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David Kotok on Upcoming Mass Eurozone Refinancing and the Hunt for Total Return

Chairman and CIO of Cumberland Advisors David Kotok sent out a note over the weekend discussing the sheer amount of refinancing facing the Euro area in coming months and the difficulties that may create. He does not, however, think the spillover effects into U.S. markets will be enough to derail the slow-growth trajectory the U.S. economy is currently tracing out. We spoke with him on Benzinga Radio to get his thoughts on what all this means for the bigger picture.

On the matter of eurozone sovereign and banking debt refinancing and funding:

If the market doesn't provide financing, then there is a real problem, because Italy is the third-largest issuer of debt in the world. It is a huge amount of debt, a large country in Europe, and a very high debt-to-GDP ratio.

Second is the poster child for the trouble, and that's Greece. The big debt roll in Greece takes place in the second half of December. Greece has no market access; the market won't lend it money. So, the institutional structure in the eurozone has to provide the money to roll that debt.

At the same time, Greek revenue does not match expenditures--even if we cut the expenditures. So, the country is not sustainable. We have a real collision course in Greece.

Will the upcoming debt roll in Greece mark a turning point in the crisis?

Let's assume Italy rolls its debt, and the market actually believes it, and the credibility is enhanced by market action. That is a turning point that would say that the worst case is now behind us.

Let's say the other thing happens. Markets don't take the debt; it requires huge institutional support, and interest rates spike higher. Then, the markets go the other way.

The outcome will depend on the consensus view of the market: do you put up money and lend it to Italy, or don't you?

Is the ECB really as unwilling as they seem to step in and provide support?

I think the ECB would prefer not to monetize debt. It may not have a choice. The Federal Reserve preferred not to monetize debt either; look what happens.

Central bankers don't like to monetize, but central bankers also have another test. That is, when you are faced with catastrophe, do you let the economies melt down into a slump, or do you provide the emergency finance, even though you don't want to do it?

The answer is that most of the time, central banks provide the emergency finance at the end because the economic consequence of the meltdown is worse. So, it's a least-worst choice. My view is that the ECB will provide market-stabilizing finance. It won't walk away from it.

That is in the interest of all of the countries of Europe and all of the banks in the banking system because they want the system to maintain functionality, and if they allow a meltdown, it won't have functionality.

What of the banks, facing similar funding issues in the near future?

I think rolling bank debt is an issue. Bank funding is an issue. The issue is complex in Europe because the banks are surveilled and regulated by their respective national banks. So, the French banks are under the supervision of the Banque de France. The Greek banks are under the supervision of the Greek Central Bank--and no one believes they are solvent.

So, you have this complex interbank relationship, and the national banks are the lead agency within each country. That is a construction that is creating fog. It's not clear; there is no transparency. No one for a minute doubts the German banks, for example, but the minute you start some rumor about French banks, the bank stocks fall, and the cost of bank finance rises.

In the case of Greek banks, they are experiencing runs. They are in liquidity crunches. Anybody who is thinking about it takes their euro out of a Greek bank and deposits it in a German bank.

On the US economy--you don't buy into the idea that we're stuck in stall speed?

If anything, I think the growth rate in the fourth quarter of this year is actually picking up a little. It's not shrinking. The U.S. economy has been growing the entire year--at a slow rate, but growing. The unemployment number is very high, but total employment is rising. The private sector is creating jobs every month. Those jobs are there because of demand and hiring.

So, I'm not in the recession/double-dip camp; I don't see it. There is a lot of evidence--especially recent data releases--to support the fact that we will have slow growth, but that's not shrinking. That's growing.

So, are stocks cheap right now?

In my view, stocks are very cheap. We've had a bear market. We had a market that peaked on April 29, and it hit a low on August 8. It retested that low several times, and sort of had a final low on October 3. That would be very typical of a bear market if there is no recession. A bear market correction like that is normal in the history of stock market annals if there is no recession.

