The European Debt Debacle Comes To A Theater Near You

by: Lloyd Clucas

People only accept change in necessity and see necessity only in crisis. -- EU founding father Jean Monnet

Europe is sliding into recession collectively. The variation by country is substantial. But I see most all going down the drain. They don't have The Right Stuff. While peripheral Europe has the most immediate basket cases, they actually distract from the more serious problem states (Spain, Italy, and now, France). Obsessing over spots on the collective Eurozone tie obscures the overall aggregate gravity of the situation. Unemployment in the zone, at 11.1% in May, is at its highest since 1999.

Here is Greg Weldon (5-23-12) on the subject (via John Mauldin's insightful blog):

The EU Commission Surveys include detailed data for each EU-27 member nation, across the Service Sector, the Retail Sector, and the Construction Sector ... with May readings being heavily skewed towards the negative, in every category, in nearly every country….

Having dissected all fifty-two pages, we come out with a common theme as it relates to the 'country-performance'.

· Spain, Portugal and Italy are severely damaged, and sinking fast.

· The Netherlands, France, Belgium, Finland and Sweden are hurt, and the pain is worsening.

· Hungary is a potential wild-card.

· and, there is now sequential erosion in Germany.

Our problem from Europe is not so much recessions/depressions over there, but rather our banks' financial exposure to their banks.

Euro banks: There are runs in some countries. Greeks will soon have all their euro deposits in foreign bank accounts; weakness of German banks will surprise some. Some EU countries' banks are bigger than their nation's economies (e.g., France). If they go, it will be huge, not a Greece spot on their ties. US bank-reported exposure to European Banks finally stopped growing in 2H11, the latest data we have from the Bank for International Settlements (BIS). Foreign investment is fleeing the weakest countries, but it apparently hasn't fully comprehended the contagion effect, nor its magnitude, nor its scope. We see flight of private capital from Spanish and Italian government debt securities right now.

European Financial Collapse: We reviewed the most recent BIS data (December 2011 data in its June 2012 report). Total U.S. bank-reported exposure to all European banks looks to have been $5.86 trillion, virtually unchanged from 6 months earlier. That means that US institutions in the aggregate have not pared their collective exposure! All they did was stop digging the hole deeper - which they had been doing in the previous 6 months. Just who is it the regulators are protecting, again?

Assuming a 60% haircut (it was at least 70% in the case of Greece), that would be gross potential exposure of ~ $3.52 T - just about 23% of our GDP. The concern is that US institutions are failing to get their exposure down. And, if they don't, that our busybody FRB would jump in to save the miscreants - again - or print enormous sums to "help" the European financial derelicts themselves, who are overloaded with European sovereign debt.

I recall GMO's James Montier's observation:

Central banks are extensions of academic ignorance. (CFA Annual Conference this past May)

We have little doubt that the 'solution' will involve a further softening in collateral eligibility criteria, which should solidify the ECB's position as Europe's biggest 'bad bank'. (Pater Tenebrarum - Seeking Alpha, May 29, 2012)

Fits our internal forecast - and current events. LTRO lending from ECB to Eurozone banks at low rates, has presumably taken short-term bank liquidity risk off the table through 2014. It doesn't do anything to fix bankrupt nations or their banks; nor does it change the dysfunctionality, nor the non-competitiveness, of those economies. Entitlement spending growth overruns the capacity of those underlying economies to support it.

My brother remains an astute investor in his retirement from chief of an institutional investment firm. The other day he lamented to me that he'd long thought Europe was our canary in the coal mine. He lives in Europe, with his Italian wife, part of each year. He thought we'd see our suicidal destiny over there long before it arrived here at home. Today, he shares my view that recent administrations and Congress have run us up to near parity with the Euro-weenies. There is little lead time left. Only the dysfunctionality of the Eurozone political structure and retarded growth rates make their situation worse - more urgent and more immediate in consequences.

The old European colonialists are still busy exploring "Da Nile." Their proposals never have the inflationary scope that will be needed. Structural change proposals are too wimpy, won't happen for political reasons, or will not occur soon enough for existing financial conditions. But, they continue to pretend: Leaders at an EU summit recently agreed to ease conditions for emergency loans to Spanish banks and for a possible financial rescue of Italy. German Chancellor Angela Merkel made significant concessions, clearing the way for the Eurozone to take a wide range of measures to mitigate the debt crisis. The news sent the euro soaring on currency markets. [Bloomberg (6-29-12)] This was cause for market celebration? I guess hope has become an investment strategy.

