Demography Charts – 2

9 December 2014

See also Demography Charts – 1

Below are lists of largest country populations in 1950, 2015 and 2050, assuming the UN’s medium-variant projections. Key takeaways:

  • Lower growth for world population in upcoming decades as total fertility ratios (TFR = children per woman) decline in Africa and Asia.
  • Four European countries were in the top 10 in 1950. Only one (Russia) remains in 2015 and none in 2050.
  • US population drops from 6.3% of world in 1950, to 4.4% in 2015, to 4.2% in 2050.
  • Huge increase in Sub-Saharan Africa from 2015 to 2050, despite an expected decline in TFR.

Top 10 populations in 1950:

Population (millions) 1950
WORLD 2526
Sub-Saharan Africa 179
China 544
India 376
United States 158
Russia 103
Japan 82
Indonesia 73
Germany 70
Brazil 54
United Kingdom 51
Italy 46


Top 10 populations in 2015:

Population (millions) 2015
WORLD 7325
Sub-Saharan Africa 949
China 1401
India 1282
United States 325
Indonesia 256
Brazil 204
Pakistan 188
Nigeria 184
Bangladesh 160
Russia 142
Japan 127


Top 10 populations in 2050:

Population (millions) 2050
WORLD 9551
Sub-Saharan Africa 2074
India 1620
China 1385
Nigeria 440
United States 401
Indonesia 321
Pakistan 271
Brazil 231
Bangladesh 202
Ethiopia 186
Philippines 157

Finally, here is a chart of Europe and Sub-Saharan Africa as percent of total world population.




Oil Quake 2014

2 December 2014

The consequences of a collapsing oil price will be deep and wide ranging. Brent oil has crashed from $115 per barrel in mid June to around $70 today, and WTI from $107 to $66. Here are the likely ramifications, the obvious and the less obvious:

1- Pressure on US shale oil producers: “Tight” shale oil is more expensive to produce than conventional oil. A lower oil price means lower profits for shale producers, or losses in many cases. OPEC’s alleged strategy and gamble are to put some of these people out of business in order to maintain the cartel’s long-term control on pricing. See next two charts.


On this, four issues should be considered.

First, the breakeven oil price for shale producers is a moving target. It may be $70 today but it will be lower than $70 in the future thanks to new technology and cost cuts.

Second, the breakeven oil price, for example $70 for a given shale well, includes upfront investments which means that the marginal cost of production is lower. In many cases, this marginal cost is below $40 at wells which are already up and running. After the crash, producers will treat upfront investments as sunk costs and will continue to operate these wells for their attractive cash flows.


Third, US law does not allow oil exports from the lower 48 states which means that the shale oil produced in the US ex-Alaska must today be processed domestically. OPEC’s calculation may be that the price of Brent will go low enough to displace domestic US producers, but this looks unlikely as long as there is a discount between WTI and Brent prices. If shale oil production slows down, one would expect the discount to narrow and disappear. In fact, factoring in the cost of transport, Brent would have to trade at a discount to WTI, instead of the current premium, before OPEC’s strategy could be considered a success. WTI is still trading at a $4 discount to Brent today, essentially unchanged in the last two months, albeit lower than it was in the earlier part of the year.

WTI Brent

WTIBrentDiscount 20141201

Fourth, there is some risk of financial turmoil. Several US shale oil producers are highly indebted and will suffer from declining cash flows. Marketwatch has compiled a list of companies that “are in big trouble if oil prices remain low”.

In addition, this article in The Telegraph (which appeared before the latest decline in oil) states that:

“Based on recent stress tests of subprime borrowers in the energy sector in the US produced by Deutsche Bank, should the price of US crude fall by a further 20pc to $60 per barrel, it could result in up to a 30pc default rate among B and CCC rated high-yield US borrowers in the industry. West Texas Intermediate crude is currently trading at multi-year lows of around $75 per barrel, down from $107 per barrel in June.

A shock of that magnitude could be sufficient to trigger a broader high-yield market default cycle, if materialised,” warn Deutsche strategists Oleg Melentyev and Daniel Sorid in their report.”

In 2010, energy and materials companies made up just 18pc of the US high-yield index – which tracks sub-investment grade borrowers – but today they account for 29pc of the measure after drilling firms spent the past five years borrowing heavily to underwrite the operations.

In the end, a lower oil price may deter some new shale investments, but it will not, or not yet, shutter existing wells. It is difficult to make a case that $70 per barrel is low enough to significantly alter the shale oil dynamic, unless a large number of companies run into financial distress.

2- Pressure on oil-dependent governments: The outcome here may be the difference between a manageable shock for some, and a much more challenging situation for others. Stratfor has compiled the table below which shows the energy dependence of several government budgets. Countries such as Iran, Venezuela and Nigeria need an oil price well in excess of $100.

In the right column are each country’s financial reserves which are a measure of each government’s firepower to withstand the shock. Budgets with a high breakeven and low reserves relative to their populations will experience greater strain than others. Venezuela and Nigeria appear vulnerable. Russia will also feel pressure but it has larger financial reserves and a falling currency which will dampen the shock internally.


3- Relief for US consumers and manufacturers: The fall in oil and slower fall in gasoline prices are a clear positive for US consumers. Deutsche Bank analysts estimate that every cent decline in the price of gasoline results in $1 billion of annual energy savings in the United States. A one dollar decline would free up $100 billion every year for investing or spending. The Wall Street Journal estimates that, since 2007, Americans have underspent on apparel, household textiles, appliances and real estate, all sectors which stand to benefit from years of pent-up demand.

WSJ chart

More broadly, the US economy will experience a new stimulus from lower commodity prices. All sectors (ex-energy) are beneficiaries but transport and manufacturing companies could enjoy significant windfalls.

Keurig Green Mountain: Overpriced Coffee and Stock

20 November 2014

From a press release on 14 August 2014:

Keurig Green Mountain, Inc. (NASDAQ: GMCR), announced today a price increase of up to 9% on all portion packs sold by Keurig for use in its Keurig® brewing systems and on all its traditional bagged, fractional packs, and bulk coffee products. This price increase will be effective beginning November 3, 2014.

According to Dr. Travis Bradberry, author of Emotional Intelligence 2.0, caffeine boosts your adrenaline level and “adrenaline is the source of the “fight or flight” response, a survival mechanism that forces you to stand up and fight or run for the hills when faced with a threat.”

So Keurig has opted to fight any threat to its margins. It will not be easy.

