The situation in the eurozone is rapidly spiraling out of control. The latest member to join the deadbeat club is Italy.
Italy could find itself in the same position as Ireland, Portugal and potentially Greece. Before the crisis unfolded in Greece it had a debt to GDP ratio of roughly 115%. Despite all the deep cuts, the situation has not improved. The debt to GDP ratio now is in excess of 150%. Italy has a debt to GDP ratio of roughly 120% today. The government of Berlusconi was sparring until the end to find ways to reduce the deficit. Eventually, he was kicked out, and the hope is now that the new guy in charge will be able to pull a rabbit out of his hat.
Despite having approved the new austerity measures there is no guarantee that these cuts will prevent the situation from escalating out of control. If the economy weakens, then these cuts could have the impact of further depressing growth, which in turn would mean that the debt to GDP ratio could rise despite these recent cuts. This in turn would necessitate even further cuts, potentially creating a vicious cycle that feeds on itself. This is the situation Greece finds itself almost two years after implementing its first cuts.
Economists are already projecting that the eurozone is close experiencing another recession. Given that at best economic growth is going to be anemic, the recent cuts approved by the Italian government will not be enough to keep debt in check. Ultimately, we feel that it is just a matter of time before Italy and maybe even Spain are both forced into seeking some sort of bailout.
Let us not forget that both Ireland and Portugal are closely watching how the situation unfolds with regard to Greece. Now that 50% of Greece debt is about to be canceled, you can rest assured they are going to want better terms going forward. There are rumors Portugal is already asking for better repayment terms, so it is just a matter of time before both these nations come forward and demand Greek-like terms. There is a limit on how many cuts a government can implement before it pushes its people over the edge.
Now Fitch has stated that large U.S. banks could be hurt because of their exposure to debt from so called stronger euro members such as France. France is struggling to hold onto is vaunted AAA credit rating and as growth is expected to be weak in the eurozone there is a good chance that France could lose its triple A rating within the next 9 to 18 months. Italy’s borrowing costs have reached unsustainable levels. Rates above 7% are generally considered unsustainable and serve as a signal that a country is in trouble. Unless these rates drop fast and remain significantly below 7%, Italy will most likely meet the same fate as Greece.
As an illustration of how bad things are, there is already talk of creating a core zone. We actually spoke of this possibility a number of times in several articles we published here on Seeking Alpha. Two that come to mind are Eurozone: Trim The Fat, Roast The PIIGS and Insolvent Banks: The Real Threat Facing The Eurozone.
EU sources told Reuters that German and French officials had discussed plans for a radical overhaul of the European Union that would involve establishing a more integrated and potentially smaller eurozone. The discussions among policymakers in Paris, Berlin and Brussels raise the possibility of one or more countries leaving the zone, while the core pushes to deeper economic integration.
The Europeans continue to drag their feet and refuse to make the hard choices that are necessary to put a lid of this problem. In that sense, they are no different from the Americans. Both share the same ideology - try to kick the can as far down the road as possible and hope for the best. The problem is that the can has become so heavy that a strong kick barely budges it. Each solution offered to date has been nothing but a temporary band aid. The deteriorating situation in Europe is clear evidence of this.
Investors who want to take advantage of a falling euro might consider opening up positions in ProShares UltraShort Euro (NYSEARCA:EUO) and Market Vectors Double Short Euro ETN (NYSEARCA:DRR). EUO attempts to offer daily results that correspond to 200% the inverse of the daily performance of the U.S. dollar price of the euro. Market Vectors Double Short Euro ETN (DRR) seeks to replicate the double short euro index. The index is 2X leveraged; for every 1% the euro drops relative to the U.S. dollar, the level of the index will generally rise by 2%, and vice versa.
Shorting financial shares would also make sense as many large banks have exposure to European debt. They purchased what they thought was the debt of the stronger EU members but as time progresses one can see that almost no member in the EU is safe (other than possibly Germany). Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC) can be shorted directly or via put options. If worldwide economic growth slows down significantly, even stellar companies such as Google Inc (NASDAQ:GOOG) and Apple Inc (NASDAQ:AAPL) could experience slower growth. GOOG earns the bulk of its revenue from advertising and if economic conditions continue to deteriorate, businesses would not hesitate to cut back on their advertising budgets. Deteriorating economic conditions could also hit AAPL. Consumers with less money in their pockets might think twice before purchasing a new iPhone or an iPad.
As the following article indicates the contagion is spreading. Along with their bonds, Europe sovereign CDS spreads are getting hammered today as contagion fears hit core and peripheral countries. The cost of buying default insurance on France is 21 basis points wider at 234 basis points. Belgium is 22 basis points wider at 342 basis points. Spain is 30 basis points wider at 477 basis points.
We suspect that nothing decisive will be done until the situation appears to be totally out of control. The mediocre and half-baked actions that the EU has implemented so far seem to support this view. Individuals should consider taking measures to protect themselves from the possibility of a full blown disaster. Opening positions in some of the above-mentioned stocks would be one way to hedge oneself against the possibility of a euro meltdown.
Disclosure: I am long EUO.