Europe Is Drinking Its Own Kool-Aid

February 5, 2018

Europe Is Drinking Its Own Kool-Aid

  • Europe is full of confidence which is good, but is it really that healthy?
  • Listening to the Davos ‘global leaders’ tells you a lot about what is going on.
  • Yes, Mario Draghi is a magician. Be careful that your money doesn’t disappear.



Introduction

A recent Wall Street Journal video from Davos interviewed many global leaders about the European economic upturn. The level of confidence in their words amazed me because from my perspective, Europe is in deep trouble.

Let me first tell you who said what and then we’ll look under the hood.

Confidence In Europe Is Sky-High

Here’s what was said, and by whom, in the WSJ interview.

David Rubenstein, Co-executive chairman of the Carlyle Group, said that prices in Europe are still pretty low and that Europe is actually a pretty good place to invest now because Mario Draghi, to quote: “has been a magician … in making sure the economy did pretty well.”

Ken Moelis discussed how there is more stability in Europe, the feeling is that Europe will push through the negative effects of Brexit.

David Serra, CEO of Algebris Investments, believes that in the next 3 to 4 years we will see in Europe what we’ve seen in the States in the past 3 to 4 years.

Jonas Priesing, CEO of the Manpower Group, praised the Marcon government for what it has done in the French labor market as he says it was more than what had been done in the previous 40 years.

Isabelle Kocher, CEO of ENGIE, discussed how the atmosphere is very positive and France is back.

Wopke Hoekstra, the Dutch finance minister, praised themselves that they have done great things on the field of supervisory and resolution in favor of a banking union in Europe.

Pier Carlo Padoan, the Italian finance minister, expects to bring many Europeans back to the labor market by applying new technologies.

Now, I don’t know what they give these people to drink at Davos, or if it’s the rarefied high altitude air, but what these people have to say is the biggest pile of bullshit I’ve heard in a while. It also signals that the situation is extremely dangerous because when you look at similar situations historically, when people have been extremely confident based on past success, things didn’t turn out that well. Just think of Irving Fisher saying that “Stock prices have reached what looks like a permanently high plateau” in September of 1929, or about how in early 2007, Ben Bernanke was mostly concerned about the economy growing too fast in the future.

Therefore, when I hear such a bunch of “global leaders” speak with such confidence, I get really scared. However, there is one thing I 100% agree on. Mario Draghi, the European Central Bank president, really has been a magician as he has printed so much money out of thin air that it puts David Copperfield to shame.

I’d say that confidence is good, but not when it comes to free money. People are so accustomed to free money that no one sees it as a problem, but don’t forget that the ECB is still injecting 30 billion Euro in the economy every month. How confident would you feel if someone was buying all the bonds you could issue and most of them at negative interest rates, which means that you can borrow now and return less money later.

Figure 1: ECB monthly pace of bond purchases. Source: Bloomberg.



This has led to distorted financial markets which has spilled over to customers. Just as an example, real estate prices in Amsterdam have increased 60% in the last 4 years.

Figure 2: Happy I bought a home in 2014, but this is just paper gains. Source: Financieel.

The ECB still holds interest rates at zero and it even charges banks 0.4% on the money they hold at the ECB. It seems to me Europeans are high and have become addicted to free money.

Figure 3: European interest rates. Source: Trading Economics.

To me personally, any country—or federation in this case—that has had interest rates at zero for almost 4 years and has been buying both government and corporate bonds at negative interest rates is sick beyond repair.

Of course Italian banks don’t look risky as they can get free money. Greece didn’t go bankrupt because of even more free money. Spain and France are strong because of high liquidity levels. Don’t forget that the ECB has been increasingly buying French bonds so that the situation in France remained stable and Macron won the elections.

Figure 3: ECB purchases pre-French elections. Source: CITI.



I can go on and on about how European demographics look terrible, or how the youth unemployment rate is sky high and there is a low development of human capital while the growth comes from free money, etc., but I’ll focus on something else that has been bugging my mind, a currency crisis.

Currency Crisis

Even if the system looks stable, the extremely low interest rates have made it extremely fragile to higher interest rates. As the situation is similar in the U.S., Europe, and Japan, the next financial issue might not come in the form of a stock market crash but in the form of a currency meltdown where people lose faith in their currencies.

Only after 8 years of heavy monetary stimulus has Europe reached a relatively good growth rate. As soon as the stimulus slows down, there will be turmoil that will be solved with more stimulus. This can go on until, to keep it in a European spirit, someone yells that the king is naked (Hans Christian Andersen – The King’s New Clothes).

First, if you are in the U.S., don’t be tempted by the lower valuations in Europe and the stronger Euro. If you are a trader looking for a short term play, ok, but if you are a long term investor, it’s better to look for international diversification in Asia or in South America. If you are from Europe, take advantage of the strong Euro to invest abroad.



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