Argentine inflections

Anticipating inflection points is the Holy Grail of investing: we all know that past trends, up or down, will not continue indefinitely; at some point, the curve will bend and change direction.  But when? 

When will the fundamentals of a company start to show an improvement after sustained restructuring efforts by its management?  When will financial markets start assigning to a company a stock price that is closer to its intrinsic value?  And more challenging still, when will a country abandon failed policies to save itself from chaos?

Argentina is the perfect – some may say terrible – example of a country that has followed bad economic policies for much longer than deemed possible.  Indeed, how bad these policies have been remains unrecognized abroad: not so long ago, I recall some reputed economists stating that the 2005 Argentine debt renegotiation was a model for Greece, that the Argentine economy was growing at a healthy clip.

That is nonsense, but the question remains as to why Argentina seems to defy gravity, and why it has done it for so long?  Two reasons may be given.

One is that Argentina’s growth is illusory.  Measured in US dollars, it is greatly exaggerated because of an “obese” official peso/dollar rate which stands today at 4.78.  This is to be compared with the implicit rate of around 7 when one compares the stock prices of Argentine companies on the local and New York exchanges.  In other words, the peso is overvalued by some 45%; this led the Colombian minister of finance to brag that, measured at true exchange rates, his country’s GDP had overtaken Argentina’s.

The other is that the Argentine government has picked the pockets of everyone in sight:  foreign creditors were squeezed in 2005 in a restructuring in which they lost 75% of their money; private pension funds were nationalized and their resources used to finance the public deficit; energy prices were frozen to subsidize consumer spending; official inflation calculations were fudged, defrauding everybody (and independent economists were heavily fined when their findings departed from the official ones[1]); more recently, insurance companies were forced to finance government-designated projects, foreign exchange controls were implemented to try and stop capital flight and the largest oil and gas company, YPF, was expropriated and no compensation has been paid to date.

As Mexican president Calderon said shortly after the YPF grab, anybody thinking of investing in Argentina should have his head examined. 

Despite grabbing other people’s money, Argentina is paying a very steep price for its policies. 

The refusal by Argentina to pay holders of non-restructured sovereign bonds has kept it from international financial markets since 2001.  After announcing an ambitious investment program, YPF, unable to tap these markets for billion dollar issues can only raise $100 million at a time locally; it is also unable to attract international partners to develop the vast Vaca Muerta shale oil deposits[2] because of the uneconomic pricing of hydrocarbons and pending lawsuits from Repsol[3]; electric utilities are on the verge of bankruptcy; and the ubiquitous intervention of the government in the economy has led to widespread corruption.

Starved for money and growth, Argentine companies carry low valuations.  That, plus the limited remaining number of pockets to be picked has led sophisticated investors to bet on a policy inflection point.  Eton Park, one of the most prominent US hedge funds, built a substantial stake in YPF between September 2010 and March 2012.  I estimate their average purchase price at around $40[4].  The stock closed today at $10.46.  When rumors of expropriation started to surface last April, I was tempted to buy the stock as I thought the government wouldn’t have the money to take the company over.  I just couldn’t imagine that they would just grab it, but they did.

Yet I think that we are getting close enough to an inflection point to dip a toe in Argentina.  I see three reasons for that. 

One is that having taken control of YPF, officially because its former controlling owner (Repsol) didn’t invest enough, the government now “is it”.  In other words, it must show it can succeed where others failed; it needs to attract deep-pocketed oil and gas multinationals as partners, but for that it must (1) improve hydrocarbon pricing, (2) settle with Repsol and (3) regain access to international debt markets.  This looks to me like a chicken-and-egg situation as to what comes first, a major oil joint-venture or the above three-point policy change.  Meanwhile, the clock is ticking because Argentina, once an energy exporter, is now an importer.

Second, the 2005 restructuring saga is turning sour.  Having the Navy frigate Libertad seized in a Ghanaian port is acutely embarrassing for the Argentine government and begs the question: what next? If Ghana is not safe, what more restrictive measures will the government have to apply to its movable assets?  Furthermore, the recent decision by a US judge that Argentina must pay interest on all of its external debt, including that portion which was not restructured, raises the pressure as it carries the threat of escalation in case of non-compliance.  Granted, Argentina has so far been able to delay the execution of court decisions, but it can’t expect to do so forever.  Justice may be slow but it is not dumb.

Finally and perhaps more importantly, the Argentine people are showing growing signs of opposition to the government policies.  The harsh measures taken to effectively prevent them from buying US dollars have been received , and this is understandable in a cvery badlyountry where there is little faith in the willingness of the government to pay its debts, and where real inflation is on the order of 25% p.a.  High profile corruption cases, where government members appear to have enriched themselves illegally, are especially grating when popular unemployment is high.

