Cyprus - severely wounded with euro exit the likely ultimate outcome

 

So, the banks in Cyprus finally reopened today at 10.00 UK time, freshly filled with newly minted ECB euros and transported in armored trucks overnight (to keep the rioting masses at bay!) as the Cypriot authorities were concerned with what could happen when the banks reopen. The British company G4S (they obviously know nothing about the Olympics fisaco…) will in fact provide 200 men to help police ensure the safety of banks and the people of Cyprus.

There are fears that even with the various capital controls imposed by the authorities that money could disappear from the banks in just a few hours due to fear-led huge withdrawals - who can blame them? Cyprus actually has a record amount of money deposited per inhabitant. With just 860,000 people, total deposits amount to €68 billion, which averages €79,000 per person although that is skewed by very large deposits from a number of Russians - a very bad move on their part given the haircut’s they are taking now!

After failed negotiations with the EU and a veto on the initial plan A, which sought to confiscate 6.75% of deposits under €100,000 and 9.90% on deposits over that amount, Cyprus leant on Russia in asking for help - to no avail in the end however. Ultimately, in an 11th hour deal in the late hours of last Sunday, her politicans reached a deal with the EU under which the main Laiki Bank will be dismantled and its assets sold. Depositors  with in excess of 100,000 euros initially take a cut of 40% on deposits over €100,000 whilst deposits below this figure will be honored in full albeit in staged withdrawals per the capital controls. The tight capital controls include a maximum daily cash withdrawal of €300, no cheque’s, a limit of €5,000 credit card spending per month outside Cyprus and no one can leave Cyprus with more than €1,000 in his pockets!

Even though cash will not be withdrawn all at the same time, we’re certain that here people will try to get as much as possible out of the banks and the country - certainly the larger depositers near the 100,000 euro threshold. At the same time, if you were a business, would you accept payments other than with cash? So cash will be more valuable than any other means of payment and the economy will most likely struggle in the short terms. We expect the financial system to almost freeze and the country ultimately be pushed to a situation under which it not only needs but actually wants to leave the Euro - just look at the zombie state of Greece as a consequence of remaining in the euro… Cyprus is a much more palatable exit.

How will Cypriot businesses survive without liquidity? How will new projects get financing. Will the ECB provide it? Temporarily, yes, but we doubt they will continue to finance if they see money wholesale leaving the banks. What could be a small and contained problem may become a huge blow in the Eurozone. Messing with deposits changes rules. It was previously sacrosanct and we think the repurcussions of this will be far reaching.

If deposits aren’t safe anymore and Governments may take your money, especially in peripheral European countries - what fait can citizens of Greece and Portugal for example have in the integrity of their banking systems and the implicit trust in making a deposit? This is what may be the slow burn that accelerates once more the euro crisis for the 3rd summer in a row.

Cash has in fact already started leaving those peripheral countries in the form of reduced demand for sovereign debt as we have seen in Italy yesterday for example. Yields are rising again, having surpassed 5% in Spain on 10-year debt, and hitting 12% in Greece, while the German government can continue raise money at a miserable 1.32% rate. This is the consequence of the new deposit measures. Money flows from periphery to the centre. This new “bail-in” way of solving EU problems is the most dangerous route so far within the region and one that will help the fragile European economy sink again in our opinion.

With unemployment rates around 20% and GDP heading south, how can you sell the idea the Euro is the best place to remain for the peripheral countries? You just can’t, and as a consequence of this, euro-skepticism is rising as never did.

The Euro is losing once more against all the majors today. After hitting 1.37 against the dollar, the Euro is now trading around 1.28 and threatening to go even lower. In fact, it is our opinion the common currency is trading much above what it should be - realistically against the Pound it should be 1.30-1.35. The matter is not only an economic issue but also political one. If mining in some African countries is seen as a risky business due to political instability, depositing money in Europe is also a risk, so why not look elsewhere? With banks charging to keep your money unsafe, it is time to buy a good mattress with a safe vault under it.

