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Cyprus and Europe's black swans.

"It was worse than a crime, it was a blunder". This was Talleyrand's verdict on Napoleon's order for the execution of the Duc d'Enghien, a minor Bourbon prince in exile. So it is with the EU bailout programme on Cyprus. Not a crime but definitely a blunder that could well precipitate the very European banking system meltdown it sought to avoid. Cyprus, an island state I have known since boyhood summer vacations in the Troodos Mountains and a love of halloumi cheese/ Ayia Napa, is now a geopolitical hot potato in the Med. bankrupt island state, a EU member with the British military base at Akrotiri, a member of NATO whose northern third was invaded and occupied by Turkey, another NATO member.

Cyprus, like Iceland, had a banking system seven times its GDP, was to Russian capital what Lichtenstein is to the Germans, Chiasso to the Italians and Guernsey to the British. Cyprus, wrested by Lord Palmerston from the Ottoman Empire, Whitehall's "unsinkable aircraft carrier" during Sir Anthony Eden's Suez invasion, is now the epicentre of a new tempest in international finance. A run on a banking system is never pretty and an EU banking run can well trigger the grisly chain reaction of cross border contagion.

The indefinite bank holiday in Cyprus means that the ECB has, in essence, imposed capital controls on a member state. Now that the Parliament in Nicosia has rejected the bailout package, a ECB lifeline funding for Cypriot banks could well be challenged by the German Constitutional Court. The Troika (IMF, ECB, EU) bailout package is 10 billion Euro. Where will Cyprus find another 7 billion Euros if it does not tax insured bank deposits, though the successors to Archbishop Makarios at the Orthodox Church have offered their 3 billion Euro nest egg.

I find it difficult to believe that Cyprus can continue to remain Russia and Ukraine's offshore tax haven after the events of last week. So the mathematical payoffs of game theory (Prisoners Dilemma) suggest Cyprus may as well tax uninsured depositors since they will eventually flee its tainted banks in any case. The worst case collective scenario is often the optimal one for an individual player in an uncertain game milieu.

This means the Kremlin could well have an incentive to act as the financial white knight for Cyprus, though a Russian naval base in the Med in a NATO member state seems surreal to me. Since the Cypriot banks have no real senior bonds, this is not a viable source of funding. Cyprus could raid its pension fund to finance its banks, a strategy used by Argentina's Peronist government and even Ireland's last Taoiseach.

A key variable in Cyprus is that the ECB will do its best to avoid an escalation of banking tail risk for the sale of a miniscule 5 - 7 billion Euros, even though a bailout of Russian "oligarchs" is anathema to Berlin at a time Chancellor Merkel faces an enraged electorate. Given capital flight and the inability to devalue its currency, Cyprus will face an economic contraction that will exceed the miseries seen in Greece and Spain.

Yet all is not lost for Cyprus. Russia could well provide Cyprus with an emergency bailout in exchange for its offshore gas reserves, though Turkey has threatened military strikes against companies drilling for oil in disputed offshore sea lines. Yet a Gazprom/loan deal with the Kremlin will be impossible for Nicosia to implement if it is opposed by Washington, Ankara, Brussels and Berlin. The Kremlin does not want to alienate the EU who buys its gas and Gazprom does not need Cypriot gas reserves if it means alienating Ankara. The geopolitics and financial fallout of the Cyprus crisis once again exposes European finance to the malign shadow of black swans. That much, at least, is certain.

Macro Ideas - What next for Southeast Asia equities?

Asian equities in 2013 were dominated by the bull markets in Japan and Southeast Asia, yen depreciation and consequent foreign selling in South Korea and Taiwan, political and inflation woes in India, a cyclical uptick in China and a non index fairy tale in Vietnam. In Hong Kong and Singapore, weaker exports and restrictions on property speculation have cast a spell on the Hang Seng and Straits Times indices. Malaysia and Pakistan await critical elections.

The most amazing aspect of Asian equities is the spectrum of valuation indices in the regional stock exchanges. So South Korea trades at 8 times forward earnings while the Philippines, despite its undeniable macro and sovereign credit momentum, trades at an incredible 20 times earnings. The Dow Jones has scaled its 2007 highs but Hong Kong is 10,000 Hang Seng points (one third) below its 2007 high now that central bank money printing created epic bull markets in the former British Crown Colony/now China's SAR.

