The Gruesome Twosome of Deflation and Stagflation Approaches Europe

The last two weeks or so, I've been alluding to an emerging thesis I have that Europe is about to undergo a very rough repeat of what we've seen in the US with mortgage-based woes. I hoped to thoroughly detail my causes for concern during my presentation at the BC Investment Club [BCIC], but I had a lot of topics to cover in outlining a macro investing view. The end result is that I had to gloss over much of the second order effects in order to present some basic information.

Keep in mind, this kind of exercise is meant to give optimal positioning for a portfolio with some strict rules about buying and selling. BCIC can only buy and sell stocks based on a majority vote of members, and we only have so many meetings each year to accomplish those moves. This makes portfolio pruning essential, so a good thesis that generates a series of portfolio moves can quickly add a lot of value.

My current outlook through mid-year 2009 is dominated by the idea of a "Gruesome Twosome" set of economic headwinds that are going to be reaching the shores of Europe. The Gruesome Twosome leads off with the death of the global decoupling thesis and says that we're in a global slowdown, and Europe is the next big domino to fall. In many ways, I'm looking at the posturing of European Central Bank President Jean-Claude Trichet and his "price stability first" talk and seeing a repeat of our Federal Reserve in the summer of 2007. Inflation in Europe is being driven by oil, and the ECB has no control over the price of oil. Setting monetary policy based on uncontrollable variables is simply nuts.

Now, the ECB has seen what happens when housing prices get out of line with long-term affordability and the financial system is betting on ever-rising housing prices. They've also seen the consequences of being stuck behind the curve and being reactionary. So when you consider the run-up in housing prices in Europe, it really makes America on the whole look rather mundane.

The major problem here is that European banks have balance sheets that are a much higher proportion of their home countries' GDPs, which would make any necessary bailouts much more costly, difficult, and ultimately politically unfeasible. Also, European banks operate on a much more highly leveraged basis, and they have generally increased their leverage on a year-to-date basis… probably the exact time when they should be cutting back exposures, given how the tide looks set to go out on housing and the European economy as a whole.

This data in itself is troubling, but the effects on the next level paint an even more disturbing picture. If Europe goes through an American-style unwinding of its  housing bubble, it's going to bring with it the same destruction of the "home wealth effect" and the same situation with constrained financials causing credit to be scarce and expensive. The wounded European consumer starts to get back, just as its American counterparts have done, and that in turn spills over to the export manufacturing-driven emerging market countries. After all, with the major markets – essentially the entire "First World" – undergoing a credit contraction, it's hard to believe the developing markets will be able to grow and prosper at the rates they did when their main trading partners were in the middle of the largest and most illusory wealth bubble ever.

This brings us to point two of the Gruesome Twosome thesis: deflation becomes a threat because of the destruction of wealth via declining asset values, and is exacerbated by the contraction of credit terms. But deflation is not the only problem; it's really just a metaphor for extreme economic stagnation… although it isn't the only thing.

Deflation generally is taken to mean falling prices caused by a lack of demand. I think that's a real possibility here, but I also think there is a threat of falling consumer prices even while we see commodity-driven inflation because no new credit is available to fund enormously expensive, capital-intensive exploration projects.

Emerging markets will still be growing and increasing their demand for hard resources, just not as quickly as in the past few years. In other words, I'm saying that this recent commodities pullback is just a passing correction. This combination of high (or higher) input costs coupled with low realizable output costs would certainly put corporate profitability in a bind, but it would also go a long way toward bringing down historically high profit margins and readjusting our senses as to what activities are economic where, and under what circumstances.

If this comes across as extremely pessimistic, it is not meant to be. It's simply meant to give the frame of mind that stockpicking has to be done from a different perspective, and oriented to pricing power and balance sheet strength, two traits which are overlooked during bull markets.

Because it's almost obligatory, I was compelled to give my view on whether or not equity markets have bottomed. There are certainly positive signs - the degree of fear that's out there regarding credit quality, the high level of volatility, and the $50+ billion in corporate buybacks announced just yesterday, but the most noticeable things we don't have yet are probably the most important - stability in real estate, and time to work excesses off.

You can see the full version of the Powerpoint I assembled (slightly longer than the version I used during my talk) here.

Stock position: None.