Is it time to load up the truck once more on the Mining Sector?

It seems like it was only a few weeks ago, and indeed it was, that we relayed the best performers in the FTSE 350 were our picks of Lonmin, Bumi & ENRC. Well, in the space of just over 3 weeks, certain of the mining stocks have fallen by almost 50%. Yes, that’s right 50%, whilst the FTSE has rallied towards new highs. This is actually one of the fastest dislocations in the market of sectors since late 1999/early 2000 when the “old economy” stocks were sold down to crazy levels whilst tech stocks moved to stratospheric ones. Are we in a similar situation again with the likes of Kazakhmys down some 43% from where they were at the end of Feb?

Out of 38 FTSE 350 sectors, there are in fact only two in the red this year as global monetary easing has continued to pump confidence higher and cause investors broadly to return to the equity asset class. Lagging behind almost every sector is mining which is currently showing a loss of 8.6% for the year, only better than that of industrial metals which has lost more than 17%. Is there a reason for this massive underperformance experienced in mining and in particularly in the gold miners? There are some good reasons why the mining sector isn’t rising with pockets of oversupply, renewed corporate governance fears, recent large scale asset write downs etc but in relative terms, we think this is an excellent multi year opportunity to add certain stocks to one’s portfolio.

While it is becoming tougher and tougher to justify buying shares at the top of the performance ranking tables, there are some good reasons to pick up gold miners. The sector is out of sync with gold prices and many companies are trading at a near generational discount in terms of book value. We should expect some M&A activity in the near term as the stronger capitalised companies take the opportunity to consolidate. We suggest you read the latest edition of our magazine in which we pick 5 gold miners for the medium term. We included four UK companies and one from the USA: Avocet Mining, Aureus Mining, African Barrick Gold, Amara Mining, and Iamgold.

We havein fact been bearish on gold since the autumn of 2012, due to the mix of an improvement seen in the US economy, a decrease in the Eurozone’s “perceived” problems (Cyprus notwithstanding!), a wholesale move into riskier assets, and more recently the relatively mild solution to the fiscal cliff and debt ceiling issues in the US. All these factors highlight the fact that gold is even more costly to hold as investors are losing opportunities with the rising equity market and so diminishing further the attraction of gold. Even though all these factors are against gold prices and somewhat against gold miners too, we are still confident in the sector as we believe there is a massive disjoint between gold prices and gold miners that must be filled.

If we look at the following chart, we can see that while the gold price has been moving sideways since July 2011, gold miners have been losing value at a rapid rate. The link between the two has been broken and mean reversion will likely occur. We expect the gold mining sector to rally materially throughout the balance of the year on the back of M&A and an asset allocation rotation into the sector by institutional investors.

While gold has risen 7.2% since July 2011, the FTSE 350 mining sector has lost 31.4% and gold miners, or if measured by the Market Vectors Gold miners ETF, 30.1%.

Gold mining is an operationally geared business. Explorers usually have high fixed costs with their revenues highly dependent on the price of gold. When gold rises, share prices of gold miners are expected to rise by a greater degree than the rise in gold prices and vice versa. That hasn’t been happening for nearly 2 years now and as a result Many are trading at a heavy discount to book value and on EV:EBITDA ratios of sometimes just around 2 -  a level which is usually a steal.

The wider mining sector is also heavily oversold at this point with Rio down 25% this past month, Lonmin a similar amount, ENRC almost a third from its peak and worst of all Kazakhmys nearly 50% - in the latter’s case it is trading at a discount to tangible book of almost 40% and this includes writing ENRC down to current value.

Kazkhmys relative to FTSE YTD

We contend that we are within days of a sharp rebound for the wider sector and called the turn almost to the day last November (see here - http://www.spreadbetmagazine.com/blog/second-train-leaving-mining-sector-opportunity.html). We have positioned ourselves accordingly.