Odds Of EU-Triggered Global Economic Crisis Better Than 50/50 This Year

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Includes: EWP, FEZ, HEDJ, RSX, RUSL, VGK
by: Zoltan Ban

Summary

Last few years of relative economic calm in Europe have given the market an excuse for complacency.

Latest economic data points, such as industrial production and consumer demand, suggest that complacency should not be the norm.

In addition to the economic situation, the political mood, in part triggered by years of economic hardship and in part by the migrant crisis, is becoming volatile.

I am of the opinion that the EU stands a better than 50/50 chance of triggering a global economic crisis given ongoing trends.

Some of the numbers coming out of Europe have been encouraging in the past few years, bringing a certain amount of psychological relief to the market after years of seemingly never-ending fears that things may go wrong. Latest signs suggest that things are far from well, and definitely headed in the wrong direction, therefore complacency is not the way to go. The sources of evidence of strain are coming from the increasingly bitter political mood and economic data alike. Of particular concern are the industrial production numbers we have seen in the past few months.

Data source: Eurostat.

When looking at EU numbers, it does not at first sight seem to be anything that should be of particular worry, except perhaps the lack of overall industrial expansion since 2010, which is only up about 3% through a five year period of global recovery.

If we look at Germany's numbers, clearly they are headed in the wrong direction. As we can see, in past years Germany enjoyed far superior industrial output expansion compared with the EU average. Since last summer, however, it is quite obvious that things are not well. From a high of 110 in July, industrial expansion is now down to 107.8.

There are many factors that are contributing to this decline, and I do believe that we will see a continuation of it, because many of those factors are not going away soon. We know that Germany is most likely taking a hit due to the Volkswagen scandal. We also know that exports to China are not stellar. On top of it, we have the on-going conflict with Russia, which is one of the top importers of German goods, with 11.5% of Russian imports coming from Germany. The situation in Europe is not very favorable to German export expansion either. Europe is by far Germany's biggest market, but as George Friedman put it, countries like Spain, Italy, and Greece used to be its best customers, while now they are living through a depression-like situation due to the dysfunctional common currency pact.

Meanwhile, the on-going migrant crisis, which among other things is causing the Schengen open borders agreement to collapse, is leading to disruptions in trade will not go away any time soon. The effects of the disruption to cross-border labor commuting should not be under-estimated either. Things are likely to get worse in this respect in coming months as more and more countries are introducing border controls, or toughening the already existing control regime. Austria just announced that it intends to suspend the Schengen agreement, while Sweden and Denmark have also recently announced border controls. Open internal borders have now become the exception in Europe, rather than the rule. It would be naive to assume that this will not continue to disrupt economic activity. I think we are only just starting to see the effects of it now.

The fact that in most major eurozone countries aside from Germany industrial output is shrinking cannot be helpful to German industry. As I pointed out in my graph, the Netherlands' industrial output is now 11% bellow 2010 levels. It almost reached breakeven last year, before going into a tailspin starting in February. France dipped bellow 100 in November, Italy was at 93 in October, Spain was at 95.5. In other words, of the top five largest economies in the eurozone, only Germany has seen industrial expansion since 2010.

If it were not for Germany's industrial expansion, as well as the relatively robust industrial growth in the Eastern part of the union, where countries such as Poland, Slovakia, the Czech Republic, Hungary and Romania have seen their industrial output increase between 15-35% since 2010, the EU would be in the process of severe deindustrialization for almost a decade now.

Now, with Germany looking like its industrial production volume is headed South, it means that the last bastion of EU growth, economic stability and activity is likely headed for a similar fate as its less fortunate EU peers. This of course also means that the high-flying East European countries, such as Poland and Hungary, will also suffer a significant slowdown. These countries export a very large volume of intermediate goods to Germany. For that reason a declining trend in Germany's manufacturing can have an exponential effect on industrial growth in the former communist countries, where industrial production makes up a relatively high percentage of the overall economy. The signficance of this fact should not be underestimated since consumers in these countries helped a great deal with boosting overall EU consumer demand. Click to enlarge

Source: Eurostat.