Comments

[User 232038:]

The head of the North Carolina state pension fund was unsure about the severity of the crisis in credit markets outlined by eggheads Bernacke and wall streets $500 million net worth boy Paulson. He said that if the fed will guarantee a reasonable 7% return on 30 yr. bonds he would send them most of the bailout money from his pension fund and neighboring states pension fund managers would gladly do the same!!
I`ll send them $100,000 tomorrow!

2008 Sep 24 09:25 AM

[OldLimey:]

"Inflation in Europe is being driven by oil, and the ECB has no control over the price of oil. Setting monetary policy based on uncontrollable variables is simply nuts."

The ECB isn't trying to control oil-driven inflation, it's trying to control second-round effects. In some European countries, notably Germany, unions are still strong and they're stepping up to the plate with large wage claims (e.g., 8% just this week from one). JCT is trying to suppress inflation expectations.

Regarding your second thesis, there is no single European housing bubble. Bubbles in the UK, Ireland, and Spain are indeed of truly epic proportions. Holland and parts of France have also had bubbles. Upward pressures have been less extreme in most other countries. Furthermore, although there has been plenty of daft property lending - most notably in the UK - the type of insitutionalised insanity seen in the US has been largely absent in much of Europe.

As an aside, relevant perhaps to that part of the UBS book accounted for by domestic mortgages, it is interesting to note that in Switzerland if the value of a mortgaged property falls to the amount of the outstanding loan the lending bank has the right to demand additional security, in the absence of which it can cancel the mortgage -notwithstanding that the borrower might be entirely current. My point: 'Europe' is not as homogenous as it sometimes seems.

2008 Sep 24 10:17 AM

[carey_jim:]

Whenever someone actually stops to think about things he/she is worth listening to.

Most people are unaware of the dangers of deflation because deflation hasn't been seen since the Great Depression.

Another deflationary shoe that could drop is stock markets. If we had a real crash of the (percentage) proportions that occurred in 1929 crash then, combined with a continued drop in real estate prices, both commercial and residential, we might see real deflation for the first time in fifty years.

And, as everyone knows, deflation feeds on itself just as inflation does.

It might be interesting to explore these ideas further, although they are not popular. But when the emperor is scantily dressed, someone has to point it out.

2008 Sep 24 10:18 AM

[107Sid:]

Count me in for another $100,000.

2008 Sep 24 10:20 AM

[Nobby:]

We are seeing a great transfer of wealth to the rich. Bush has given tax cuts to the super wealthy while burdened the average American with inflation by printing too many dollars. The US personage will be reduced to serfdom status with the military on hand for those who are not happy with being backdoor robbed. This is outrageous. I do not live in the US but i would be seriously worried if i did. Look at all the other things that are happening at the same time.
Laws are being passed that are frankly, unlawful. The police are given more powers, congress is simply trodden over. The war on terror is a war of terror towards the US population and the land of the free is drifting off into the sunset like a distant dream.
Is this what Bush senior meant by a New World Order? The big question is whether people will decide to be servants or want to remain free. This is unchartered territory now. This is history in the making for better or for worse. I think i would start praying.

2008 Sep 24 06:43 PM

[gerrele:]

SAUDI ARABIA, VENEZUELA, KUWAIT AND THE REST OF THAT ULTRA RICH GANG MUST HAVE THEIR NECKS NAILED TO THE HANGING POST. THEY HAVE NO CONCERN FOR THE REST OF THE WORLD. THEY CERTAINLY DO NOT NEED MORE RICHES. THEY ARE CAUSING WARS AND MISERY. I SAY THEY SHOULD BE "ORDERED/THREATENED" TO GREATLY LOWER THE OIL PRICE SO THAT NORMAL/HEALTHY BUSINESS GIVES EVERYONE THE CHANCE FOR A GOOD LIFE. IF THAT GROUP DOES NOT HEED THE ORDER, THEN TAKE AWAY THE OIL AND SPREAD IT AROUND EVENLY. THE SAUDI KING SHOULD HAVE HIS HEAD AND ARMS CUT OFF FOR "STEALING" FROM THE WORLD.

IT HAS ALWAYS BEEN SAID, THAT THE HEALTH AND WELFARE OF THE MAJORITY IS MORE IMPORTANT THAN THE INDIVIDUAL. LETY'S APPLY THAT HERE.

2008 Sep 24 07:24 PM