Do Panic Over Europe

Includes: EWG, FXE, GREK
by: Macro and Cheese

Yesterday Jeff Miller penned an article here, "Don't Panic Over Europe," in which he wrote that as an economist he is calm about Europe. I regularly read Jeff's articles, and in fact he is one of my favorite bullish-leaning economists. I'm an investor, not an economist, so I'm not going to debate Jeff on economics--I would lose. But I'm very anxious about the continent, and the only reason I'm not losing sleep over my investments in Europe is because I'm short.

European debt

(source: Eurostat)

The main reason is debt. We've all seen the chart above before: It's the debt of EC countries relative to their GDP, and not a pretty picture at that. The Eurozone has pushed through the 80% of GDP level in aggregate--not as bad as Japan's 200% level, but then, Japan funds its debt with sub-1% borrowing costs. Compare that with what the Europeans pay: Portugal's 10-year bonds at 11.25%; Ireland's at 6.78%, Spain 6.05%, Italy 5.58%. Japan's debt coverage is much, much cheaper than Europe's. You'll notice that in all cases, 2010 debt levels are higher than 2009's. This past year some countries have made some progress, but there's a very, very long way to go.

But it's not the sovereigns that are of most concern, though they're certainly in crisis. Consider this chart of the debt of the world's ten largest countries:

International debt

This chart of total debt (sovereign, institutional, and individual) is even more sobering. First, we can see that the UK has as much debt as popular wisdom's champion Japan. Second, we see that the European contingent bunches itself around the 300% level, and is on the upswing, unlike even the US, which has its own hands full as it is. Third, we can see that the trend has been solidly up for two decades. Which begs the question: If European economies have been growing in low single digits over the past two decades with a massive increase in leverage, what happens when that process is unwound?

Reversing that leverage will also represent a major challenge to European banks, said to be leveraged 30:1, or about three times more than banks in the US. European banks have been very slow to reduce their balance sheets, let alone deal with their nonperforming loans. In Spain, 8% of bank loans are now at least 3 months in arrears. Even if Spanish banks are conservatively managed in terms of capital ratios, by any definition they're insolvent. They are de facto wards of the state.

In an effort to offset the private sector deleveraging process, the ECB has been expanding its balance sheet through various programs, most recently through the three-year LTRO program. However, this process cannot continue indefinitely. The ECB's balance sheet is just shy of EUR 3 trillion in size, up from 2 trillion just last summer, and now stands at fully 1/3 of the Eurozone's GDP. If the ECB doesn't continue to leverage itself, this will complicate the deleveraging process that has to occur in the rest of the economy.

With that tableau in mind, if we overlay Europe's demographics, we can see we have a problem that is going to get worse before it gets better. Italy has joined Japan in sharing the distinction of the lowest birth rate in the world: 1.3 children per woman. Three years ago Japan's population began to shrink, and is now contracting at about 100,000 people per year, with a population of 128 million. Simple math tells us Italy will start down that slippery slope sooner or later. Germany is not much better, at 1.4 children per woman. A smaller population puts pressure on GDP: There are less people to make things, so a rise in debt to GDP is baked in, unless these countries take action.

Worst of all, the 17 countries that make up the Eurozone are stuck with a common currency. Under normal conditions, countries in distress--and there are famously 5 of them now, the PIIGS, though I would add Belgium--would devalue their currency. This is a critical mechanism to reinstate equilibrium when the economy starts to unravel. When the currency cheapens, exports increase, and job losses are minimized. There is a general decline in living standards through depreciation, but it is slow, and shared across the population. Instead, countries like Greece are facing massive job losses and wage declines, a very painful way to regain economic competitiveness.

It's hard to imagine the weaker countries toughing it out in the Eurozone, but we probably don't have to. Already, Citibank is giving Greece's exit by 2013 a 75% chance. I view the orderly exit of some member countries as a good thing (let's leave aside the possibility of a disorderly mess), but it will be a painful, expensive process and will almost certainly entail more writedowns and defaults.

These stresses and strains have consequences, and we're starting to see them. Most PMI-style business surveys in Europe have rolled over and are below the 50-line demarcation that separates growth from contraction. These timely readings only serve to validate the slower process of collecting and reporting GDP data for member states:

Euro GDP

Note that Greece isn't even reporting its GDP, and as we see it's not only the PIIGS that are contracting, it's also countries of perceived strength such as Denmark and the Netherlands.

There is no easy way out. Germany has promoted austerity as a means of paying back debt and repairing balance sheets. But cutting back on spending exacerbates economic contraction, and leads to political turmoil and social unrest. Let's face it: Austerity isn't fun. People get tired of it, as necessary as it may be, particularly after a decade of free spending.

As we just saw on Sunday, the French have thumbed their noses at the notion of more belt-tightening, opting for a socialist president who promises to ramp up spending and cut utility bills, among other handouts. But even incoming president Hollande campaigned on a plan to return to a balanced budget within five years. Even if he backs down from such a drastic measure, and he almost certainly will, he'll be facing a much bigger problem in a few years than he is now. A can kicked down the road becomes bigger and bigger, until finally the can kicks you.

It is sure that the unprecedented government intervention that has taken place around the globe has reduced or eliminated tail risk. Interest rates are at rock-bottom lows, and at 14 times earnings, European equities are reasonably high-yielding. But stocks depend on margins and growth, and on these two points, prospects are bleak indeed. That's a fact of life when credit card bills are running way ahead of income. This is not necessarily a recipe for European crash and burn, but for equity investors this receding tide won't feel a whole lot better.

Relax about Europe? Nope. Be afraid, be very afraid.

Disclosure: I am short S&P and Dax futures.