- The EU is not only one of the hardest-hit by the COVID-19 pandemic, but also the weakest, most problematic economy due to pre-crisis problems.
- The pandemic is not the cause of the impending crisis, it just accelerated trends that were already in place. The entire Eurozone is set to fall into a debt trap.
- The trigger of the crisis will be the global recovery, as was the case with the Greek crisis a decade ago.
- Inflationary pressures and a return of higher interest rates will overwhelm over-indebted countries and the magnitude of the problem will be too big to bail out.
If it would be just me saying it, perhaps it would carry very little weight. When the likes of George Soros will declare that the EU may not survive this crisis, perhaps it is time to take it seriously and much of the MSM did. He is advocating for the passing of the EU recovery fund, but I do not believe that the $826 billion bailout will make any difference in this regard because the EU's economic problems predate the COVID-19 crisis. All that is happening now is just an acceleration of events, not a cause of the events that are about to unfold.
EU problems are much deeper and predate the current crisis
Even before the COVID-19 crisis, the EU was struggling with economic and institutional dysfunction with very deep roots, which were only getting deeper. The 2008 global financial crisis may have been sparked by the US sub-prime mortgage fiasco, but in the end, it was the EU that saw the worst outcome of all major economies, because it led to a Eurozone debt crisis, mostly because of Greece. Now that we have another crisis this time originating from a viral outbreak in China, it seems the EU is once again set to bear the brunt of the economic damage.
The main dysfunction of the EU, which is directly responsible for the bailout dilemma faced by its members stems from the deeply flawed monetary union of a number of countries with different needs. As I explained many times in previous articles, the Euro currency benefited the likes of Germany, not so much because of its social policies, budget discipline and other such factors that are too often invoked. It benefited because it is home to powerful global brands, which are benefiting in terms of global competitiveness due to a Eurocurrency that is perpetually weaker than it would be if it were to only reflect the German economy. The reason why it is perpetually weaker is that the Euro currency is perpetually stronger than it would be if it were to only reflect the strength of a country like Italy and its domestic brands which have much less of a presence outside the EU. In other words, one economy is stuck in a perpetual virtuous cycle thanks to the fact that the other is stuck in a vicious one.
I should note that 2015=100 in the chart above, meaning that since the beginning of this century until 2019 Italy's industrial output has shrunk by about a quarter while Germany's increased by about 20%. The EU as a whole saw an increase of about 15%.
There are of course always skeptics who will argue that the Euro is not responsible for the underperformance of Italy compared with Germany, but the industrial production data for the decade of the 1990s, before the Euro was introduced shows that Italy was doing just fine before the common currency came into force.
Keeping in mind that the chart I am using is calibrated for the year 2015 to equal 100, as we can see, Italy was always above 110 for the decade before the Euro was introduced. In fact, in the second half of the decade, it was constantly over 120. Germany on the other hand never surpassed 80 for the decade. Overall for the decade, Italy seems to have performed just slightly better than Germany while each had its own currency. It is hard to ignore the correlation between the introduction of the Euro and the reversal of fortunes for these two major EU economies.
The EU stimulus package that might never be
If the EU were a state, perhaps such issues would not come up. The reality is that the EU has some state-like attributes, but it is a club of states. The 750 billion Euro rescue fund is currently opposed by a number of prominent countries as well as a few of the newer members in the Eastern part of the union. Some of it has to do with the overall issue of moral hazard, invoked mostly by Denmark, Netherlands, Austria, and Sweden. Data source: Bloomberg
As we can see, Italy, Greece, and Spain are the main targets of the recovery fund when population size is factored in. It is supposed to take into account how hard a country was hit by the virus, as well as overall economic health. Poland stands out because the virus did not hit them hard compared with its EU peers, while its economy remains solid. Belgium on the other hand is set to see a much deeper hit, yet it is not set to see much help from the fund. There is already some talk about having to rethink the parameters used to decide on the distribution of the funds.