Until now, Keurig’s profit margins on K-Cups have been very attractive. Profits from the Keurig coffee machines are probably small or nonexistent, which means that the EBITDA margin on coffee alone is higher than the 24% group-wide EBITDA margin. And within coffee, the margin on K-Cups is higher still, which explains GMCR’s 5x price to sales ratio and its $23bn market cap.

The problem going forward is that competition will only increase, putting pressure on market share and on margins. I sum it up through three main headings: K-Cups, Machines and Nestlé.


If you collect enough coffee from K-Cups to fill a one-pound bag, you will have spent anywhere from $25 to $50 in K-Cups. That could be well over twice the retail price of bagged coffee, which itself already enjoys a hefty markup.

Put another way, if I prepare my daily coffee using K-Cups and a Keurig machine, it will cost me anywhere between 60 cents to over a dollar per cup. But if I buy bagged coffee and EZ-Cup Filters, it could cost me say 25 cents for the coffee and 10 cents for the filter, all together about half the less pricey K-Cup option. The bottom line is: coffee sold in K-Cups costs a lot more than the same amount of coffee sold in bags (to do the math, 1 pound = 453.6 grams).

In this photo taken at a coffee shop, the same brand coffee is selling for $13.95 per pound and for $11.95 for a box of 12 K-Cups, each weighing 12.9 grams. Pound for pound, the K-Cup coffee costs 2.5x the bagged coffee. Some premium is certainly justified for processing, grinding and packaging K-Cup coffee, but 2.5x looks like a very generous markup.

This large price difference creates an opportunity which puts Keurig margins at risk. If I were a manufacturer instead of a consumer, I could buy coffee wholesale for less than 25 cents per 10-gram serving (the amount of coffee in most K-Cups appears to be in the 9 to 12 gram range), put this coffee in compatible cups or filters and sell it at a tidy profit while still undercutting Keurig prices. The large Keurig markup means that there is ample room for competitors to enter at various price points and still derive a profit.

None of this has gone unnoticed. As many as 14% of K-Cup compatible pods have come from private-label suppliers (other estimates are closer to 10%). The remaining 86% come from Keurig’s own brands and from Keurig licensees (Starbucks SBUX, etc.). Keurig believes that the 14% will decline and that the 86% will grow. But the opposite is just as likely because competition does not usually decrease when margins are large for a product which is being progressively commoditized.

There will certainly be more competition at lower price points in single serve units whether they are called K-Cups, pods, capsules, or something else. This company for example offers tiny suppliers (as small as individual coffee shops) the opportunity to package their coffee into Keurig compatible cups, starting with very small volumes. Going forward, one could buy single serve cups from Keurig or a Keurig licensee or buy them from a favorite coffee shop at about half the price.

In this vein, I am reminded of an interview with Harvard Professor Clay Christensen in which he discusses Apple’s success within its own ecosystem. You could substitute Keurig for Apple in the following quote and it would make sense:

In the end, modularity always wins… You can predict with perfect certainty that if Apple is having that extraordinary experience, the people with modularity are striving. You can predict that they are motivated to figure out how to emulate what they are offering, but with modularity. And so ultimately, unless there is no ceiling, at some point Apple hits the ceiling.

Granted this is long-term theory. In the near term, as the good times continue, Keurig can be described as a marketing rollup. In a traditional rollup, a company grows by acquiring several of its peers sequentially over a period of years. It brings its expertise and economies of scale to its acquisition targets and benefits from their improved profitability. In a marketing rollup, a company convinces several of its peers to join its platform by promising to sell their product at a higher price and splitting the benefits with them. Keurig has clearly been masterful at deploying this strategy, selling its own and third-party coffee at a premium.

Keurig has also been masterful at announcing new partnerships frequently and methodically, in a way that has so far been hugely beneficial to the stock price. There is a measure of genius in this management who have not only convinced millions of Americans to pay more for coffee in return for some convenience, but who have also convinced investors that new technology can make a huge difference in the erstwhile mundane task of preparing a cup of coffee. This explains why Keurig’s stock is today very near its all-time high.


A visit to Bed Bath & Beyond’s website shows that there are now several competing single-serve coffee makers on the market. Some of them like Cuisinart, Mr. Coffee and Hamilton Beach use K-Cups. Others like Nespresso use different capsules. You can now bypass Keurig machines and Keurig coffee brands by buying another machine and by using private label cups. You can choose, from a growing number of alternatives, to enjoy a single-serve cup of coffee delivered with the convenience of a K-Cup (or similar pod) without paying the Keurig company a single dime.

The notion that Keurig can reverse this trend is, in my opinion, unrealistic. Still, the company is giving it a good try with the Keurig 2.0 machine. It includes a carafe and some proprietary technology which will only work with Keurig-approved K-Cups. This means that an unlicensed K-Cup does not work in a Keurig 2.0 coffee maker. A key question for the future is whether Keurig’s market share in K-Cups will erode further or whether it will reverse and trend back towards 100%.

I expect that it will erode further. The restrictive Keurig 2.0 is in theory a good attempt to rebuild the walls surrounding Keurig’s ecosystem, but it does not appear to offer the consumer something truly new and exciting. It does offer the ability to brew a single K-Cup and/or larger batches into a carafe but this is something a consumer can already do with a traditional coffee maker sitting next to a K-Cup machine (made by Keurig or someone else).

Keurig says that a large number of US households have not yet switched to single serve and that their main reason for staying away is that single serve machines do not brew large enough batches of coffee. This may sound like circular logic to justify a plateauing in single serve penetration, but Keurig believes that there is a broader target market for a machine that offers the convenience of both the single-serve and the larger carafe bundled in one product. Except for saving a small area atop the kitchen counter (not an issue in most American kitchens), it is not clear what the consumer is getting in the bundled product that he does not already have.

Notwithstanding the above and judging from the stock’s performance, the market seems to have accepted the success of 2.0 as a foregone conclusion. This may be overly sanguine if Amazon reviews are a good indicator. All three Keurig 2.0 machines available on Amazon have consumer reviews below three stars out of five. By comparison, the older Keurig machines have nearly five stars.

Pricing of Keurig 2.0 machines may be an important determinant of success and needs to be low enough to be competitive with the alternative, which is to own two machines (one single serve, one carafe) for less money and with fewer restrictions than the Keurig 2.0 bundle.


In theory, Keurig has a large potential for expansion outside North America. Today, Keurig’s revenues come from the US and Canada. But the company has recently started to expand into foreign markets, beginning with the United Kingdom. Yet, nothing is as easy outside one’s own home turf. It is not uncommon for a growth consumer company to stumble soon after its entry into a foreign market. In addition, by going overseas, Keurig is entering a world dominated by the giants of global coffee, Nestlé and Mondelez.

