Europe is doomed!
I know it's a harsh statement, but if the European Central Bank ("ECB") and its president, Mario Draghi, are determined to end the QE policy they are running over recent years, there's simply no way that European capital markets can withstand the loss of the largest, most important, and by far the most significant player in the European credit markets.
Credit spreads of (most of) the PIGS countries are already reacting to the anticipated departure of the ECB from its bond market, with the 10-year of Italy, Spain and Portugal already starting to feel the impact.
The impact but not yet the pain. Let be very blunt and clear about it: If the ECB isn't buying European sovereign bonds starting 1.1.2019 (and don't come up with other tricks that have the same effect, of course), I expect yields of these countries to be higher by at least 1% one year from now. At the very minimum. In this article, I'll explain why.
- Italy (EWI), Italian banks (OTCPK:IITOF, OTCPK:ISNPY, OTCPK:IITSF, OTCPK:UNCFF, OTCPK:UNCRY)
- Spain (EWP) and Spanish Banks (BBVA, SAN)
- Deutsche Bank (DB)
Let's now put everything together and see why Europe might be doomed for the next couple of years, if not more.
In essence, it's very simple; almost feels like a binary option.
If the ECB keeps (or restarts) pumping money into the European markets, the bluff may continue. However, if the ECB stops - and doesn't restart - purchasing European sovereign debts, I see no way how the bluff isn't going to be exposed in its full scale.
The European Bluff
Let's start with Italy, which is probably the best example how the European bluff is working.
Italy's bond yields surged to a new multi-year high recently.
The spreads investors demand to hold Italian debt compared to German (EWG) debt more than doubled in recent months.
Local bank stocks have completed a nearly 30% fall between April to end of August, before seeing a bounce in September.
At the end of August, Fitch ratings cut the outlook for Italian bonds to "negative" in light of the upcoming budget and fiscal plans of the new government.
The sovereign debt of Italy is currently rated (on a composite basis) BBB by all rating agencies:
- Standard & Poor's: BBB with "stable" outlook, as of October 27th 2017.
- Moody: Baa2 with "under review" outlook (for a possible downgrade), as of May 25th 2018.
- Fitch: BBB with "negative" outlook, as of August 31st 2018.
Still within the investment grade side (AGG, LQD), but getting closer to the border line (below BBB-) that would turn the debt into a high-yield (HYG, JNK) one. Unlikely in the foreseeable future, but not out of question, especially if the new government adopts a loosening fiscal policy when it decides on a new budget in few weeks.
In case you are wondering how come that the yield on the Italian 10-year bond dropped by about 50 basis points, from 3.25% to 2.75%, over the past few days, the reason is the same-old reason: ECB.
Per the ECB's weekly report, the balance sheet increased by €12.6B over the past week - the largest weekly increase since last April - out of which, €8.2B were purchases of European government bonds. Wild guess: Italy accounts for a big chunk of the increase.
Meanwhile, foreign investors are already starting to flee. According to Citibank (C), foreign investors sold €33B of Italian sovereign debt and €9.4B of Italian corporate debt in June, following a sale (in total) of €33B in May.
This is the highest outflow since 1997! (even when the debt crisis hit the country in 2011, capital outflow was lower).
ECB is Controlling the Market
Here are few charts that illustrate the problem through the Italian lenses.
- At some point last year, the ECB was buying 7x more Italian bonds than the government issued (on a net basis).
- Since announcing on its QE program more than three years ago, the ECB is the largest - and in most cases the only - buyer of Italian bonds.
- If you wonder what is the real effect of the ECB's most recent QE program, shrinking spreads by over 60% would be just about right.
- Since the ECB is already reducing its bond purchases, and soon will stop buying completely, the obvious question is: Who can/will step in???
The simple answer: No one can step into the ECB's huge shoes. They are too big, and besides I doubt that many wish to fill the gap in the first place.
As such, there's another question which I believe is relevant/unavoidable: How quickly will the ECB announce a new QE program?
D(raghi)-Day Approaching soon
As the end date of the ECB's purchase program approaches, we can see a few interesting trends that suggest what "the day after tomorrow" may look like.