If the recovery fund will pass, it will still fall far short of what is needed to fix the EU's economic woes
Assuming that all the necessary compromises will be made to push the stimulus package through, it still doesn't mean that all is fine with the EU. Economic growth will continue to be sluggish, for there is nothing to drive activity higher. It is estimated by the EC that by the end of 2021 the economy will still be below the end of 2019 levels. The debt/GDP ratio is set to rise this year from 86% to about 103% in the Euro area. It is basically a debt trap for an increasing number of countries.
As the chart shows, the Hellenic countries, in other words, Greece and Cyprus, as well as the Latin countries, namely Portugal, Spain, Italy, and France are all set to see their debt/GDP ratios rise above 100%. Portugal, Italy, and Greece were already there before the crisis. Belgium is also set to join the mostly Southern club in this regard. What this means is that these countries will never be able to tolerate an increasing yield curve on their debt again, unless they will do something to bring their debt under control. If all these countries are unable to tolerate higher interest rates, it means that the entire Eurozone is stuck in a debt trap.
One last point I want to make, which I believe best illustrates the fact that things will not be alright for the EU, even after the virus outbreak will be brought under control is in regards to where the union's industrial production trajectory was headed even before this crisis.
While the recent plunge in industrial production stands out in the chart above, we have to pay attention to the fact that a steady decline in production already set in at the end of 2017. The reason why I think it is important to mention this trend is that it should be taken as an indication in regards to what a post-pandemic recovery will look like, not only in terms of industrial production but for the overall economy.
Whenever the EU economy will finally recover to pre-crisis levels, it will then most likely resume its overall stagnation mode. Industrial production in particular may never regain its pre-crisis output levels. It will most likely recover to some extent from the steep decline we are seeing now and then resume its more gentle decline path. In other words, the peak seen at the end of 2017 may end up being a permanent peak, which in turn will contribute to an overall stagnated economy.
Once the pandemic becomes subdued, assuming that it will be neutralized in some way eventually, the EU will still have to contend with the Eurozone dysfunction. It will still find itself struggling to keep up technologically with the US and China. There is also the matter of an ideological issue in relation to the drive to unilaterally continue reducing EU emissions, which is causing the EU to self-inflict a net competitive disadvantage on its industry and other economic activities. There are many other aspects of the EU that contribute to its lack of competitiveness relative to its major peers, such as a burdensome set of rules and regulations, a stagnation in the decision-making process due to a lack of consensus, and much more. It is, therefore, safe to assume that the EU's problems will be far from over once the COVID-19 crisis will fade.
While the overall economic situation in the EU looks grim from my perspective, there are nevertheless investment opportunities, although there are also many pitfalls given economic prospects of the domestic market for EU firms. Entire sectors, such as banking can be considered to be too risky. The fact that a growing number of EU governments are becoming excessively indebted makes it unlikely that a more normal interest rate environment will prevail. This, in turn, means that banks will continue to struggle. Deutsche Bank's (DB) stock value has gone from a high of over $150/share in 2007, to under $10/share currently, which illustrates to a great extent the trouble that the sector is in. For a broader measure, the iShares MSCI Europe Financials ETF (EUFN) lost almost 15% of its value since it started trading in 2010. It is down 23% YTD. Not even the slashing of 60,000 banking jobs in 2019 helped to revive the fortunes of Europe's banking sector. The poor performance of Europe's banking sector is likely to continue going forward, given the lack of prospects for a more profitable interest rate environment. Investors may be tempted by seemingly cheap stock prices, but in this case, the low price is more than justified.
I used to believe in the European auto sector. I thought that luxury brands such as Daimler (DMLRY) or BMW (OTCPK:BAMXF) will navigate the EV trend successfully, given their extensive resources, and also the fact that EVs sell to the same demographic as luxury cars. So far they mostly failed to keep up with pure EV maker Tesla (TSLA). There is still time for them to recapture the initiative in this regard, but the window of opportunity is closing while a growing number of the income demographic segments that traditionally bought conventional luxury cars are opting for an EV instead.
While the luxury car makers absolutely need to get their act together on EVs the likes of Volkswagen (OTCPK:VWAPY) need to preserve their people's car brand, in other words, cater to Europe's middle class as well as the growing middle class of the developing world. Yet it is betting its entire future on EVs. It has announced that it will cease development of its ICE and related technologies by the middle of this decade. The main problem with its strategy is that EVs that can be priced at a level that the global middle class can afford simply do not have the range utility needed to be more than just a city car.
