. In fact, some airline “stalwarts” such as Delta and United have more than 85% buy ratings from the sell side. Delta, in particular, is at almost a 52-week high and only 1.2% of its shares are short. This isn’t totally surprising since Delta is “cheap” on conventional metrics.
Now if this time is totally different for the airlines, Jay may be wrong on his thesis. That said, it is a little hard to believe that much has changed in this highly competitive industry. Just like every other period in modern airline industry, management teams are incentivized to shift planes to competitive routes to suck the profits out of those routes and eventually out of the system.
A key catalyst from Jay’s research is the American bankruptcy, which may actually kick start a new bankruptcy cycle. By the end of Q3, AMR should have lower costs than both Delta and United and these costs will be rapidly passed on to customers. Since Delta and United cannot rapidly cut costs to compete since many costs involve long tail labor expenses, their profitability will come under increasing pressure in Q3 and beyond.
I should probably stop there at risk I give away too much and you aren’t incentivized to sign up for Jay’s call at 11am eastern today. But I will leave you with one quote on airlines from Sir Richard Branson:
“I’ve always said the quickest way to become a millionaire is to start as a billionaire and get into the airline business.”
Of course, Branson has his incentives as well, which are to keep competitors out of the airline business!
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, and the SP500 are now $1549-1593, $88.02-93.62, $81.99-82.63, $1.24-1.26, and 1306-1336, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research