They too have ambitions beyond their largest markets. Nestlé is redoubling its efforts in the US. The Swiss company is the world number one in coffee with 22.7% market share, in part because most of the world drinks instant coffee where the Nescafé brand is dominant.


Nestlé is already present in single-serve coffee with its Nespresso machines and capsules. Nespresso is dominant in Europe but, in the US, it has lagged Keurig by a long mile because it was slow to adapt to American preferences. Compared to Keurig, Nespresso machines have had higher retail prices and, in the past, have served smaller cups of coffee which are more suitable to the European taste. Although Nespresso has introduced newer machines which can make espresso and larger cups of coffee, it still does not appear to have a product in the US that is designed to take Keurig head on. That could change soon if it is serious about gaining significant share.

We can be confident that competition will intensify here and overseas. But what is of greater importance is the current debate on open vs. closed systems. An open system allows other coffee brands on your machine (for example Starbucks, Dunkin Donuts etc). A closed system does not.

As discussed above, Keurig allows a large number of licensees and a wide portfolio of non-Keurig coffee brands on Keurig machines, all of which bolster the case that Keurig offers an open system. A truly open system however would allow other coffee brands on the machine without extracting a fee from them. So Keurig can be called semi-open (or semi-closed), or open only to the extent that it can obtain a fee from third parties.

Nespresso has been even more restrictive, allowing only Nestlé coffee capsules on its machines. But Nespresso recently lost a ruling in France which forced it to open its machines to other capsule makers. France is Nespresso’s most important market and if Nestlé has accepted that it will run a completely open system in France, it is likely that it will run an open system everywhere. What this means is that there will be more coffee companies making capsules for Nespresso machines. More importantly, it could also mean that these companies can do so without being licensed by Nestlé. If this new openness migrates to the US, it will result in a new headache for Keurig which is trying to remain semi-open (or semi-closed) through its licensing policy and the proprietary technology of Keurig 2.0.

From the point of view of the consumer, a completely open system makes the most sense because it will lead to greater choice, greater competition and lower prices. And as we have seen, prices are high enough that they can fall significantly and still deliver a profit.

Because of its global footprint and large portfolio of brands in other categories, Nestlé could likely sustain pricing pressures in US coffee for longer than Keurig could. Nestlé’s annual coffee revenues dwarf Keurig’s ($16 billion vs. $4.5b) but they amount to less than one fifth of total Nestlé revenues. This is where a large global player like Coke could be helpful to Keurig. But the question remains how much Coke should pay for the rest of Keurig? And when should it make its move?

Coke and Keurig

Keurig stock has been one of the best performers in 2014, in large part due to bid speculation surrounding Coke’s acquisition of a 16% stake in the company. While it is very probable that Coke will eventually buy the rest of Keurig, it does not follow that such a bid is imminent. It could come next week or it could come years from now. Here are the three main scenarios:

1. Coke makes a move fairly soon and offers only a small premium or no premium, arguing that the stock has raced 50% from $80 to $120 and beyond after the acquisition of its initial stake. In other words, the premium is already included in the current stock price.

2. Coke makes a move in a few weeks, months or years at a higher price. By then, the performance of Keurig stock will be largely justified by its own operations and Coke will have to offer a premium to the then stock price. So say that by then the stock is at $170 and Coke will have to offer $200+.

3. Coke makes a move in a few weeks, months or years at a lower price. This could occur if Keurig’s results deteriorate and the stock falls back towards $80 before the bid.

Although investors are excited about scenarios 1 and 2, a trade buyer would normally prefer scenario 3. Why pay $200 per share when you can pay $80 instead? That $120 difference amounts to a $19 billion difference on the current share count.

In February, Coke could have easily bought all of Keurig, given that Coke’s market cap was then over twelve times the market cap of Keurig. The fact that it did not bid on all of Keurig outright could suggest that it viewed the stock as overvalued. Or it could suggest that it needed more time to get comfortable with the prospects of Keurig Cold.

With a choice to act now or wait longer, it may be wiser for Coke to wait longer given the mounting uncertainty facing Keurig. In addition to the competitive challenges discussed above, rising coffee prices could exert further pressure on margins.

Severe droughts in Brazil have resulted in the price of Arabica coffee soaring from $1.10 to $2.10 per pound in the six months to May 2014. It then dipped to $1.60 in June as suppliers sold down their inventories. But the depletion of these inventories boosted the price back to near $2 as of now. The onset of a new El-Nino effect has some predicting a further increase to $3 per pound. Keurig is hedged for 2015, but at higher prices than for 2014. As noted above, it will try to pass on some of these increases to consumers but from $30 per pound equivalent for K-Cups, it is not clear whether consumers will accept the increase or migrate to lower-priced private labels in greater numbers.

Keurig’s rich pricing and margins are not sustainable in the face of rising competition from Nestlé and private label suppliers. Keurig’s management have done an excellent job bringing the company to where it is today. But competitive pressures are mounting and a full bid from Coke is already priced in. At 20x 2015 EBITDA, the stock looks stretched.

This article only represents the author’s opinion, may include unintentional errors, and is not meant to influence the reader’s decision to trade Keurig stock long or short. Do your own work, read more research and draw your own conclusions. If you short the stock, you should be cognizant that 1) Keurig has been very adept at boosting its stock price despite declining revenue growth and 2) a full bid from Coke could come at any time.

Demography Charts – 1

13 November 2014

Below are charts of country and regional dependency ratios.

First some definitions:

The total dependency ratio is the ratio of the population aged 0-14 and 65+ to the population aged 15-64. They are presented as number of dependents per 100 persons of working age (15-64).

The child dependency ratio is the ratio of the population aged 0-14 to the population aged 15-64. They are presented as number of dependents per 100 persons of working age (15-64).

The old-age dependency ratio is the ratio of the population aged 65 years or over to the population aged 15-64. They are presented as number of dependents per 100 persons of working age (15-64).

The charts below are derived from the United Nations’ World Population Prospects – The 2012 Revision

In theory, the economy does better when the dependency ratio is falling and less well when it is rising. But, as discussed in this previous post, two important mitigating factors are a country’s rate of innovation and its institutional strength.

United States, Europe, Japan

Figure 1 shows the total dependency ratios of Europe, Japan and the US from 1950 to 2050.

