Posted by: Simon Lack | December 21, 2011

Why the Euro is Likely to Remain a Good Short, and Another Good Year in MLPs

Euroland euphoria has broken out – so say Ambrose Evans-Pritchard and Louise Armitstead of the Daily Telegraph. Mario Draghi rode to the rescue with Long Term Repo Operations (LTRO), and it’s now reported that Eurozone banks borrowed 489 billion Euros from the ECB for three years. If they are so moved they can engage in the carry trade, buying southern European sovereigns and steadily recapitalizing themselves. The symbiotic relationship between Euro area governments and their banks assures that they can only survive together.

It illustrates the multiple tools available to the ECB and the Eurozone to avoid catastrophe. And betting on a Eurozone collapse is to place your chips on one specific number at the roulette table, with a commensurate low likelihood of success but a big payout. But choosing red pays much better than 2:1, where red is defined as long U.S. equities hedged with a short Euro position. It’s analogous to borrowing money in Euros to buy risky assets. There is already so much excess debt issued by European governments that you can be reasonably assured they’ll do everything they can to stop the cost of funding it going up anytime soon. It’s clearly in their interests to keep borrowing costs low, and the ECB has few measures with which to combat a depreciating Euro. Ultimately the Eurozone needs real GDP growth, and so the current procyclical policies being followed (fiscal austerity during a recession) are likely to make it a long road back to better economic times.

The correlation between the Euro and the S&P500 (SPY) has been increasing in recent months, not surprisingly since Europe’s issues are the major risk visible to investors. But the attraction of combining long equities with short Euros, with a hedge ratio of around 0.4, is that the Euro is unlikely to rally strongly without an equivalent reaction in stocks, whereas a European disaster will see the Euro leading stocks down. The GDP 2.5%+ differential between the U.S. and Eurozone in 2012 provides a steady US$ bias.

MLPs have had another strong year, delivering 12% so handily outpacing high-grade bonds and far better than stocks. We own a diversified portfolio of midstream names including Kinder Morgan (KMP), Plains All America (PAA) and Williams Partners (WPZ). Identifying sources of income is every investor’s challenge given today’s punitively low interest rates. MLPs can be part of the solution.

Disclosure: Author is Long EUO, KMP, PAA, WPZ

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