In a macro sense, accelerating growth in China and the US is bullish for Asian equities, though fiscal drag in Washington, the Politburo's crackdown on property speculation and Italy/Cyprus event risk on European growth all have the potential to cash dark (if fleeting) clouds on the sunshine scenario. Central bank policies will be no impediment to Asian bull markets. The Kuroda BOJ will embrace a 2% inflation target and the Bernanke Fed will unquestionably not take El Toro's punch bowl away. Asian earnings/margins, after two mediocre years, have compelling uptick potential.

The DMK's threat to pull out of the ruling coalition on Sri Lanka related issues just reinforces my conviction that Sensex valuations (or reform momentum) cannot rerate at a time when India faces ten state elections and a general election. Asia's largest current account deficit, fiscal indiscipline, a downgraded 5% GDP growth, a iffy rupee and optimistic earnings prediction made me Sensex bearish 1200 points or two months ago still skeptical on Dalal Street.

Thailand (1.6% of the Morgan Stanley EM index but a 38% dollar return sine November 2011, when I flagged the Siam macro trade idea in successive columns just after the election/floods) seems the best positioned value market in Southeast Asia. 5% GDP growth, an infrastructure spending bonanza, 18% expected earnings growth, compelling valuations at 13 times forward earnings and a 3.4% dividend yield on the SET index, a political rapprochement among rival Thai elites all suggest the Thailand bull market is secular, not cyclical. Can the SET index fall to 1450 amid a global market hit or even Thai specific event risks? Yes. Yet if there was a buy in dip market in Asia, Thailand is it.

The Straits Times index in Singapore could have another 200 point downside and the Sing dollar has lost its strength momentum. Singapore trades at 14 times earnings, EPS growth is mediocre at 5 - 7% in 2013, and the local bank shares seem overvalued. However, somewhere in the 3000 STI level, Singapore could well prove a less inexpensive proxy ASEAN market. South Korea, thanks to the yen/Nikkei, offers far more compelling deep value global brand companies. In any case, South Korean EPS growth will easily be triple Singapore.

Indonesia is one of the strongest domestic growth themes in Asian, with 6% GDP growth and 15 - 20% earnings growth. Yet Jakarta is dangerous as the overheating/inflation/current account deficit will trigger a rupiah depreciation even as the political scrum to succeed President Yudhoyono heats up. I will only invest in Malaysia if PM Najib Razak and the ruling Barisan coalition, whose economic transformation plan is key to the Kuala Lampur Borsa, wins the next election.

Wall Street - The message from global markets

The financial markets are once again at an inflection point, thanks to the Italian political impasse and the Cypriot banking shocker (which has the footprints of Frau Nein von Berlin all over it! Are we headed for the biggest spat between the Fatherland and Mother Russia since Operation Barbarossa?). US and European equities have emerged (somewhat) unscathed from Italy/Cyprus, definitely not a Lehman/Archduke Franz Ferdinand moment for Europe. In the US, accelerating economic momentum, a high equity risk premium, stellar corporate balance sheet, a growing LBO/deal pipeline now rules the roost. This is not the case in emerging markets, commodities/mining or even European banking shares. The Federal Reserve is on hold, the US Dollar Index is at 83 (as I write) and the S&P 500 index is outperforming its DM peers in Europe and Asia.

I have made no secret of my belief that Brazil's Bovespa and India's Sensex will be probably two of the more obvious Cinderella emerging markets in the world in 2013. A non-index market (Ok, 1.6% of MSCI EM is philosophically, if not mathematically, non index) that was a spectacular home run since late 2011 is, of course, Thailand and the Thai baht is actually the best performing currency against a stronger dollar in 2013 (up 5.6%), beating even my beloved Mexican peso (up 4.8%). The Swiss franc also depreciated to my 0.95 target.

It is no longer accurate to speak about a broad global bull market in equities, as its two poles lead by Wall Street and Marounuchi (Japan). This is a performance divergence which is reflected in credit, where US high yield has outperformed investment grade (duration risk?), Club Med (Beppe Grillo?) and emerging market debt (China, iron ore, Cyprus, oil, mining?). Commodities should lead in a global asset reflation but that is not remotely the case. The conclusion? Despite Mario Draghi's OMT, tail risks can still hit global growth, the reason the Oil Services Index (OIH) has now once again begun to trade as a risk aversion instrument. It is essential that US money center banks regain the leadership they lost after Cyprus hit the tapes. If not, the entire easy money/asset reflation theme trade loses its momentum and its intellectual raison d'etre. This is a risk rally that has begun to exclude entire asset classes, sectors and even continents (Latam?). That makes me think something is rotten in the kingdom of Denmark, in a Hamlet and not geographic sense, to be sure.