A large currency depreciation may be the next step, rather than better economic policies.  However this would only diminish people’s savings and living standard, which would hardly be helpful in president Kirchner’s bid to amend the Constitution in order to run for a third term.

As the above diagnosis may still be a bit optimistic - after all, Peronism in its current incarnation still has many followers - one has to look at valuation and to what extent it mitigates the risks to be undertaken.

In the case of YPF, the main risk is really that of full nationalization, a close second being delisting from the NYSE (since one buys the ADR at a 45% discount to the local share price).  Looking at its ADR stock price, YPF looks pretty cheap compared to its government-controlled peers:  Ecopetrol (Colombia) and Petrobras (Brazil):

 

	Ecopetrol	Petrobras	YPF
Market value (bn)	$115.3	$131.1	$4.1
Proven reserves (bn barrels)	1.9	12.9	1.0
Daily production (‘000 of  boe)	719	2,463	467
EV/boe of proven reserves[5]	$61.6	$15.28	$6.36
EV/boe of daily production	$162,880	$80,007	$13,615

 Of course, the above calculations are very rough and do not take into account non-upstream assets such as refineries, pipelines and other long term investments.  But they are informative nevertheless.  For example, while Ecopetrol and Petrobras have similar market values, the former has zero net debt while the latter is burdened by excessive debts.  Still, YPF looks quite cheap.

 YPF faces two specific challenges: as an oil champion under government control, it is in the quasi permanent threat of having its management and strategies politicized; it also faces a very onerous investment program.  Another, less politically risky way of playing the “Argentine inflection point”, is Telecom Argentina (TEO).

The controlling shareholder is a holding that includes Telecom Italia and the well regarded Wertheim group from Argentina.  TEO is well managed and has strong financials.  It is the second largest telecom company in Argentina after Claro (controlled by Carlos Slim’s America Movil).  Its investment needs are more modest than YPF’s on a relative basis. It has a lower profile than YPF.  Finally, its ADRs enjoy a similar discount to local shares.  On a per mobile subscriber basis, it is worth less than one tenth of America Movil.

As history shows, populist governments rarely act in an economically rational way; when they control rich countries, and when they resort to reprehensible policies, they can endure far longer than orthodox thinkers imagine.  But even they cannot repel the laws of gravity forever.  They usually don’t see the light or change their ways; their rule generally ends when they can no longer afford handouts and resort to heavy handed policies to stay in power.

I have started to build small positions in YPF and Telecom Argentina.

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[1]   It is ironic that one of them was the former minister of finance who had presided over the heavy-handed foreign debt renegotiation.

[2]   Which YPF estimates to hold 23 billion barrels of oil resources.

[3]   The Spanish company whose controlling shareholding of YPF was seized by the Argentine government this year.

[4]   Based on the average prices during the periods in which Eton Park reported building its stake.

[5]  EV: Enterprise value, i.e. market capitalization – cash and equivalents + debts.  For YPF we have used the official exchange rate to convert debt amounts to US dollars since most of these are dollar denominated to begin with.

 

 

 

The Gallois Report

One learns from experience at any age.  Look at me.  Having calculated that the odds of two consecutive once-in-a-century mega-storms were close to zero, I declined to purchase a standby generator.  Wrong.  The generator guy is coming by tomorrow.

In France and the US, politicians have become experts at kicking the can down the road, until they hit a wall and need to come up with Plan B.  In this country, we had the Simpson-Bowles Commission; its report was quickly buried but, within the next twelve months, it will likely resurface as the US margin of maneuver is squeezed and public finances are in dire need of fixing.  If our politicians succeed, they should send their French brethren a copy of their recipe, because France could learn from it.

Likewise, France commissioned a report on industrial competitivess from Louis Gallois, one of its most prominent grand patrons[1].  Mr. Gallois just delivered it today.  Having lamented the decline of the US industry, our politicians would do well to read his report, for even if our problems are not quite the same as the French, there is enough commonality to make it required reading.  The diagnostic of the French industry’s weaknesses and falling from grace is particularly instructive, because we could be next on that slippery slope. 

Generally, Mr. Gallois recommends a “competitiveness shock” where key measures are applied quickly rather than being diluted over a decade.  He also stresses that French society must debate the reforms and come together on a plan which will carry the conviction that sacrifices and benefits will be fairly shared.  Indeed, the plan is as much about mutual confidence as it is about specific measures.  