Germany is selling two-year bonds that won't make any interest payments. The move reflects the "safe harbor" of German debt while revealing trepidation about the Eurozone. There is even talk of German bonds with negative yields. "In these uncertain times, people are more concerned about the return of capital rather than the return on capital," said Eric Wand, a strategist at Lloyds Bank WBM. [The Wall Street Journal (5-22-12)] That is what gold is for, Eric. But some probably see currency gains coming in German debt if the Euro blows up and Germany returns to the D-mark. Better read the bond indenture paperwork, guys.

A report from Der Spiegel on 6-24-12 said the paper had access to a German Finance Ministry internal study the government doesn't acknowledge exists. If the Euro blows up, that study reportedly suggested German GDP contracts by -10% in the ensuing 12 months and unemployment more than doubles. An anonymous Ministry source told Der Spiegel that the German cost of leaving the Eurozone would exceed the cost of shoring it up. If so, Merkel will back down even more as time passes.

However, I wonder how much the cost of shoring up the Eurozone rises with the passage of time? It surely does. No one seems to have the capacity to grow their way out from under their expanding debt loads. So the cost-benefit equation for the Germans may worsen and still result in Germany terminating financing for the Eurozone. If they do, you can bet a lot of miscreant states will be happy to default on their substantial existing debt obligations to Germany in return. German banks could fail.

France's Socialist government is pushing $9 billion in tax increases! Major banks, oil companies, and wealthy households will be hit with some of the biggest increases. President Francois Hollande said France is trying to bring last year's deficit of 5.2% of gross domestic product down to the EU limit of 3% in 2013. [Reuters (7-4-12)] Nonsense. France is the most retarded state in the EU. Greece crooked; France retarded. That France has some bright people and a number of good companies simply lets them draw out their terminal illness. 56% of GDP is government spending. Unemployment hasn't been under 7% in 30 years. (The Economist). Banks are 4x the size of their economy and heavily exposed to peripheral Euro country sovereign debt. There was little to like even before the electorate brought in their version of Barack Obama. It would be nice if U.S. leftist elitists were capable of learning from others' errors.

While Italy appears in better shape than Spain, it too seems destined for major financial trouble. Though its debt is not as short-term, when you see Silvio Berlusconi, Mr Crony Capitalist, mounting a come-back you know things are not well there, either. Their private sector is going limp, even at their public sector expands.

Spain's dying economy should be the one that blows up the Euro. But our best guess is that massive Euro printing and further degradation in collateral quality will be attempted to hold that line. A recent Spanish debt auction drew lots of bidders, but at over 6% for 5-year bonds. That is up from about 5.5% in early June. Debt service costs soar as the economy contracts. The time for default or massive inflation is coming soon. It will be a Eurozone political decision. At least in Mario Draghi, the ECB appears to have an economic adult in charge. France does not. Hollande sounds like an economic child: "Waah… gimme more! Now!"

The ECB could theoretically cut off the flow of bailout money to an errant nation. The problem is that most of the Eurozone nations have serious problems. Germany reportedly does not have the votes to cut off the Eurozone's ELA (Emergency Liquidity Assistance) to any nation. Evidently all the Greeks need is 5 allies scared enough of their own situations, to block a required 2/3 vote. (Thomas Warner - Seeking Alpha, 5-25-12) Said Warner:

This is really critical. Under [the ELA], the Greek central bank can independently create euros and lend them to its banks, apparently against even the most dubious collateral.

If one country leaves or is cut off, then you have "runs" on other countries in the Eurozone as markets try to figure out, "Who's next?" When that sort of thinking sets in, a cascade effect would likely ensue. The EU recession goes from the overly-optimistic -1% contraction forecast by economists now, to -4% or much worse. That could bring down a lot of European banks.

With no cut-off, the Greeks (or others) can continue to use the Eurozone's ELA currently in force to continue "printing" Euros to finance dead banks. Hence our firm's internal conclusion that massive monetary inflation will occur before reality overruns the printing presses, a state of emergency is declared, and the Eurozone blows apart. The alternative is that the Euro-printing binge panics Eurozone nations into a political and fiscal union that gives up national sovereignty - along with national pride and freeloader perks. Unlikely! Hence our guess that the alternative of political and fiscal union fails.

The only certainty in the Eurozone financial debacle is that it cannot continue as is. So it won't. Crunch time looks imminent, but I'll do a lot of mumbling if pressed on that. It is scary to be dependent on fascistic welfare-state politicians. The lowest common denominator is really low - whether in Europe, Japan, or the United States.

For many reasons beside the preceding, a U.S.-based, blue-chip, defensive, dividend-growth, equity-based approach, with some gold, seems worth investors' consideration. Fixed income looks dangerous except as the trading vehicles they have become. Reaching for yield remains a dangerous game. Financial stocks and all of Europe seem worth avoiding for all except speculators, traders and tourists. But portfolio strategy is a subject for additional pieces beyond the backgrounder above.

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