Total Dependency Ratio
Fig. 1. Total Dependency Ratio, Europe, Japan, USA

Key takeaways are:

  • The ratio bottomed in Japan two decades before it bottomed in Europe and the US, which may explain Japan’s stagnation relative to the US and Europe in the 1990-2008 period.
  • In the 1980s, 1990s and early 2000s, Europe and the US benefited from a declining ratio.
  • All three ratios will rise from now into the foreseeable future. But Japan’s ratio will rise faster due to its older population.

BRIC countries

Figure 2 shows the total dependency ratios of the BRIC countries: Brazil, Russia, India and China.

Fig. 2. Total Dependency Ratio
Fig. 2. Total Dependency Ratio, BRIC countries

Key takeaways are:

  • The ratios of Russia and China are both bottoming in the middle of the present decade and will rise for the foreseeable future.
  • Brazil’s ratio will bottom later this decade and will subsequently rise.
  • India’s ratio will continue to fall until about 2030 and will level off until 2050, which may help its economy grow faster.

Country Charts

Following are charts for a few individual countries and for Europe and Africa, showing all three dependency ratios as defined above. The blue line is the total ratio, the red is the child ratio and the green is the old-age ratio.

DR United States
Fig. 3. Dependency Ratios, USA

In the case of the US, Europe, Japan and China, it is clear that the rise in the total dependency ratio is mainly driven by a rising old-age ratio. Japan has the fastest rising old-age ratio. None of these countries is expected to see a big rise in its child ratio.

DR Europe
Fig. 4. Dependency Ratios, Europe


DR Japan
Fig. 5. Dependency Ratios, Japan

Note the steep 40+ point decline in China’s total dependency and child dependency ratios between 1970-2010. It is due to the country’s one-child policy and it provided a big boost to the Chinese economy in recent decades.

DR China
Fig. 6. Dependency Ratios, China

The following chart compares the total dependency ratios of the US and China. China’s ratio fell faster and will also climb faster.

Fig. 7. Total Dependency Ratio, USA, China
Fig. 7. Total Dependency Ratio, USA, China

India and Sub-Saharan Africa have a more promising demographic profile. A declining total ratio could markedly improve their economies, if other obstacles can be overcome. In addition, unlike other regions, Sub-Saharan Africa will not have a rising old-age ratio for the foreseeable future.

DR India
Fig. 8. Dependency Ratios, India


DR SubSaharan
Fig. 9. Dependency Ratios, Sub-Saharan Africa


DR Russia
Fig. 10. Dependency Ratios, Russia


DR Brazil
Fig. 11. Dependency Ratios, Brazil



It’s the Demography, Stupid

11 November 2014

(See also the post Demography Charts – 1)

America’s anemic recovery can be explained by its slowing demographics.

Politicians tend to overstate the positive impact of their policies on the economy and to also exaggerate the negative impact of their opponents’ policies. In all likelihood, there are other more potent factors at work.

Instead of GDP, we look at wealth creation as the main measure of the economy. GDP measures economic activity which means that building roads to nowhere is a positive contributor to GDP in the near term because of the jobs provided and the material and services purchased. But building roads to nowhere is a waste of money. By contrast, wealth creation accounts for the return on invested capital and differentiates between good and bad projects.

And wealth creation has three main drivers: innovation, demographics and the economy’s institutional framework.

To illustrate the importance of innovation, consider a country where there is little innovation and therefore little creation of intellectual property assets. The main assets in such an economy are hard assets, such as real estate, natural resources and the like. Unless there is strong demand for these assets from foreign markets, the economy of that country would stagnate or grow slowly with its population. Good examples of such countries today are commodity economies like the leading oil producers, industrial metal producers etc.

Now consider a country where there is innovation but where the population is small. Here the amount of wealth created by innovation would be quite small unless there is strong foreign demand for the products and services brought about by that innovation. A new iPhone that can only be marketed to a small population would create a lot less wealth than one marketed to a large population. Good examples are Switzerland and Finland which are quite innovative, have relatively small populations but export their products in large quantities.

Innovation is back.
Innovation is back.

Finally, consider a country that has lots of smart innovators and a large population but that suffers from a poor institutional framework. It is a country where the government and citizens are corrupt, where contract law is nonexistent, where capital markets are small, where property rights are not protected. There would be little wealth creation in such a country because the innovators would emigrate to another country where they could more readily prosper from their innovations.

Since 1945, the United States has been blessed by all three major contributors to wealth creation: strong innovation, strong demographics and a stable and supportive institutional framework. The same has been true for Europe, albeit with slower innovation and slightly worse demographics. The same has been true for Japan, with still worse demographics.

So where do we stand today? Of the three main engines in the US, innovation and the framework are still going strong. But demographics have weakened in several ways. First, after declining for several decades, the dependency ratio (number of dependents per worker) has been rising since 2005. Second, the number of Americans aged 30-60, arguably the most economically active age bracket, has stagnated at a little over 120 million people. Previously, the 30-60 group had grown steadily in every year from 1978 to 2005.

Presidents Reagan and Clinton are credited with a successful economy but their years in office also benefited greatly from a falling dependency ratio. The same is true for the second President Bush until mid-decade when the dependency ratio bottomed out and started to rise.

The anemic recovery since 2008 can largely be explained by our deteriorating demographics. The US population used  to grow by 1 to 2% every year, which meant that companies could count on real growth of 1 to 2% and another 2 to 4% of inflation. But since 2007, annual population growth has fallen below 1% and inflation has also fallen. So what used to be safe annual domestic revenue growth of 3 to 6% is now looking more like 1 to 3%.


In Europe too, the dependency ratio bottomed and started to rise in the middle of the 2000s decade. In addition, Europe has been less innovative than the US in the past ten years, which explains its stock market lagging the US market. The rise of Google, Facebook and others and the resurgence of Apple have all taken place in the new millennium. Europe has had no such large success stories. Worse, one of its former superstars, Nokia, has nearly disappeared. So Europe still has a strong institutional framework but its other two engines of wealth creation are sputtering.

Japan’s dependency ratio bottomed in the early 1990s which may explain the country’s stagnation since then. It remains highly innovative but perhaps not sufficiently so in new focused companies with higher returns on capital.

The lesson of recent years is that US innovation may be strong enough to counter the effect of weakening demographics, but not strong enough to produce strong GDP growth. In addition, revenue growth in several industries has become highly dependent on exports to emerging markets. The economy and markets will do well if export demand continues to grow. But if emerging economies experience an important slowdown, our worsening demographics means that there will not be sufficient demand at home to pick up the slack.