Such convergence of efforts and ultimate rewards (you think of Reagan’s motto “trust but verify”) calls for lower social charges for both employers and employees (1.5% of GDP), greater participation of employees and union representatives in the policy deliberations of large corporations and a robust support for small and medium-sized companies.

Although Mr. Gallois is reputed to be left-leaning, he sees a key contribution of the state as doing no harm.  In his view, any significant new law or governmental decree should be accompanied by a document estimating its impact on industrial competitiveness, and recommendations as to reduce adverse consequences, if any.  The state should also refrain from changing key provisions that affect such areas as R&D investment tax credit, incentives affecting the formation of new companies, among others.  But in typical French manner, the ghost of Five Year Plans of yore would return in the much milder guise of Commissariat à la Prospective.

There are twenty two recommendations made in the report, ranging from broadening and codifying employee participation on corporate boards to ways of fostering innovation, rewarding long term portfolio investors, developing shale gas resources, etc.  Many of these recommendations should be studied in this country because we could benefit from them.

On a higher level, the Report is daunting.  It calls on the government to reduce public spending and it aims at reshaping the French industrial fabric: creating more mid-size companies (think of the German Mittelstand model) and pushing the sector up market where higher quality products permit higher profit margins (think LVMH, Sanofi- Aventis and, I wish, Delage and Delahaye instead of dreary Peugeot).  That is a very tall order, hence the deliberate step-by-22 steps approach.

Equally instructive, and courageous, is Gallois’ call to stimulate capital investment in industry, which in turns necessitates toning down overregulation and the demonization of executives.  This capitalization drive also requires greater stability in the relations with stakeholders which Gallois hopes to achieve by (1) offering greater employee participation in corporate decisions (up to four but in any case less than 1/3 of the board of director seats at companies with over 5,000 employees) and (2) stronger voice for long term shareholders (doubling of their votes after two years).

The initial French government reaction was typical: countering Gallois’ 22 recommendations with 35 proposals, yet watering and complicating the proposed key reduction in social charges.  As the Shadoks[2] of my youth used to say, GA BU ZO MEU, why make it simple if you can make it complicated.

France like the US is faced with mounting pressure to reform itself, yet neither country is on the cusp of the abyss.  Their respective governments have been divisive so that there is no popular consensus on the necessary reforms and shared sacrifices. Yet well connected outsiders (Gallois, Bowles, Simpson) have started to speak up.  In the days of instant communication and interconnected economies we should and need to pick what they have to say, wherever they may be domiciled.

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[1]   Louis Gallois is a former CEO of Airbus, EADS, SNCF.

[2]  A popular and off-beat French TV series in the 1960s.

Revisiting privatizations

Over the course of last year and this year, I have advocated that European countries facing excessive indebtedness and sub-par growth should consider selling public assets.  In the case of Greece, I noted in 2011 that ex-ECB board member, Juergen Stark, had estimated Greek public assets available for sale at around €300 billion; this was to be compared with a national GDP of €240 billion and an overall sovereign debt of €320 billion.

I also advocated the same course of action for others, such as Italy, Spain and France.  The benefits of such a policy would be to increase overall economic efficiency and to raise funds to reduce national debt.  It could also help develop a large and stable pool of savings for future retirees.

I also noted that the best example of what this policy could yield was the Chilean experience in the 1980s.  This is one in which I was closely involved as a banker and investor.  Back then, Chile received no outside financial help, in stark contrast to the current European situation.  Yet, thanks to well conceived debt-to-equity and debt prepayment programs, it managed to reduce its external commercial debt by one third without alienating international markets.

Therefore I was happy to read an interview of Mexican billionaire Carlos Slim in which he too advocated the sale of public assets as a necessary although not sufficient condition to get European economies back on track.

Countries are often reluctant to part with public assets, for very human reasons:

1.      Bureaucrats will lose a sinecure and a power base while employees may see their benefits cut back and even be terminated;

2.      Selling assets during a crisis is bound to bring less than optimal prices;

3.      Deep pocketed foreigners will take advantage of their momentary weakness to take control of national assets;

4.      Public services, once privatized, will be rationalized, resulting in higher tariffs and smaller geographic coverage.

 Indeed, reducing bureaucracy is one of the benefits of privatization.  In many instances, public employee benefits are far more generous than those accruing in the private sector, and the difference represents a subsidy which is unfairly borne by the latter and should be eliminated.  Privatizations often result in job cuts, but the resulting hardship can be controlled and reduced with compensatory and retraining policies and by the opening of new private job opportunities in a resurgent economy.