As we can see, there has been a great deal of expansion in consumer spending in countries like Poland, Romania and others in the region, while it has been considerably weaker in major eurozone countries such as France, Italy, Spain, Netherlands and Germany. If German industrial demand for intermediate goods from these countries declines significantly, as should be expected given the apparent contraction in German industry, which has more or less gone on uninterrupted since July, these countries stand to lose many jobs. Lost jobs, which tend to pay better than average in the region, will lead to a significant drop in consumer demand in these countries, which will in turn hit West European exporters.

As an indication of just how big of a hit a slowdown in Eastern Europe can be for Western Europe, I want to point to the fact that most of the former communist countries would qualify as top ten external export destinations for West European goods. Hungary for instance imports 75% of all goods from fellow EU members.

Click to enlarge

Source: EC.

Given that total imports were almost $100 billion in 2014, it means that Hungary alone imported $75 billion worth of goods from other EU members. That level of trade would make it equivalent to the EU's fifth largest external trading partner. All the former communist countries, which are currently part of the EU, when put together, rival the EU's largest external export market in size, namely the United States.

This secondary effect will of course come in addition to the primary effect which I believe we are already seeing unfolding. Among the signs which point towards the primary effect already being here, we have retail trade numbers which are in contraction.

Data source: Eurostat.

As we can see, the euro area, which makes up the bulk of the EU economy, is in fact seeing a shrinking consumer demand trend. In fact, it seems that the declining trend is accelerating. The overall EU numbers are somewhat better, but that is only because of the strong retail numbers registered in Eastern Europe. Romania registered a month over month increase of 2.6%, Poland 1.6% and most other countries in the region registered a healthy increase in November as well as the previous month. Germany, on the other hand, which has been touted as the success story within the eurozone, has seen growth in retail sales averaging less than 0.1% month over month, since June. So, not only is its industrial output contracting, but consumer demand has stagnated as well. In fact, if it were not for growth in industrial production and retail sales in Eastern Europe, as well as a few other bright spots such as Britain and Ireland, the EU would most likely be experiencing overall contraction according to both indicators.

It is possible that in coming months we will see improved numbers and perhaps the EU will weather this latest set of challenges, just as it did with the great Greek tragedy. At the same time, we have to be mindful of the fact that we are currently looking at numerous points of pressure on the EU. There is the ongoing situation with Russia, which is causing job loss in an EU that can barely afford it, given that it already has an unemployment rate of almost 10%. There is the threat of a British exit from the Union, there is the ongoing euro currency crisis, which in my view will never be resolved because it comprises countries with different currency value needs. To top it all off, we have the migrant crisis, which has already effectively destroyed one of Europe's most important political and economic institutions, namely Schengen, which will most likely cause a further drag on Europe's economy.

All these problems are ultimately likely to trigger a political crisis, which will serve to greatly exacerbate the already dire situation the EU finds itself in. Lackluster economic growth, combined with the pressure and tensions being caused by the on-going refugee crisis are already causing the center of the political spectrum to empty. Radical parties are gaining, while the former centrist parties are increasingly adopting radical ideas and introducing radical policies, in order to fend off the rising popularity of the extremes. This process has been going on for years, but now there is an unprecedented amount of stress caused by the migrant crisis, causing the process to accelerate. Just as I am writing this, the president of the European Council, Donald Tusk, is warning that if the EU does not resolve the migrant inflow issue within two months, the Schengen agreement will completely collapse. Meanwhile, Germany's government, together with EU president Jean-Claude Juncker, hinted that if Schengen collapses, the future of the common euro currency and even the EU is uncertain.

China may have released data which seems to have the effect of calming fears of a crisis coming from that direction, at least for now, by coming up with numbers that were in line with expectations. The EU situation, which should be in the headlines, seems to have faded from the market's and general public's attention lately, to the point where the markets no longer seem to pay attention and react to what is going on there. Perhaps it is because people simply got tired of the seemingly never-ending EU crisis. Or perhaps it is because its ability to survive thus far has created the false expectation that it will always pull through. The data and events, however, point to a worsening crisis and an increasingly sour mood in the halls of Brussels, as well as on the streets. I believe that the odds of a major global crisis originating from Europe this year are now better than 50/50. If I am right, anyone tempted to continue ignoring the unfolding crisis is wrong to do so, because things could get very ugly, very soon.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.