Wall Street is a tale of two asset classes. Steel, miners, chemicals, BRIC equities, cyclicals are not the flavour of the month. China has given back 10% of it rally and Taiwan/South Korea are haunted by the Empire of the Sinking Yen (though rising Nikkei!). This is not exactly a compelling argument for global economic growth. This could change if the PBOC goes dovish or the US data (ISM, payrolls, retail sales, industrial production) go even more ballistic but global growth needs a catalyst, a white knight. Unfortunately, the converse is a credible scenario too. Any hint that Joe Sixpack in the US will see his consumer spending fall due to fiscal drag, any hint that the PBOC will abandon easy money to combat inflation, means a bloodbath on Wall Street. A correction, to use the polite language of capital markets euphemism. Growth delta and tail risk, of course, will also determine the strategic decision to slash/extend duration risk.

If there is any silver lining on Cyprus, it only makes the Fed, the ECB, the Bank of Japan and the Old Lady of Threadneedle Street provide more high octane risk insurance against the reemergence of tail risk. Welcome to easy money, the Ben/Mario/Mervyn/Kuruda-san put on global risk assets.

Stock Pick - What explains Russia's deep discount?

Winston Churchill once described Russia as a "riddle wrapped in a mystery wrapped in an enigma". After more than a decade watching and investing in Russia, I can well sympathize with Churchill's riddle-enigma metaphor. Russia has been the most volatile major emerging market on earth, albeit spectacularly profitable after major macro shocks. These ranged from the de facto collapse of the Russian banking system and rouble debt markets in August 1998 to the Chechen war/Brent crude collapse in 1999, the Kremlin's takeover of Yukos in 2003, the rouble/bank borrowing shocks of 2008, the war with Georgia.

It is impossible to invest in Russian oil and gas shares without some insight into the rival siloviki clans in the Kremlin and Putin's quest to make the state the catalyst of Russia's economic development (a quest inherited from Tsar Nicholas II's reformist premier Count Stolypin and Brezhnev's KGB boss and successor Yuri Andropov). It is impossible to invest in nickel, telecom or construction without some feel for the Moscow/Londongrad axis of rival oligarchs. Even business trips to Russia give only a superficial sense of its complex, constantly shifting financial realities.

I find it ironic that Western fund managers gung ho about China, another opaque society with companies that are governance/accounting/shadow banking challenged, flinch at the thought of more than a token allocation to Russia. The financial water torture in Gazprom, the headline risk in Russian politics and neo Cold War diplomatic rhetoric make Russia a hard sell in the West.

This is uber-yummy because the Putin III era once again offers one of the lowest, most compelling equity valuations on earth, at 5.6 times earnings, one times book value on the RTS index and volatility that has now fallen below 20%. Russia's macro metrics put Europe or even emerging market darlings like India and Turkey to shame. A 4% GDP growth rate, undervalued sovereign credit, $600 billion in hard currency reserves, a stronger rouble, a central bank committed to inflation targeting, a liquid/vibrant local debt market (that is now Euroclearable), WTO membership, record investment from Malta, BVI and Cyprus, (Russia suffered history's greatest exodus of capital after the collapse of the USSR. No less than 50% of the deposits in the Cypriot banking system is offshore Russian funds!), an embryonic current account surplus.

Putin's new campaign against corruption and foreign assets bodes well for the return of flight capital, the local OFZ rouble debt market and, ultimately, the stock market. The world's smart money investors are dangerously underweight Russia at a time when its macroeconomic and investment case looks the most compelling to me since early 2006, when I first experienced the dubious magic of a Moscow winter.

Apart from oil and gas, metals and strategic industries, Kremlin politics has minimal bearing on the investment calculus of companies leveraged to the extraordinary growth of Russia's middle class consumer. After all, even a superficial visit to St. Petersburg, (once Hero City Leningrad and now Blingsville on the Neva) or Moscow can enable foreign investors to grasp the sheer exponential mathematics of consumer spending in a vast nation with 140 million people, a rising per capita income, ownership of some of the planet's priceless fossil fuel prizes, nine time zones from the Nevsky Prospect in Saint Petersburg to Vladiovostok in the Russian Far East. There is a geographical reason why the Tsarist imperial symbol was a double headed eagle.

The new Russian middle class were the catalysts for the 2012 street protests and Putin's new crackdown against corrupt, Chekovian dead soul apparachiks. There is a spectacular risk arbitrage between the Russian Eurobond market and the equity risk premium of the RTS index. Russia is a riddle-enigma, sure. It is also one of the most transformational stories in the emerging markets.

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Publication:CPI Financial
Geographic Code:90SOU
Date:Mar 25, 2013
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