It is obvious that, at least in the beginning, public assets will be sold at depressed prices, but getting optimum prices is not the name of the game, putting the economy back on track is.  Besides, the cost of a weak economy with a depressed job market is far higher than the money left on the table, so to speak, by selling assets early.  And experience in Brazil and Chile has shown that, if privatizations are accompanied by sound fiscal and economic policies, markets soon adjust and subsequent asset sales command higher prices.

Rich multinationals or vulture funds are often the bugaboos that discourage countries from privatizing.  The reality is that it all depends on how privatizations are structured.  In Chile, most privatizated companies were bought by local entities, sometimes operators, sometimes financiers, sometimes by consortia which included local pension funds; in the case of the largest privatizations, special financing was made available so that local households could buy into blocks of shares that had been reserved for them (the so called capitalismo popular).  In Mexico, it is worth remembering that the largest privatization was won by a consortium of Mexican, American and French interests led by Mr. Carlos Slim who retained effective control.  I might also add that, in my experience, foreigners who have bought local companies on the cheap in times of great national stress end up paying a fair price over time, as governments find ways to extract more money or consideration from them.   One can only look at the electric utility sector in Brazil where the current government is trying to force through a new tariff regimen.

One large and apolitical source of funds to tap in order privatize public assets would be national pension funds.  These were instrumental in similar projects in Latin America and some Nordic countries.  Unfortunately, countries such as France, Italy and Spain largely rely on pay-as-you-go pension schemes, and their pension funds control very small pools of funds (0.2%, 4.6% and 7.9% of GDP respectively).   By contrast, pension funds in countries such as Chile (67%), Finland (82%) and the Netherlands (135%) are much larger and offer far more strategic flexibility.  It would be highly controversial in France in particular, but just imagine if it had a pension pool of 1 trillion euros!  If Italy had €900 billions and Spain €600 billion!  Such funds would dwarf the much maligned hedge funds and vulture investors; they would also match their long term investment horizons with the government desire to find stable institutional investors.

Finally, there is the fear that privatized public services will no longer serve the public, or that tariffs will be raised too high.  With sound regulations, the former concern can be allayed.  The real question is whether essential services should be subsidized, and if so how, or not.  If a country decides that the provider of such services should subsidize them, then privatization may not be appropriate.  Witness the continuing frictions between Telmex and the Mexican government on this issue, or worse, the case of the energy sector in Argentina or even EDF in France.  Countries can’t have it both ways: they can’t privatize and then control prices.  Ultimately though, tariffs may initially increase and then gradually decrease as most of the efficiency gains are passed on to customers.

The current debate in Europe has little chance of bringing about a workable solution to the prevailing financial and fiscal problems:  drastic austerity, be it via spending cuts or tax increases, cannot work because it is socially and politically unacceptable; fast growth is unrealistic because, in the absence of other measures, it is equivalent to Northern member countries subsidizing their Southern fellow members and cosigning their debts.

Austerity is necessary, but its focus should be a combination of shrinking the public sector and making the economy more efficient.  Privatizing public enterprises should be the key driver of this effort.

Growth based on EU subsidies and wealth transfers is a non starter; but growth based on a leaner, more flexible private sector is possible and sustainable.  Indeed, examples of this are easy to find in recent history.  Part of the privatizations proceeds should be earmarked to retrain downsized employees and to help them bridge a conversion period leading to new jobs in the private sector.

Finally, privatizations are essential to reduce sovereign debts in a manner which doesn’t disrupt markets, encourages new investments and keeps financing costs affordable.

At the end of the day, return to fundamental financial equilibrium and economic growth is possible but no single silver bullet exists that will do it all.  Rather, European democracies will need to find a workable balance of some austerity, some tax increases, gains in efficiency and delayed but better quality growth.  To that end, a broad privatization program is essential to help achieve many of these goals in a sustainable and socially acceptable way.  It would also provide the opportunity to establish a modern and potent retirement pension fund industry.

The Yellow Brick Road

It is too soon yet to guess who will be the next president, but not too soon to detect a change in the dynamics of the country.  And that is good news.  Perhaps unexpectedly, the American voters seem to take a greater interest in the substance of the debate and to realize that any solution will have to be negotiated in the political middle.

I think that it all began with the first presidential debate.  The Republican candidate, Mitt Romney, surprised almost everybody: he won, did so on substance and was much more moderate than the press had painted him to be (in fairness, he moved back to the center after having won the nomination on the right).  By contrast, the President demonstrated that eloquence needed a base in facts, in experience and in a successful track record to be effective, at least if you are the incumbent.  Though it had lapped screaming TV talk shows and the vacuity of The Wives of … reality programs for some years now, the public gave Romney a decisive victory in post debate polls because he had presented sounder arguments.