For more data on US and world demographics, please refer to these previous posts:

The Economy’s New Boss: Demographics

Is America Heading Towards Zero Population Growth?

European GDP: What Went Wrong

Demographic Megatrends of the 21st Century

US Demographics and Housing

European GDP: What Went Wrong

First the two world wars, then a decline in the birth rate.

Newspapers these days are full of stories on World War I which started 100 years ago. They are also full of stories on today’s anemic European economy, as for example with Italy’s negative growth rate in the second quarter and France’s struggle to reach 1% GDP growth this year. At first blush, these two sets of stories are unrelated. But on closer look, it is apparent that the economy today is a distant echo of the war a century ago. And it all comes down to Europe’s demographics.

4 August 1914
4 August 1914 (via Wikipedia)

In my view, there are essentially three main catalysts of economic growth: innovation, demographics, and a favorable institutional framework. To illustrate this, imagine that a firm develops the best smartphone in the world but that there is only a potential market of 1 million buyers. Clearly, the wealth created by this innovation would be far smaller than if the potential market was 100 million buyers. Thus the importance of demographics.

Now imagine that there is a market of 1 billion people but that there is no innovation of any kind. In this case, wealth creation would be greatly stunted and, with few new assets being created, wealth would become essentially a game of trading existing resources. Thus the importance of innovation. Finally, imagine a country where institutions are weak, where contract law is weak, where access to capital is difficult, where the government is corrupt and political risk is high. Here again there would not be much innovation because there would not be much capital or much incentive to innovate. Thus the importance of a favorable institutional framework.

Too many deaths

So going back to Europe, we could say that it has some innovation and that it has a favorable institutional framework, though in both cases to a lesser extent than the United States. What Europe lacks most is a strong demographic driver. It is enlightening in this regard to look at the sizes of European populations in the year 1900 vs. today:

 Population (millions)  1900 2014 Growth CAGR  TFR 
France 38 66 74% 0.5%  1.98
Germany 56 81 45% 0.3%  1.42
Italy 32 61 91% 0.6%  1.48
Russia 85 146 72% 0.5%  1.53
Spain 20.7 46.6 125% 0.7%  1.50
United Kingdom 38 64 68% 0.5%  1.88
Brazil 17 203 1094% 2.2%  1.80
China 415 1370 230% 1.1%  1.66
Egypt 8 87 988% 2.1%  2.79
India* 271 1653 510% 1.6%  2.50
Indonesia 45.5 252 454% 1.5%  2.35
Japan 42 127 202% 1.0%  1.41
Mexico 12 120 900% 2.0%  2.20
Nigeria 16 179 1019% 2.1%  6.00
Philippines 8 100 1150% 2.2%  3.07
United States 76 318 318% 1.3%  1.97

* includes India, Pakistan, Bangladesh and Burma.

Source: Various, United Nations. Data may include errors. Estimates vary due to shifting borders and uneven reporting.

Two important points stand out:

First, in 1900, European countries were not only the world’s economic and military powers. They were also among the most populous countries in the world. By contrast today, Russia is the only country in the top 10 most populous. Then Germany is 16th and France is 20th. More importantly, some of the new demographic powers, India, Nigeria, Egypt, Mexico, the Philippines and Indonesia, are growing at a healthy clip, as can be seen from their Total Fertility Ratios (TFR, see table) whereas European countries are growing very slowly at TFRs that will ensure stagnation or shrinkage in the sizes of their population. A ranking ten or twenty years from now may show no European countries in the top 20 most populous countries.

Second, comparing European population sizes in 2014 vs. 1900 reveals a very slow annual increase in the 114 year period. And this is where the effects of the two World Wars, of the Spanish Influenza and of communism can be seen. Populations have grown with a CAGR of less than 1% per year for the last 114 years.

The United States had fewer casualties in the two World Wars, more immigration and a strong post-war baby boom, resulting in a healthy 1.3% population CAGR and a near quadrupling of the population over the past 114 years. However, as I wrote previously, the US faces slower, sub 1% population growth in the next few decades.

Here is the tally of deaths for some countries in the two World Wars:

 Millions of deaths  WW1 % of pop WW2 % of pop
 France    1.7 4.3%   0.6 1.4%
 Germany    2.8 4.3%   8.0 10.0%
 Italy    1.2 3.3%   0.5 1.0%
 Soviet Union    3.1 1.8% 22.0 14.0%
 UnitedKingdom    1.0 2.0%   0.5 0.9%
 United States    0.1 0.1%   0.4 0.3%

 Source: Various. Estimates vary widely and may include errors.

Estimates of deaths from the Spanish Influenza of 1918-19 vary widely from 20 to 50 million people worldwide. And Stalin’s purges are estimated to have killed over 20 million. Tens of millions of people and a larger number of descendants would have been added to today’s European population had these events not occurred. I made the case last year that Europe’s economies and markets suffer from weak domestic demand and have for a long time been driven by events outside of Europe itself.

Too few births

In general, a large number of countries are facing a more challenging demographic period in the next fifty years compared to the last fifty. Since the 1970s, there had been a steady decline in the dependency ratios (the sum of people under 14 and over 65 divided by the number of people aged 15 to 64) of the US, Western Europe, China and others. This decline is explained by a lower birth rate and was accelerated by large numbers of women joining the work force in several countries. There were fewer dependents and more bread winners than in previous decades.

In future years, dependency ratios are expected to rise due to the aging of the population in most countries and a decline in the number of workers per dependent. In the United States for example, baby boomers are swelling the number of dependents who rely on younger generations to support them in retirement (whether through taxes or through buoyant economy and stock market). But because boomers had fewer children than their parents, the burden on these children will be that much greater than it was on the boomers themselves.

In effect, our demographics have pulled forward prosperity from future years. Had there been more children in the West in the 1970-2000 period, there would have been less overall prosperity during that time, but we would now look forward to stronger domestic demand and a stronger economy going forward.

Note in the table below that the dependency ratio of Japan bottomed around 1990 which is the year when its stock market reached its all-time high; and that the dependency ratios in Europe and the US bottomed a few years ago around the time when stock markets reached their 2007 highs. The fact that several stock indices are now at higher peaks than in 2007 can be largely credited to America’s faster pace of innovation and to near-zero interest rates. Case in point: Apple’s market value has more than tripled since 2007.


India will soon be the most populous country in the world but because its dependency ratio is still declining, its growth profile may improve in future years. The same is true of Subsaharan Africa where the fertility rate is still high but declining steadily thanks to improved health care for women and declining infant mortality. As such both India and Subsaharan Africa could see faster economic growth than elsewhere, provided the institutional framework can be improved towards less corruption and more efficiency.