High correlation between the yields on Italy's 10-year bonds and the money supply rate from the ECB.
The Italian bank stock index: The pressure is (and will keep) getting worse.
According to a report by Deutsche Bank earlier this year, the holdings of commercial banks in Italy are estimated at 381 billion euros, and according to the Bank for International Settlements ("BIS"), this holding accounts for 20 percent of the total assets of the Italian banks.
Italian government debt held by the two largest lenders of Italy, UniCredit and Intesa Sanpaolo, is ~145% of the Tier-1 capital. For the third largest bank, Banco BPM (OTC:BNCZF), this ratio stands at >300%, and >200% at Ponte di Siena.
Europe's 2011 debt crisis (PIGS, etc.) is still here, well "camouflaged" over recent years with the influx of over €2T into the European markets. The ECB has, de-facto, created a "zombie economy". Now that the ECB wishes to stop injecting more money into the system, the bluff is exposed.
There hasn't really been any sort of economic improvement over the recent years in Europe. No banking reform has taken place with the ECB always backing off at the last minute, if something real/important was about to be done/decided. Balance sheets of many European banks - especially the bigger ones - are filled with problematic, non-performing loans.
The ECB's balance sheet is over 40% of the Eurozone GDP. To put that in perspective, the Fed's balance sheet is at ~20% of the US GDP.
Once again, the burning question now is not whether the ECB starts purchasing assets again rather how quickly will this happen? It's a matter of when, not a matter of it.
Moreover, if I'm wrong - and the ECB insists on its "no intervention" policy - I expect the European credit markets to collapse. Nothing short of that!
European bonds can't trade as they trade now without the free, never-ending flow of money that the ECB has provided for years. With no safety net, there's no safety.
If the ECB sticks to its words/plans, the bluff will be exposed and one of the biggest bubble in modern history is going to burst. Soon. Real soon.
Growth Forecast Is Likely To Get Cut
According to a recent report on Bloomberg, the ECB now sees a higher risk for economic growth in the EU, a change from the previous ECB meeting in which the message was that "risks are generally balanced."
According to recent projections, the ECB is likely to cut its growth forecast for 2020 from 2.1% to 1.7%.
The troubles in EM are the troubles of Europe. About 30% of Europe's revenue comes from Latin America. In addition, according to a report by the BIS, Europe's total exposure to Turkey (TUR) amounts to $224B, with Spain leading the way with an exposure of $83B of its banking system to Turkey. France (EWQ) with an exposure of $35B and Italy with an exposure of $18.1B come right after.
But exposure to emerging markets is not the only problem in Europe.
The growth rate of the money supply (M1) in Europe began to fall rapidly at the beginning of 2018, when the bank began reducing its purchases to €30B/month, and is currently growing at an annual rate of ~6.9%. Nonetheless, over the past five months, the growth rate has been close to only 4%, something that (for itself) signals of and may lead to a possible recession within few months.
Pouring ~€2.5T in recent years has provided a very good cover-up for the problems in Europe. However, the "zombie economy" can't grow without the massive, direct help of the ECB. Once the cover is removed, it won't take long for the bluff to be revealed.
Both equity and credit markets in Europe are still not fully pricing in the effects of the biggest buyer (by far) of European assets moving to the sidelines. Perhaps the capital markets are still predicting, more like hoping, that the ECB somehow reverses course and keeps buying bonds (something which legally can't be done).
Unlike the capital markets, it's much more difficult to manipulate the real economy. One can't sweep such problems like the ones Europe is dealing with under the carpet over and over and over again. No matter how many times you struggle, juggle or mumble, at the end of the day, PIGS remain pigs.
Eventually, the house of cards falls apart, the "ponzi scheme" collapses, and the bubble bursts. Nothing of that kind and/or of that magnitude (can/should) last forever.
The big question now is how quickly the ECB will announce a new purchase plan. It can't reverse course, but it can decide on a new one. However, until it does, the European economy continues - and is probably destined - to gallop towards the cliff.
If the ECB sticks to its guns, Europe may enter a recession no later than September 2019, just when Mario Draghi is expected to leave his post as chairman of the bank.
Frankly, he/it ain't looking happy/encouraging.
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