To my mind, the vice-presidential debate reinforced this trend towards problem-solving.  Vice-president Joe Biden was very aggressive as expected but was also very rude and at times contemptuous of his opponent.  His arguments often lacked substance and his tone was generally populist in the extreme.  By contrast, Paul Ryan was composed and displayed greater command of facts and numbers; he was also surprisingly at ease debating foreign policy.

Democratic pundits were delighted: Joe Biden has come out with all guns blazing.  Yet I think that this strategy was flawed.  For one, he made his boss, President Obama, look weaker.  For another, his demeanor seemed to have turned off the Independents and undecided voters who were less interested in televised combat and wanted to hear solutions to their and the nation’s problems.  Paul Ryan may have taken a lot of verbal abuse but he seemed to have won on points so to speak.

The next presidential debate will be interesting and likely will determine the outcome of the elections.  By temperament, President Obama is more collected than his vice president; he also will be faced by Mitt Romney, some 20 years his senior and a person with a strong track record in private and public life.  As is clear to most already, winning over the American Middle is the key to winning the presidency and there is ample evidence that the winner will need to win on substance: that is what people want, besides, while Obama is generally viewed as likable, Romney is no longer viewed as a cold hearted money-maker.

Whoever becomes president in November, it looks to me that the American people are realizing that the solution to the country’s problems will cause pain to everybody rather than a few thousand plutocrats: effective tax rates will have to rise (sorry Republicans) and public spending will have to be cut (sorry Democrats).  Failed experiments in Japan and Western Europe have brought this country back to reality and none too soon.  Welcome back to the Center!

Apple (and RIM) stock revisited, part 2

In an earlier post, I made the argument that Apple was not necessarily undervalued.  Since market valuation is by nature a relative concept, I would also like to make the argument that Research in Motion (RIMM) is most likely undervalued.

Since I wrote my first post on Apple, a few things happened.  One of them was that a power surge caused by a particularly strong storm destroyed my 2006 iMac.  Why was my computer plugged into the wall socket rather than into my surge protected outlet?… So I bought a new iMac, and it really is a thing of beauty, it works great and it couldn’t be easier to set up, for the most part.

 

As I wanted to retrieve some of the data from my original iMac and had bungled my first attempt, I called Apple’s hot line; their specialist couldn’t have been more helpful.  I also wanted to synchronize my iPod, and there, things got messier.  One staff at the Apple store told me that I could do that.  But when I called Apple’s hot line again, the new specialist declined to help, suggesting that I bring my new iMac, the hard disk drive of my old iMac and my iPod, all thirty pounds of them, to an Apple store for further assistance.  I was not happy.

The change of computer also necessitated the transfer of some Adobe programs which required the de-authorization of my previous iMac.  The Adobe customer support person was efficient and told me that I would receive by email a link to rate his service.  I did, but I was very surprised to see that the questionnaire also asked about my satisfaction with similar support service from Apple.  Clearly, the questionnaire was not tailor-made for me, but it made me wonder: besides its ongoing Flash Player saga, did Adobe know something I didn’t about Apple customer service?

The second thing that happened was when my wife suggested that I upgrade my iPad to IOS6 as she had just done.  Aware of the Apple switch to proprietary map software, I asked her if she still had Google Maps, which she confirmed.  Yet much to my annoyance, when I rebooted my iPad, both Google Maps and Youtube aps were gone!  At no point in the upgrading process had I been forewarned that I would lose these two aps, and the new mapping ap, too cleverly in my opinion, had a similar icon to that of Google, except that, underneath, it said “Maps” rather than “Google Maps”.  My wife had been fooled and so, I suspect, many other users.  The iPad allows you to “restore” an earlier version of its software, except that restoring will not get rid of IOS6 and therefore will not get your Google Maps and Youtube back.

Today, much was made of the Apple CEO’s apology for installing a poorly performing mapping application.  In my view, he should have apologized for not giving his customers an informed choice of upgrading or not.  In this instance, a company that prided itself on being customer focused, sacrificed its customers to its ongoing battle with Google.  Which brings the question, aesthetics apart, if Apple justifies its premium pricing on providing a premium experience, what happens when this experience (technical assistance or software upgrade) starts to falter?

The final thing was the release of the latest RIMM quarterly results.  Much has been commented already.  Suffice to say that the loss (ex-goodwill impairment) was lower than expected, cash holdings were slightly increased despite selling devices at a loss (thanks to cost cutting and a reduction in working capital due to business shrinking), sales fell sharply from a year ago but the subscriber base increased at an annualized rate of 10% quarter-over-quarter.

