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WHAT I LEARNED THIS WEEK

Executive Summary
April 19, 2012

COMES THE END GAME FOR THE EURO

1. Could the upcoming elections in France, Greece and Ireland spell the end of the euro? There are a number of political events that pose risks to the euro over the next several weeksthe most significant of which is the election in France. Although the first round appears to have tightened, Francois Hollande enjoys a large lead in the all-important second round slated for May 6th16 percentage points ahead of Sarkozy. Then, the parliamentary elections in mid-June that could play a big role in shaping the policies that the next French President puts in place. As Noel Grima of The Independent wrote this week: One can feel all Europe standing motionless, awaiting the outcome and, whatever platitudes may be expressed, things will change if the Socialists take over the presidency from Sarkozys center-right. There were some scary days this past week regarding the stability of the euro as the spreads in Spain and Italy rose beyond danger point. But the worst may still happen if, as expected, Hollande wins the election and proceeds, as he promised, to tear up the European Fiscal Compact even before it is ratified by the euro nations. Hollande has raised eyebrows in Berlin by criticizing a European Union accord on debt and deficit control. Germany understands that it cannot remain an island of prosperity in an ocean of recession, he told Les Echos. The changeover in France will pave the way for a change of direction in Europe. Now, even Sarkozy, eager to draw more votes, has voiced criticism of the ECB. Is this the beginning of the French-German rift? 2. Is Spain reaching the breaking point? As the Spanish debt and banking crisis rages on, attitudes are hardening in Germany. According to Bloomberg, earlier this week German Chancellor, Angela Merkel, made very hawkish comments at a rally in the city of Muenster, criticizing countries that have not pushed their austerity measures far enough while also saying the following: We have to watch out that high interest rates on our

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debt dont lead to the point where we cant decide and shape anything anymore [in Germany.] In a television interview in Berlin, Finance Minister, Wolfgang Schauble said the following, according to Bloomberg: Thats why the countries with too high debt, Germany included, have to reduce debtAnd the countries with insufficient competitiveness have to become more competitive. Then you need a common finance policy in Europethats the fiscal pact. And if you need anything else, then you build the firewall. If you only build the firewall, you can take 10 trillion and its not going to solve the problem. 3. Why the euro will fall and what it means. Over the weekend, Frances president, Nicolas Sarkozy, said the following at a campaign rally: If the central bank does not support growth, there will not be enough growth...Europe must purge its debts, it has no choice. But between deflation and growth, it has no more choice. If Europe chooses deflation it will die. That Sarkozy would go so far as to criticize the ECBwhich is tantamount to criticizing Germany and its policymakersillustrates that he is in the fight of his political life. Not to be outdone on the campaign trail in calling for an expanded central bank mandate to promote growth, the Socialist candidate, Francois Hollande, said the following: Hes been in office for five years, which is a long time for him to have just noticed that. We wouldnt be in such a mess if the European Central Bank very early on had massively bought sovereign bonds. While we have been generally neutral to mildly bullish on the eurofor short-term trading purposessince May 2010 (see WILTW May 20, 2010), we have likewise maintained that the long-term outlook for the euro is poor, in part due to Germanys deep-seated resistance toward spending aggressively to support other countries. Indeed, as the peripheral countries of the eurozone find themselves locked into a currency they can no longer devalue on their own as they try to improve their competitiveness, the risks of a long period of economic stagnation have become increasingly apparent. The inability to devalue among the peripheral countries is being compounded by the growing interconnectedness of the banks and their governments, which appears to point

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to a greater likelihood of bank bailouts and more economic contraction as the weaker countries reduce government spending and raise taxes.

ACTIONABLE INVESTMENT IDEAS

5. Are mega-caps poised for leadership? Why big-caps are the place to be (continued). In early 2011, we noted that large-cap equities were emerging as new leaders after more than a decade of underperformance. In fact, WILTW April 14, 2011 marked very close to a turning point when the Russell 1000 Index of large-cap equities began to outperform the small-cap Russell 2000 Index. Since then, megacaps, the largest of companies, have become the leaders of the pack. A temporary top or correction in the markets may lie ahead, yet large and mega-cap stocks, especially ones with strong yields and dividend histories, could perform relatively stronger than their smaller peers, as was the case during last years selloff. Slower economic growth and risk-adverse lending may continue to benefit mega-cap stocksmany of which have strong balance sheets, easy access to low-cost credit, and strong dividend histories. Large companies with strong yields and sustainable dividends will increasingly be looked to as alternative sources of income to replace deteriorating sovereign debt markets.

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