Europe is in a bind in the sense that, even if it had the wherewithal to do so, it cannot now raise its birth rate without making its demographic situation worse in the near term (by raising its dependency ratio faster). For the foreseeable future, its economy will become even more dependent on exports towards the United States and emerging markets. The new frontier for European exports may well be in the old colonies of the Indian subcontinent and of Subsaharan Africa.

Facebook in a Perfect World

24 July 2014

Using Google as a comp for future growth and valuation.

Last Thursday, Jim Cramer compared Facebook (FB) to Merck (MRK). According to this Seeking Alpha report,

Cramer compared Facebook to the early days of Merck, when many were skeptical about the value of the big pharma company. Some declared Merck “the most overvalued stock on Earth,” because its valuation surpassed that of General Motors (GM). Cramer had to face angry clients when his hedge fund held Merck, but his call ended up being a winner; Merck’s products ended up becoming the biggest blockbuster drugs of all-time.


Facebook has real earnings. Cramer thinks FB could earn $3 per share for 2016, and it has 60% growth. This means it should trade at $90, a 30% premium to where it is currently trading. CEO Mark Zuckerberg outlined a multi-year growth strategy. Cramer thinks it is “preposterous” that FB is that cheap. A couple of years ago, FB had no mobile strategy, and now it is the “king of mobile.” User-generated content is good for gross margins and for advertisers. Facebook may be one of the most lucrative stocks of the era.

Generally, the business model and operations of Facebook have little in common with those of Merck. But even if Merck and Facebook were similar in some ways, it would still be possible for Cramer to be right about Merck back then and less right about Facebook today. As to Facebook’s valuation, a stock price of $75 may be cheap when we look back years from now, but only if the intervening years deliver on today’s more bullish forecasts. A long-term promise is not as good as a near-term projection. And on this and next year’s metrics, the stock certainly looks richly valued.

I mention Cramer to make a point about the way investors influence each other’s decisions. I wrote recently that, because investors and traders influence each other, for example through shows like Cramer’s Mad Money or articles on Seeking Alpha or other platforms, large cap stocks like Facebook and Apple (AAPL) could at times be mispriced by very wide margins of 20%, 30% or even 50%+. We certainly saw how this could be the case in the bubble of 1999-2000 and again in 2006-07. And we are now again in a similar ‘influence’ game which further pushes up market favorites, against a very helpful backdrop of near-zero interest rates.

Instead of Merck, the company that is probably a good comp to Facebook today is Google (GOOG). Not a perfect comp, but close enough. So here is a comparison of their evolution.

Facebook’s market cap is now very close to $200 billion. Its projected sales for 2014 are around $12 billion, which means that its stock is trading at over 16x forward sales. To many, this valuation seems justified by Facebook’s very high margins and growth rates.

Google’s market cap reached $200 billion for the first time in 2007. Back then, its revenue growth rate was similar to that of Facebook today (not far from 60%) and its margins were slightly lower. Google stock in that year traded in a range of 8 to 14x sales, significantly lower than Facebook today.

Judging by what happened in subsequent years, you could say that Google’s 2007 peak valuation was justified. Since then, Google’s market cap has doubled to exceed $400 billion today. So if you are a Facebook bull, you can pencil in $400 billion as a target market cap and $150 target stock price.

The main problem with this logic is that things rarely evolve in a linear fashion. In other words, on the road to $400 billion and $150, we may first see $100 billion and $38.

An investor who bought Google stock in late 2007 and who held until today has outperformed the S&P 500 by a wide margin. But all of this outperformance has occurred in the 18 months from July 2012 to December 2013. In 2008, Google stock crashed like everything else, falling by two thirds, and its stock did not regain its 2007 high until late 2012.

Nonetheless, despite the 2008-09 crisis, Google sales continued to grow, albeit at a lower rate. Revenue growth was 56%, 31%, and 9% in 2007, 2008 and 2009. It reaccelerated in the subsequent years 2010-2013, to 24%, 29%, 32% and 19%.

Screen Shot 2015-04-22 at 4.15.25 PM

(Tables show 2014 year to date.)

As shown in the table, these are attractive growth rates but a far cry from what they were in the years to 2007. Even if you ignore the 2008-09 collapse, sales growth at Google has been on a long-term downward trend. It is very difficult if not impossible for a large company to maintain 50% growth rates.

Screen Shot 2015-04-22 at 4.15.25 PM

Going back to Facebook, there are no doubt multiple justifications to hold the stock: the increased role of mobile, the potential for higher revenues per user, the integration of acquisitions etc. But a long position is betting on both flawless execution and a supportive macro environment.

At current valuations, the stock is priced for perfection not only at the micro level (its own operations) but also on the macro level (the overall economy and market). The odds are we will not see a major crisis like 2008 again soon, but what happens to Facebook stock if the economy slows down? Advertising is a notoriously cyclical business. What if Facebook’s own growth rate slows from 60% to a still strong 30%, as happened at Google? From a level of 16x sales, Facebook’s stock would certainly fall by 20%, 40% or more, depending on the severity of the slowdown.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Facebook stock or any other security. The reader is responsible for any loss he may incur in such trading.

Large Stocks Are Widely Mispriced

11 July 2014

Research suggests that when investors influence each other, the stock market becomes less efficient.

A different perspective

Conventional theory holds that the stock market is efficient and that it does a good job pricing stocks at or close to their fair value, in particular the stocks of large widely followed companies. But could the opposite be true? Could it be that the larger and more followed companies are the less efficiently priced by the market? Could it be that their market value is chronically 20%, 30%, or 40% off from their fair value?

Here is the theory. Assume that there is a finite number of investors, say 1,000 investors, who are active in the stock market and that they each independently derive a value for each stock in the S&P 500. ‘Independently’ here means ‘without sharing thoughts with each other and without letting themselves be influenced by other sources’. Under these admittedly improbable circumstances, the resulting level of the S&P 500 would be quite close to ‘intrinsic value’. We could say that the market would be ‘efficiently’ priced.

Now assume instead that the 1,000 are not working independently but that they influence each other, sharing valuation models, qualitative opinions, price targets, etc. Under these circumstances, the level of the S&P 500 would deviate, in some cases significantly, from its intrinsic value. The market would be inefficiently priced.

This at least is the conclusion you can draw from some recent research on collective decision-making. A recent article titled When Does the Wisdom of the Crowds Turn Into the Madness of the Mob? explains it (my emphasis):

When can we expect a crowd to head us in the right direction, and when can’t we? Recently, researchers have begun to lay out a set of criteria for when to trust the masses.