Earlier this week, RIMM’s management disclosed some of the features of its upcoming Blackberry 10.  Even to a non-geek like me, the upcoming RIMM smart phone looked sleek and well thought out.  Will it have many meaningful applications?  Will it have something comparable to Skype or Apple’s Facetime?  I don’t know.  A keyboard and a touch screen versions are set for release during the first quarter of next year.

At the time of this writing, RIMM has no debt and a market value of US$3.9 billion.  Net of cash, its enterprise (or business) value is US$1.6 billion.  This works out to US$20.4 per customer.  In other words, the company is priced as if it were going bankrupt.

Yet, it looks like the company has the financial resources to produce the BB10.  It also looks like it will have the resources to market it, as it will receive financial support from carriers that are anxious to reduce Apple’s negotiating leverage and interested in having a wider smart phone offering.  It is true that RIMM runs far behind Apple and Android-powered phones and that it is unlikely to catch them any time soon, if ever.  But it does have strengths, apart from his new technology: a secure network, a hardcore customer base, and excellence in text messaging.

We already have a “going out of business” value estimate for RIMM: US$1.6 billion.

What if it makes it?  That is very difficult to estimate, in part because RIMM has already announced that it will strike alliances and licensing agreements with third parties which will share the downside as well as the upside of the BB10 and beyond.

If we look at Apple, we can make some very rough estimates: its revenue per iPhone is about US$660, its gross margin US$ 430 and its net profit after-tax US$270.  Using a p/e multiple of 13, each one million iPhone sold would have a market value of US$3.5 billion.  Analysts expect that it will sell over 160 million units in 2013.

RIMM is not the market leader that Apple is, its new BB10 may be priced lower than the iPhone 5, its leverage with sub-contractors is much weaker, and as we already pointed out, it has decided to share some of its upside.  So for argument’s sake we will assume that its normalized net profit/BB10 unit will be US$150; using an arbitrary p/e multiple of 11 and assuming that RIMM sells 10 million new phones a year, its market value would then be US$16.5 billion (I assume that all excess cash balances will have been consumed to ramp up the business).

 

Which will it be?  Probably neither of the above, but somewhere in between.  The key decision though is whether RIMM will make it or whether it will bomb. 

I think that it will make it.  I also fear that Apple may be starting to suffer from the kind of hubris which stellar performers almost inevitably fall into, sooner or later.  Putting it all together, I see more upside with RIMM than with Apple, even considering the very steep challenges that the former is facing.

I am long RIMM and have no position in Apple.

May 29, 2024

The police presence was heavy as usual, but the oppressive, volatile atmosphere that had cast a pall over the Champs Elysées, and indeed the whole city in previous weeks, had lifted.  Instead, an air of expectancy mixed with curiosity had gradually set among the assembled multitude.  But the police prefect was taking no chance, as dozens of armored transports and riot control vehicles were massed, out of sight, on the rue de Ponthieu and Avenue Kleber.

 “I wonder if he will bring his kids” wondered a thin man in a bright yellow Tshirt.  “Carla will not let him!” shot back his neighbor, “Besides, they don’t speak French so they wouldn’t understand what’s going on” added another.  “Well, is he coming or what, we’ve been waiting since four o’clock!” complained a neatly dressed middle aged woman.

HE had been waiting for an even longer time, twelve years to be exact.  He had lost the 2012 elections more than his adversary had won them.  The French had rejected an hyperactive President in favor of a calmer, blander alternative; they had turned their back on “a certain idea of France” and voted in favor of a more comfortable, traditional vision that had much in common with that of an ostrich in imminent danger.  In truth, HE had not helped his case: during most of his term, his unbound energy notwithstanding, he had rarely given a sense of what his governing priorities were or should be, and during the presidential campaign, he had shied away from focusing on the challenges and policy choices that faced the nation.

Hated by many, radioactive to his fellow UMP members, Nicolas Sarkozy had accepted a fellowship at the Hoover Institution of Stanford University.  Within a few years, he had added a teaching position at the university’s Political Science Department and become involved with Stanford’s famed Business School.  In 2018, the IPO of  Uwin, in which he had invested $200,000, made him the first billionaire ex-President.  He was half way through his traversée du desert[1].  Now a very wealthy man, and the symbol of the modern politician who reinvented himself successfully if unconventionally, Nicolas Sarkozy would spend another six years trying to reenter the French political scene. 

Far from the Californian shores, France was not doing so well.  Neither the new president nor the French felt like paring the budget.  Having promised his electors economic growth rather than public spending cuts, President Hollande found it difficult to backtrack, even when faced with a budget deficit bigger than expected.  Taxes on the rich were raised yet they brought in but a fraction of the needed revenues.  So fiscal policy was relaxed, deficit targets were postponed and pressure mounted on the ECB and Northern Europe to provide additional deficit financing.