It can be safely assumed that the global auto industry is set to experience a hard time at least for the first half of the decade, given not only the brutal effect that the current crisis is having on car sales but also due to other challenges such as the EV trend, environmental objections to driving and so on. The EU auto industry was already weakened by the emissions scandal even before the new challenges came to the fore. Adding to the troubles that the EU car industry is facing, it seems that domestic demand already took a hit at the beginning of this year, even before the effects of the pandemic caused demand to grind to a halt.
The months of January and February did not include any lock-down measures, yet there was already a significant decline in auto sales. When things will get back to normal or what will be perceived as a new normal the fundamental reasons why auto sales declined will still be there. In other words, we will see a recovery from the current bottom, but once recovery plays out, we will likely resume the old trend of decline.
There are of course also stocks which have things going in their favor. For instance, Nokia (NOK) and Ericsson (ERIC) are likely to see a boost from the 5G trend. Engineering giants like Siemens (OTCPK:SIEGY) will continue to provide the world with technological solutions and meet a wide variety of needs. These are all companies that mostly depend on the global market, not so much on the local economy and their products and services are likely to be in demand.
The timing and trigger of the crisis
Finally, I want to point out when and how an EU crisis is likely to unfold. As it was the case back in 2009-2010 when the global economy started recovering from the financial crisis, the Eurozone went into a secondary crisis, mostly caused by the realization that Greece's finances were not viable. The factor that exposed that reality was the start of money once more chasing higher returning assets such as stocks. Greece's bond yields started skyrocketing as a result by the fall of 2009. By early 2010 its bond yield was well over 10% and there was no way of servicing it, given that debt/GDP made up about 120% of GDP. In other words, simply paying interest on that debt was set to eat up about 12% of its GDP.
Once we will start seeing an economic recovery around the world, regardless of whether the EU will manage to pass its recovery package, it will be faced with massive fiscal issues, especially among weaker Eurozone member states, such as Italy, Greece, Spain, Portugal and even perhaps France. On the growth and therefore revenue side, all these countries will experience significant hardship as all of them are heavily dependent on tourism revenues. The other sectors of their economies, such as industrial output will resume their path of shrinking. On the expenditures side, more money for social spending as a way to make up for lack of economic growth, as well as rising debt servicing costs will make it increasingly impossible to produce a sustainable fiscal path. The markets will realize it and investors will ask for higher and higher yields to make up for the growth in perceived risk. Higher yields will in turn fuel even more doubts about fiscal viability.
There are three major institutions or entities which will be called on to rescue the finances of these countries. The ECB will be the first line of defense and it might also be the first line to fall, which will make it very hard for other entities to bail out the weaker part of the EU economy. The ECB already increased its balance sheet by about 1.5 Trillion Euros since the crisis began this year and it is expected to do much more in the coming months. The danger is that the ECB may be called upon to start defending the value of the Euro or to fight inflation, at which point it will have to stop buying up debt. It may even have to start reducing its balance sheet, at which point it will add to the bond supply. I am aware of the unusual call of expected inflation down the road. The general market consensus right now is for deflation to continue for as far as the eye can see. But I do think it is feasible, as I explained in a recent article.
In the absence of the ECB stepping in to buy EU debt, the IMF as well as the northern EU members do not have what it takes to bail out countries the size of Italy. In fact, Northern countries like Germany, Austria, and The Netherlands will see their own interest costs rise once the ECB will be neutralized. The rates will not be unsustainable by historical standards but we should keep in mind that these countries became accustomed to not having to pay any interest on their debt, so even a modest rise in interest rates will mean a significant extra burden on their budgets. A decade ago we saw fears of a Greek meltdown keep the whole world in suspense. This time around it could be Greece again, as well as Italy, Spain, Portugal, and perhaps France, which will make the magnitude of the crisis about 20 times bigger. It is most likely enough to trigger a massive EU and then global crisis.
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