The Weekly Report: A Summary of Europe’s Situation

11 June 2012


We mentioned in an earlier post that this coming ‘summer’ is going to be far from relaxed.

The global outlook continues to deteriorate daily. Within the last 4 days, economic data for the world’s key economies has been dismal, particularly employment and manufacturing data in China and the U.S. which have both been in a downtrend over the past 2 months. However, Europe is currently what is causing the most volatility and fear in markets globally.

The European crisis continues to rage unabated as the E.U. leadership does not take concrete action to resolve many of the underlying issues; partially because they have exhausted many of their options, and partially because the scale and scope of the multiple sovereign debt and banking crises is unprecedented.

A lot of media attention has been focused on Greece, which had inconclusive elections in May 6th, where no single party had a majority of parliamentary seats. After repeated failed efforts to form a coalition government, new elections are now scheduled for June 17th.

SYRIZA, a radical, left-leaning, anti-austerity party won the second largest portion of the vote in the last round of elections, rattling investors and markets with their rhetorical stance on leaving the Euro and or the European Union. The markets took the widespread support for SYRIZA, especially in major urban centres, as a sign that the Greek populace supported such measures.

However, it now appears that the moderate parties (PASOK and ND) are gaining ground, and some observers are attributing the high turnout for SYRIZA to the same anti-incumbent political sentiment that led to Nicolas Sarkozy’s loss in France, and the significant electoral attrition suffered by Angela Merkel’s CDU party in recent state elections in Germany.

The gains by the moderate parties in Greece are also a function of the populace realizing that an exit from either the Eurozone or the European Union would be extremely costly and painful. Issuing a new currency in itself is very costly, without factoring in setting a U.S. Dollar and Euro conversion rate for a new Drachma. Estimates have a new Greek currency being valued at between 40% and 60% of the Euro. Revaluing debt and bank deposits from Euros to Drachma would destroy savings, increase borrowing costs for businesses (leading to widespread bankruptcies), and lead to a run on the bank (assuming the Greek parliament does not pass laws outlawing capital flight).

In summary, the consequences would most likely include sovereign default, corporate default, banking system collapse, and inability to participate in international trade, all within the first year. This is not counting the negative economic impact of the social and political unrest that would inevitably follow such a decision.

Robert Zoellick, the outgoing head of the World Bank, has said in a recent interview with the Daily Mail that the most dangerous thing about a Greek exit or even a default, will be that the effects of the resulting contagion would be ‘impossible to predict, just as Lehman had unexpected consequences.’ Zoellick also actually makes a direct comparison between current market conditions and the summer of 2008, saying that the two are eerily similar.

Charles Dallara, Managing Director of the Institute for International Finance, estimates that the cost of Greece exiting the Euro would probably exceed 1 trillion Euros — as a low estimate. According to Dallara, the European Central Bank’s exposure to Greek liabilities is more than double the ECB’s capital. If Greece left the Euro, the ECB would be insolvent.

As their initial rage subsides, the Greek electorate is increasingly aware of these factors and is aligning themselves more and more with moderate parties who will avoid these outcomes at any cost. Even Alexis Tsipras, the head of SYRIZA, has gone on a multi-city European speaking tour to “clarify” the party’s positions on Euro and E.U. exit, in an effort to do some damage control. Wolfgang Schaueble, Germany’s finance minister, proclaimed that the Germans and others are viewing the Greek scenario as flat out scary. The dramatic rhetoric and anarchic protests have hogged a lot of media attention.

All that said, it appears that Spain currently poses an even bigger risk than Greece.

Specifically, Spanish banks are threatening to drag the entire country into a death spiral. Spain went through a major boom in the 2000s, with real estate and construction playing a significant role. According to the Spanish Ministry of Economy and Competitiveness, Spanish banks currently hold 323 billion Euro in assets linked to real estate development loans. 54% of these loans, or 175 billion Euros, are considered troubled by the Spanish government, and only 30% of these loans are covered by loan loss provisions.

The negative drag of these loans is being compounded by the continuing drop in Spanish real estate prices, which peaked in 2008 and have declined 25% since. Société Générale expects that home prices are highly likely to fall an additional 15 percent by the end of 2013, while Citi is even more bearish, suggesting that prices will fall 60 percent from the 2008 peak within the next two to three years.