Democratic decision-making works well when each individual first arrives at his or her conclusion independently. It’s the moment that people start influencing each other beforehand that a crowd can run into trouble.

Philip Ball, writing for BBC Future, describes a 2011 study in which participants were asked to venture educated guesses about a certain quantity, such as the length of the Swiss-Italian border:

“The researchers found that, as the amount of information participants were given about each others guesses increased, the range of their guesses got narrower, and the centre of this range could drift further from the true value. In other words, the groups were tending towards a consensus, to the detriment of accuracy.”

“This finding challenges a common view in management and politics that it is best to seek consensus in group decision making. What you can end up with instead is herding towards a relatively arbitrary position.”

If the research is valid, it debunks the idea that a widely followed stock is efficiently priced. It is not uncommon to hear someone say: “this company is followed by so many people that I have no edge investing in it”. The opposite is almost certainly true: the more widely followed a stock is, and the more ‘influence’ is traded between the participants, the more certain you can be that its market price is wrong, and possibly wrong by a substantial margin.

Take Apple stock for example which is followed by a large number of analysts and investors. When it comes to AAPL price targets, can we say, to paraphrase the article, that the “range of their estimates got narrower, and the center of this range has drifted further from the true value?” And are investors as a group “tending towards a consensus, to the detriment of accuracy?” Investors tend to cluster their price targets not far from the current price which is now $95. But we can theorize that Apple’s intrinsic value is not $100 or $90. It is probably much further from its current market price, say $70 or $120.

Another conclusion can be drawn. When discussing their investment process, fund managers tend to put emphasis on the individual expertise of sector analysts and on their team’s collaborative discussions. In a typical model, the sector analyst will initiate an investment idea and pitch it to a fund manager or to a team who will then reach a decision on how to proceed. In this case, the sector analyst may have been influenced by his peers, by the sell-side and by other sources. And the deciding team members, while searching for a consensus, may have been influenced by each other, by the analyst, and by some willingness to defer to the analyst’s expertise.

If you believe the research described above, this is not the best approach to choosing investments for a portfolio. A better approach would be to have 5 or 10 analysts value the same stock independently, without looking at other sources. It might also be better if these analysts were generalists instead of sector specialists who may be biased in favor of their sector. Once the work is done, there is no point in having any discussions which may prove to be counterproductive. In theory, ‘discussion’ means ‘influence’ and it would result in more bad decisions. It is better to simply look at the valuations derived by these independent analysts. If the average of their price targets is way off the market price, it would be worth initiating a position.

Coach: Two Opposed Ideas

Coach speaks the language of luxury but it is increasingly running a volume business.

F. Scott Fitzgerald wrote in The Crack-Up (1936) that “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function”.

Whether the same applies to corporate strategy can be the subject of doubt. But it is clear that Coach’s “one brand, two distribution channels” approach has not delivered the growth and earnings expected by shareholders. Coach is trying to elevate its brand in one channel, full price stores, while at the same time unwittingly depreciating the same brand through another channel, factory stores. An outside observer can be forgiven for viewing these efforts as “two opposed ideas in the mind”.

The most successful companies tend to have a clear unambiguous mission and message. But Coach appears to be, on many levels, a company that is mired in ambiguity, or even confusion, which explains why its stock has drifted aimlessly for over a year while peers Michael Kors (KORS) and Kate Spade (FNP) have scaled new highs.

Here are a few questions about Coach, with ambiguous answers:

Is Coach a luxury goods company?

Yes. Its handbags come with a quality and price tag (several hundred to over a thousand dollars) that put them in the category of luxury for most consumers. It has “full price stores” in prime locations such as New York’s Fifth Avenue. Coach offers accessible luxury at a price point where the European luxury players cannot compete effectively.

No. Coach’s pricing is far below that of European über luxury names like Hermès, Bulgari or Louis Vuitton. Coach derives two thirds of its North American sales from lower-priced sales at factory outlets. That is nearly half of total sales, a percentage that is too high for a true luxury company.

In addition, Coach runs too many discounted sales for a luxury company. Between Thanksgiving Week and the end of the year, I counted no fewer than a dozen discounted sales on Coach’s Twitter account. (Side note: It is not clear why Coach advertises some of its discount sales as “Semi-Annual”. This practice encourages some customers to just wait a few months for better prices).

Semi-Annual Sale
Coach Stock: Another Semi-Annual Sale

– Will Coach be a growing company again?

Yes. The company is seeing rapid growth in its men’s line and in international sales, most notably in China. International comps will improve in 2014 as the Yen’s near-30% decline phases out gradually. An acceleration in the US recovery will help North American sales rise again.

No. North America sales are in decline due to structural, not cyclical, reasons, in particular the aging of Coach’s customer demographic.

Does Coach have a strong management team?

Yes. Coach is highly profitable, generates strong cash flow and has no debt. Management has taken decisive steps to develop new revenue streams. For example, the men’s line now accounts for over 10% of total sales. And sales in China are booming.

No. Coach was too slow to develop a foreign presence. In North America, an overreliance on factory outlets has damaged the brand. And the effort to transform Coach into a broader lifestyle brand raises its risk profile since it is no longer just “sticking to its knitting”.

Is Coach still a hot brand?

Yes. Coach’s new creative director, Stuart Vevers, will reinvigorate the brand with new products that will be introduced this week at Fashion Week in New York.

No. Michael Kors, Tory Burch, Kate Spade are the new hot brands. Coach is associated with an older demographic and is past its prime. It will be difficult to rejuvenate the brand.

Is Coach a good investment?

Yes. It has a low valuation and strong cash generation. Growth will return in 2014. The disconnect between valuation and profitability will correct itself through a rise in valuation.

No. North America will remain a problem for a long time and margins will continue to erode. The disconnect between valuation and profitability will correct itself through a decline in profitability.

Scale vs. Exclusivity

Adding to the confusion are some statements by Coach executives in recent weeks. Here are two examples:

Francine Della Badia, President of North American Retail, at a Morgan Stanley Conference (full transcript here): [my emphasis]

“We’re very proud of our factory business and our factory consumer, and if you think about economics alone, there is more scale available to us to participate in a handbag category that’s under $300 than at our full-price average unit retail of $300. So I love our factory business, I’m very proud of our factory business.”

If I am interpreting this message correctly, Ms. Della Badia is saying that Coach can make more money selling a large number of sub-$300 handbags at factory outlets, than a smaller number of higher priced handbags at full price stores. This is disconcerting talk from a luxury goods company.