Had France been isolated, it may have been forced to face the music, but it was not alone; Spain and Italy were in the same situation, having to push through austerity measures which were increasingly unpopular and politically explosive. 

On the other hand, Germany, already facing slowing economic growth and the fallout from China’s recession, was growing more and more concerned that its financial commitments vis-à-vis the eurozone were becoming so large as to be internally destabilizing.  Netherlands, Finland and Austria were on the same page, and in any case too small to shoulder a greater eurozone assistance program.

This all came to a head at the Antwerp conference of 2014.  The new Spanish prime minister, who had just spent two weeks battling with the regional governments of Catalonia, Andalusia and Murcia, announced that he was neither in a position to accept more outside supervision from the troika nor to pay the sovereign debt as scheduled.  His Italian homologue noted that his new coalition in Congress wished to revisit some of the reforms voted under the Mario Monti government and that, in any case, the Spanish crisis made it impossible for Italy to access the financial markets on sustainable terms.  France for its part had been under a three weeks general strike which had escaped the control of the two dominant unions, the CGT and the CFDT, and leftwing splinter parties under the leadership of Jean-Luc Mélenchon were calling for the nationalization of half of the companies in the CAC 40 index.  President Hollande had to decide which way to go.  In the end, he calculated that he couldn’t win over the strikers or the opposing political parties because they would never accept the necessary remedies which, in any case, he didn’t himself fully embrace.  He also felt that the country was far richer than generally acknowledged and could take care of its own financial problems if these were, at least partially, reduced.

On October 15, 2014 in Antwerp, Germany, Finland, Austria and the Netherlands formed the New Eurozone, anchored by the Euromark(€Mk).  Central banks’ balances with the ECB were to be settled via new 10 year ECB bonds.  Given the instant 30% appreciation of the €Mk vs. the €, Germany took an immediate mark-to-market loss of some €200 billion on its ECB credits.  On the other hand, it also showed a comparable gain on its outstanding sovereign debt for the opposite reason.  The top French, Italian and Spanish banks were nationalized.

In the months and year that followed this historical event, it became clear that Anwerp solved only in small part an economic problem, but was even less successful dealing with political challenges.

The German economy took a hit, but not as hard as some had feared.  The €Mk proved a serious headwind to exports and corporate profits, as German exporters cut their margins to the bone to preserve market share.  Imports by France, which represented 19% of total, plunged.  On the other hand, parts and other imports from France, Northern Italy and Spain rose.  Corporate efficiency campaigns went into high gear to mitigate the pricing headwind of a strong currency.  Endowed with a super strong €Mk, German companies accelerated new capital investments in Asia, Mexico and the US.  By the end of 2017, the German economy had regained it mojo, and the timely Chinese recovery proved an added bonus.

In France, the competitive boost gained from a weaker euro was transitory.  It weakened the case for deeper reforms.  It depressed consumption and therefore tax revenues.  Faced with a diminished purchasing power and depreciated savings, the population soon became restless and clamored for “a new deal”.  But faced with high borrowing costs, the government had limited resources.  So, in 2015, new taxes were levied on those who profited from the devaluation, mainly exporters and international firms.  Next, private savings were channeled to finance what amounted to general budgetary shortfalls.  As this was not sufficient, the government reached farther for new sources of funding.  In 2017, “Social Solidarity Financing Programs”, or PROFINSS, were started whereby public assets, services or institutions were used to collateralize new public debt issues.

The state of affairs was not very different in Italy and Spain.  In particular, social and political unrest had become pervasive in Spain where the central government was still faced with a volatile conflict with the regions.  For the first time in recent memory, Italy was faced with its own kind of regional strife, as Northern Italy was in open conflict with Rome.

With stagnant economies and restive populations, these three countries pressed the ECB to increase its emission of money, trying to compensate some of the adverse effects of this policy with export incentives and targeted compensatory schemes.  By 2020, most French salaries included indexation provisions and inflation had risen to 7% p.a.  At the same time, price controls had been expanded, so that the official consumer price index was widely viewed as understating inflation by several hundred points.

As we have seen the Antwerp conference and its aftermath had brought France little relief.  The 2017 presidential elections were hotly contested but the right lost handily, divided as it had always had been.  President Hollande also lost, to his minister Arnaud Montebourg.  The new president was viewed as more charismatic and “progressive” yet not as extreme as Mélenchon. Yet Mélenchon and his Left Party scored big at the legislative elections and assured their participation in the new government.  Also scoring big was the National Front of Marine Le Pen with the support of some refugees from the UMP.