If there is a recession, there is another leg down coming, and it will be pretty rough. So, the real question is: do you bet on a recession, or do you bet no recession? If you bet no recession, then you want to own stocks, because they are cheap.

If you bet on a recession--you think we are going to have one--then you don't want to own any stocks. You want to live in the cave and bring in bottled water and canned food.

What insights did we gain from Q3 earnings?

Earnings are always a mixed picture, but as a practical matter, the earnings season wasn't so bad. Many companies reported surprises. I don't know that we had many serious misses.

I look to the profit share out of GDP--which is a consistent calculation coming from the Bureau of Economic Analysis--as the real indicator of what earnings are going to be. It's a compilation which is consistently done for decades.

The profit share is very, very high. It's remaining high, in fact. It could even be rising. That suggests to me that the positive earnings trend which will take the earnings for the S&P 500 index above 100 is intact and likely to continue. That's what our bet is. That is how we are proceeding.

We're fully invested in the U.S. market. We believe we made a bottom--and it held. That 1100 level on the S&P 500 index was a bottom in a corrective bear market.

Explain what you are looking at in terms of the link between monetary policy and precious metals prices.

We've done a lot of statistical work in the shop in which we looked at the transmission mechanism of central bank policy. Does it pass to commodity prices? You hear a lot of this, where people say, "Well, the Fed is printing all of this money, and that is the reason commodity prices went up."

I don't accept that. What we did is studied the commodity prices separately from the precious metals. What we found is that with the same statistical tests, precious metals prices--gold, silver--respond more robustly than commodity prices.

With some predictable time lag, you can forecast them. Now, we haven't had a long time since the financial crisis, so it's important to realize that we are under 16 calendar quarters of data. So, you don't have a long time-series.

What we do have is an expanded central bank balance sheet. We checked this on the four major balance sheets of the world: the yen, the pound, the euro, and the US dollar. We did a number of tests, and we found some very robust statistics which would suggest that precious metals prices will go higher.

So, in our global multi-asset class, we have taken up the weights in precious metals--about as far as we would go in a global allocation.

What do you think accounts for that time lag between policy and prices?

There are long and variable lags in monetary policy. The central bank does something today; you don't see the result for months--sometimes for more than a year. So, how that transmission mechanism works is a subject of intense scrutiny with serious research, and it has been for a long time.

We tested various lags, and what we started to see is after three calendar quarters--say, nine months--we begin to see the precious metals prices reflecting the monetary policy that was in place almost a year earlier.

It remains to be seen whether this relationship will be sustainable for a long period of time, but we are seeing early signs that there is forecast power in that monetary transmission mechanism to precious metals prices. Much less so in commodities--but in precious metals, it's there. How much, how robust? Our initial indications say it should be taken seriously.

Where are you looking for opportunities?

Yield is a tough subject with interest rates so low, but for total returns, we overweight the US these days. We overweight some emerging-market sectors. We are very cautious on the bond market in terms of global asset allocation, so that weight is probably underweight against global weight.

It's interesting--many people don't know it--but the global stock markets are probably worth $55-60 trillion worldwide, and the bond markets closer to $100 trillion. So, if you were to weight by global asset allocation weights, you would emphasize bonds. As a practical matter--with interest rates very low--we are loathe to do that.

US stocks seem cheap to us, so we are overweight. European stocks may be cheap, but there is so much in terms of problems that we would underweight them. We would definitely have smatterings of emerging markets worldwide in every portfolio.

What are your views on US municipal bonds heading into key political negotiations at the end of the month?

We don't think the Super Committee does much damage to the muni market. We think the muni market has been recovering for the last few months. It's overcome the Whitney virus of a year ago.

The forecast that the world was going to come to an end--that all of these municipalities were going to default--is clearly not true. If anything, we are seeing improving revenues and support for many of the higher-grade munis around the United States.

We think careful research into the structure of a bond can reward people and munis are a good place to be--they are a lot more desirable than, say the Treasury market, which is suffering a very low yield and is doing so because of the policy of the Federal Reserve to keep it that way. We like the muni space a lot.


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