But it fits a now familiar pattern: Coach likes to speak the language of luxury but it is largely pursuing a mass-market volume strategy. Coach continues to open new stores at factory outlets.

The second statement is from Coach’s recent earnings call in which Kimberley Greenberger of Morgan Stanley asked whether the outlet business damages the brand. Although we all know the straight answer to this question, the circuitous response offered by new CEO Victor Luis was revealing (full transcript here): [my emphasis]

GREENBERGER:  “Victor, you mentioned the endeavor to restore brand equity, and I’m just wondering, how do you think about that effort over time with the ongoing increase in square footage in factory? It would seem in some ways that those two things worked against one another, given that typically expansion in factory is not really brand enhancing. It certainly increases distribution opportunity, but having more discount product out in the marketplace would not really seem to be congruent with the effort to restore brand equity. So I’m just wondering if you can help us with how you think about those two opposing forces.”

LUIS: “It’s obviously a question we get often, and what I would share is that we believe the brand, first and foremost, must be led through the full price channel. And what you see, again, in Lower Fifth, what you see in South Coast Plaza, in terms of a direction for the future of our fleet and the equity that we want to drive through that fuller lifestyle experience, where consumers are engaging with the brand differently, without a doubt will be both a business driver but just as important, if not more so, the halo for the entire multichannel strategy that we have.”

“Outlets, in terms of their importance globally, are unquestionably the fastest growing certainly bricks and mortar channel in the luxury space. That is not only true for U.S. based multichannel brands. It is increasingly true for European and traditional luxury brands who are driving further relevance for the channel globally, whether it be here in the U.S., where it’s quite a mature channel, but of course increasingly in Europe, and now, more than ever, increasing in China and the rest of Asia as well. And so as that channel grows, we want to make sure that we participate in it, and take our fair share there.”

And further:

LUIS: The key is not just to see it as a promotional channel, but to see it as a channel which is of relevance to a certain consumer, who does not shop in other channels, and where we have the leadership position and see continued growth moving forward.”

What Mr. Luis is saying, again if I am interpreting this correctly, is that the full-price store is an important driver of the company and “just as important, if not more so”, it is a place to valorize the brand and the factory outlet business. If this means that the luxury higher end business is an important place to advertise the factory outlets, then we are in tail-wags-the-dog mode with full-price stores seen as essential to boost factory sales, instead of factory stores seen as an unfortunate but needed outlet to clear some excess inventory.

Both Ms. Della Badia’s and Mr. Luis’ statements indicate that the factory store is one of the company’s core businesses, if not the main core business. But this business poses a threat to brand equity, to growth and to profit margins.

Losing Exclusivity

Coach’s strategy dilutes its “exclusivity”. In a recent study on the global luxury industry and survey of 10,000 core luxury consumers, the Boston Consulting Group (BCG) and Altagamma indicated that 25% of luxury brands are at risk of losing their exclusivity. Antonio Achille, partner and managing director at BCG, said this: [my emphasis]

“Exclusivity is a core attribute that a brand and a product must have for core luxury consumers. Brands need to recognize that there are several ways to lose exclusivity, some of which can be only partially controlled, such as fake copies, but others are in control of the brand, for instance, discounting too often, too intense use of licenses or poor distribution. Once exclusivity is lost, the equation to rebuild it is very complex, takes time and there is no guaranteed success.

In my last article on Coach, I speculated that it may be the target of a takeover. Since then, the stock has made a round trip from the high 40s to the high 50s and back. This is yet another iteration in a tug of war between some investors who have given up and others who keep waiting for Coach to perform.

Fitzgerald’s next sentence in The Crack-Up was: “One should, for example, be able to see that things are hopeless and yet be determined to make them otherwise.”

Will Coach shareholders make things otherwise?

P.S. Michael Kors reported another stellar quarter this morning.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Coach stock or any other security. The reader is responsible for any loss he may incur in such trading.

Euro: Austerity, Breakup or Devaluation?

In a new book, Nomura’s lead currency strategist warns that the Euro is on an unsustainable path.

“I wrote this book because I care about Europe”, writes Jens Nordvig in the preface to The Fall of the Euro.

European by birth and living in New York, Nordvig, who is Global Head of Currency Strategy at Nomura, has a unique understanding of the factors that led to the creation of the Euro, and of the impact that the Euro crisis has had on financial markets.

He also has some unsettling insights about the future.

Breakup or Exit

Many people have speculated on the breakup of the Euro. But is a breakup feasible?

Legally speaking, It would be relatively easy for each Eurozone country to redenominate the Euro assets and liabilities which are within its jurisdiction back to its national currency. But, writes Nordvig,

“What would happen to financial assets and liabilities that were outside the jurisdiction of the Eurozone countries if the euro ceased to exist?… What would happen to a loan made in euros by a US investment bank to a big industrial company in Poland? Would the loan now be in US dollars? Would it now be in Polish zloty?… The lender might have one preference and the borrower another. There would be a potential dispute of this nature for every single financial contract…These disputes would be the catalyst for widespread legal warfare…There would be trillions worth of assets and liabilities denominated in “zombie euros” and outside the reach of Eurozone governments… There was no example of this in history.”

If the obstacles to a full breakup seem insurmountable, the exit from the Eurozone by one or several countries look by contrast to be more manageable. Here as with many Euro-related decisions, the outcome will likely be dictated by politics.

Although the weaker countries are seen as likely candidates for exit, Nordvig notes that any benefit they would derive from reverting to their weaker national currencies would be largely offset by the magnified burden of having to service their Euro-denominated debts.

Nordvig also explores the scenario of a German exit, an option which he views as feasible but improbable.

Austerity or Devaluation

A “hard currency equilibrium” has prevailed since 2012 but this equilibrium is entirely dependent on periphery countries (Italy, Spain, Portugal, Greece, Cyprus) sticking to tough austerity measures. In this scenario, adjustment will take several years before a strong recovery can return.

Should austerity prove unsustainable, the Euro may find a “soft currency equilibrium” in which debt limits are ignored and rescue conditions are relaxed. According to Nordvig, this could turn the Euro into a weak currency not dissimilar to the former Italian Lira.

Bond spreads have tightened and stocks have risen since the dark days of 2012 but Nordvig cautions against complacency:

“Investors should be on the alert and not be fooled by the relative market calm observed since the summer of 2012. There is a difference between bond yields that are consistent with fundamentals and yields that have been artificially pushed lower as a result of insurance from the core.”