By the time the 2022 elections came around, the world economy had mostly recovered from its slump of a decade before.  China was in the midst of its Domestic Frontier program aimed at accelerating the development of its Western provinces.  Mexico had become the latest emerging markets star and the leader of a revitalized Latin American free trade group which included Chile, Peru, Colombia and a reborn Venezuela whose oil production had reached 4 million barrels per day thanks to the historic opening of its energy sector to private companies.   The US too was on the mend, having flirted twice with disaster but finally built a block of moderates from both parties in the House.

Southern Europe lagged behind.  In France, the 2022 had brought a new president, former Socialist Party Secretary Martine Aubry in the same role of conciliator as that thrown upon Montebourg five years earlier.  The opposition was led by Marine Le Pen as the leader of the Union pour un Movement Républicain-UMR, the result of the fusion of the UMP and the National Front.

By then, the Socialists and the UMR parties had hardened their positions, as each firmly believed that it could impose its views, bloc the other and win over the support of the population thanks to massive demonstrations or other spectacular action.  Crime had become a major social issue and how to combat it was a key political battle ground; the CGT and CFDT unions backed the government while the police unions supported the more vigorous policies advocated by the opposition.  Over the next two years, the policy stalemate continued and pressure built.

In 2024, with little economic growth, continued capital flight and persistent inflation despite administrative price controls, the government took the fateful decision to nationalize what it called the Six Strategic Pillars of the economy: Electricité de France, France Telecom, Lafarge, Renault, Suez and Total.  The government had expected that this move would not be overly disruptive; after all, the Paris stock market had been in a state of torpor for years, all six stocks traded at already depressed levels and state intervention in their affairs was already pervasive.

Market and popular reaction was however wholly unexpected.  While many had not minded the state controlling prices and browbeating wealthy executives, they were now aghast that the attack was directed at their own property.  Also, while stock prices had been depressed for a long time, dividend yields were attractive as they approximated official inflation levels.  Finally, the nationalization raid had come out of the blue and nobody knew what else was in the offing.  On the far left, politicians were up in arm when the prime minister announced that compensation would be paid “based” on market prices; why should taxpayers money be used to reward those who had unjustly profited at the expense of the working class?  Institutional investors, for their part, wondered whether they should wait or just dump all their holdings.

On that day of May 21, 2024 the already depressed CAC 40 dropped by 27% before trading was halted.  International suppliers made it clear that they would suspend all non-essential dealing with the Six Pillars until further notice.  S&P, Moody’s and Fitch downgraded the Six’s credit ratings by five notches triggering sharp drops in their bond prices.  French sovereign and other top corporate bonds swooned in unison.

On the morning of the 22^nd, the Paris Stock Exchange didn’t open for trading and a €4 billion OAT issue was cancelled.  By noon, when trading finally opened, the CAC 40 fell another 11% whereupon the exchange was closed for the day.  Sporadic runs by depositors on branches of BNP, Crédit Agricole and Société Générale were reported in Lille, Strasbourg and Grenoble.

By the 23^rd, the UMR had called on the government to explain its ill advised nationalization in Congress, with supporters and detractors engaging in shooting matches and government members occasionally ducking for cover as projectiles of various shape and weight flew across the Chamber.  Outside, civilians, union members, and employees of the Six were picketing, milling around and waiting for something to happen.

On the 26^th, two things became crystal clear: (1) the government was going to fall, and (2) the UMR had zero chance to replace it.

And so, on the 29^th of May, 2024, at approximately 6 pm, Nicolas Sarkozy, former president (2007-2012), former fellow of the Hoover Institution, venture capitalist extraordinaire, walked up the length of the Champs Elysées, accompanied by his wife Carla and his two daughters, and by the clamor of half a million French.  His hair was grey and his cheeks were rounder, but years of surfing in California had helped him stay in shape, and he effortlessly glided up the famed avenue. 

The government had resigned; President Aubry had asked Nicolas Sarkozy to form a new one.  She had also agreed to resign within three months so that new elections could be called.  Already, brand new banners, white and blue background with “France Avenir” in bold red letters, were fluttering in the breeze, portends of campaign soon to be launched.

The above is just an exercise in political fiction, although it attempts to find a realistic base in history and economic realities.  But it is only that.  Alternative scenario could have been proposed which would have a chance of happening.  The point of this fable is not to guess what the future will be like.  It is to illustrate as vividly as possible the fact that the latest debt and European crises have had severe economic consequences, yet relatively mild political ones. 

In our view, the next few years are likely to bring about political upheaval on a scale comparable with the economic upheaval we have been through so far.

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[1]  Literally, crossing of the desert.