Europe Is A Long Term Ticking Time Bomb

February 9, 2017

Europe Is A Long Term Ticking Time Bomb

  • Europe is made up of many countries, which means there are even more politicians that just want to get reelected creating an immense short term attitude.
  • Don’t buy Europe just because it underperformed the S&P 500, and don’t buy European debt at single digit yields.
  • Tightening won’t work as many countries have an average debt to GDP ratio above 85%, therefore there is a high chance that the Euro remains weak for longer.

Introduction

The IMF just reported that the situation in Greece is getting better, but the debt is unsustainable. This contradictory as it implies a long term catastrophe and short term positivity. I’m flabbergasted on a daily basis by the incapacity or unwillingness of the financial world and monetary institutions to look at the long term.

That’s why I’m here. To warn you about impending catastrophes and perhaps even increase your returns in the process.

The world is a multivariable equation, so it’s important to follow what’s going on because it will impact all returns in the long term. Smartly adjusting your portfolio around global imbalances can lower your risks while also increasing your returns.

Let’s first take a look at what’s going on in Europe to see if it can affect global markets.

Europe

Unlike the U.S. or China, the European Union is formed by many small countries.

I’ll never forget a piece of advice received from a successful entrepreneur: “Try to hire as little as possible and outsource as much as possible because every new head in the office is an additional headache.” The same principle can be applied to Europe, many heads lead inevitably to many headaches.

The latest headache comes from Greece. The International Monetary Fund published its latest evaluation on the country three days ago. To summarize, it’s a ticking time bomb. External debt is 245%, while public debt is 183% of GDP. Unemployment is at 23.2%, while the fiscal overall balance continues to be negative.


Figure 1: Selected economic data on Greece. Source: IMF.

With such an economic indicator, one thing is clear: if the ECB starts raising rates, there is only one outcome for many European countries, bankruptcy, as many countries have debt to GDP ratios above 85% and continue to create deficits even though Europe as a whole is in a positive economic period.


Figure 2: Eurozone debt to GDP levels. Source: Debt Clocks.

Debt levels increased due to the financial crisis which resulted in a 50% increase in European debt to GDP levels. However, there seems to be no intention to lower the debt burden.


Figure 3: EU government debt in the last 10 years. Source: Trading Economics.

The issue isn’t the aggregate levels but the fact that if one of the above countries falters, the repercussions will be significant for all other member states and felt around the world. Further, interest rates have been kept artificially low.

Who in their right mind would buy the 10-year bonds of a country that has been in default for approximately 50% of the period since its independence, with a yield of only 4.92%? It’s incredible how people soon forget that the situation in Greece remains unsustainable, and are willing to buy such a low yield. Those investors have lost 50% in the last two weeks and even more in the last month.


Figure 4: Greeks 10 year yield. Source: Investing.

Another blatant example is the Italian 50-year bond which sold for a 2.85% yield back in October 2016. A month after the sale, the losses for the bond holders already amounted to 14% as Italy went back to its vicious cycle of political insecurity. Similarly to what is going on in Greece, rates have started to increase in Italy too.


Figure 5: Italian 10 year yield. Source: Trading Economics.

When your debt is more than 100% of GDP, every small move in interest rates is extremely significant. Europe has been recovering well in the last two years alongside lower yields but if the trend turns, and it looks like it’s turning, there could be trouble. The last time rates started rising was in 2011 which lead to the 2012 European Recession.

The low yields are the result of the European Central Bank’s Quantitative Easing program where the bank buys bonds, and it even goes so far as to buy corporate bonds. The ECB has announced it will extend its bond buying until December 2017. If rates increase too much and start hindering recovery, we might see even more easing and helicopter money could also be a possibility as monetary policies haven’t done that much in the last 7 years and growth is still slow.

What To Do Investment-Wise?

Blackrock suggests buying European stocks as it sees them selling at a discount toward U.S. stocks, and thinks the fear of political turmoil coming from French and German elections is overstated.

On the currency side, the Euro has gained some territory in the last month but given the current political unrest, it’s losing again against the dollar as has been the case for the last 3 years.


Figure 6: USD per 1 EUR. Source: Bloomberg.

It’s tempting to just buy European stocks given their relative underperformance and given the fact that the dollar is so strong right now. The European stock index underperformed the S&P 500 by ten percentage points with an additional loss of around 5% from the weaker Euro.


Figure 7: Stoxx Europe 600 index vs. the S&P 500 in the last 12 months. Source: Bloomberg.

However, buying something just because it looks undervalued in comparison to something else isn’t a good reason to do it.

Don’t buy European debt at these yields because they could easily go up, while how much they go down depends mostly on what the ECB does.

The main issue with Europe is that we have an extremely artificial environment where the Central Bank is even buying corporate bonds. This is like using drugs. Market participants and countries will easily become addicted and it will be a difficult thing to turn around.

As for investing, Europe looks like a two sided medal. On the one side, we have the weak Euro which should increase the competitiveness of European businesses and lead to an advantage toward the dollar in the long term.

The other side of the medal shows us that the risks are multiplied because it’s sufficiently possible that if one of the 9 European countries with debt to GDP ratios over 85% goes under, it’ll start a chain of disaster.

Further, it’s questionable how another ECB intervention would affect the Euro. It could send the Euro to historical lows to the dollar.

Conclusion

In regard to Europe, it’s much easier to conclude with what not do to than what to do. What not to do is simple, stay away from debt, stay away from highly indebted stocks, and stay away from high valuations, thus ETFs. Many U.S. companies have a high level of European exposure, so investing through them would lower the risk while still providing the potential upside from an eventual, probably short-term, improvement in the Euro.

One thing to do is to find great companies that will do well in any environment at low valuations. Fortunately, Europe is pretty big and it’s possible to find companies that manage to grow in a segmented market like Europe, but it will require a lot of digging in various languages.

On the global front, turmoil in Europe could spill over and lead to a global slowdown and a U.S. recession. This would require more easing which would probably inflate the money supply. Therefore, apart from great companies at low prices, the only other option to look at are precious metals. Keep an eye on Investiv Daily for an update on precious metals as they are rallying at the moment.