Additionally, Spanish banks are highly exposed to Portugal risk, with 78.8 billion Euros in loans and other credit linked to their Iberian neighbour. Financing flows are currently deceptive, showing a paltry net financial inflow of 533 million Euros. But when digging deeper into that number, when excluding ECB funding and other measures, 193 billion Euros in private capital has left Spain, equivalent to 18% of GDP, largely from Spanish banks and foreign investors liquidating positions and exiting the economy.

More than half the population under 25 in Spain is jobless, and overall unemployment is the highest in Europe, at 24.3%. This had led to dramatic declines in consumer demand, with retail sales falling a record 9.8 percent year over year in April, the largest recorded drop in retail sales in Spain’s recent history.

These data points do not bode well for the Spanish real estate sector, or for the Spanish manufacturing, services and retail sectors. Ultimately this will reinforce the negative feedback loop in the financial system until the trend reverses itself, but that outcome seems increasingly unlikely.

JP Morgan estimates that Spanish banks would need around 75 billion Euros for recapitalization, while Goldman Sachs’ estimate is at least 25 billion additional Euros beyond the 19 billion that the Spanish government has already sunk into Bankia, a ‘bad bank’ formed from the government-mandated merger of four failed regional savings banks. In either case, Spain may not be in a position to provide the funds to prop up their financial system. If banks there continue to fail, it could lead to a run, which in turn would have widespread negative repercussions and could ultimately lead to a sovereign default as well as multiple corporate defaults.

Spanish Prime Minister Mariano Rajoy, recognizing the seriousness of the situation, has made repeated calls for intervention; through a proposed ‘banking union,’ or through ‘EU bonds’ backed by the ECB (which effectively means Germany), and other measures.

However, Angela Merkel categorically rejected any such intervention or aid from Germany’s end, which contributed in no small part to last week’s volatility and a spike in Spanish government bond yields.

Germany now appears to be softening its position slightly vis à vis both Spain and Greece, but is still towing a hard line on continued austerity for peripheral E.U. members and bailout recipients such as Ireland and Portugal.

However it is in Germany’s interest to keep the Euro, and the question that remains is how long will it take them to blink in this high stakes staring content. Germany cannot and will not allow the Euro to fail yet they are showing no indication of flexibility. This fundamental contradiction is what continues to throw the market for a loop.

Ultimately, the Euro as a currency was fundamentally flawed because it established a monetary union without political union or strong fiscal coordination. The architects of the Euro believed that when the need arose, the political will could be generated to facilitate a political union, much the same way that the Coal and Steel Community of the 1960s was transformed into the European Union today.

Additionally, when countries joined the Euro they set aside their right to create fiat currency, essentially borrowing their money in a ‘foreign’ currency that they have no authority over, and preventing them from devaluing their way out of debt crises. Lastly, demographics and lack of competitiveness also play a key role, as the population ages and the economies in many peripheral countries do not have favourable efficiencies, or high specialization in a variety of exportable goods (both of which Germany has in abundance).

These conditions and the lack of cohesion and cooperation render the situation more and more intractable. No one can predict exactly how it will turn out, but no one disputes that we are in for some short term pain. George Soros, the legendary macro hedge fund investor, has said in a recent speech that Europe has around 3 months to get its act together.

Spain is currently asking for 100 billion euros in capital to shore up banks; or slightly more than the highest estimate that the IMF says they need to shore up the banking system. However, whether this will actually be enough to prevent bank failures remains to be seen, as the full extent of the bad loans on Spanish balance sheets is unknown.

In the meantime, we can expect more of the same: fear, uncertainty and volatility. It may still be too early to determine whether to move entirely into cash, but investors with faint hearts and weak stomachs should definitely start unwinding positions with Europe exposure.

If you’re looking to exit Europe but still want to tread the waters outside the Caribbean, give us a call at 1-868-622-1346 or send an email to my colleague Gerard (gerard.stephens@nullfirstlinesecurities.com) who has a list of desirable investments for just such an occasion.

Michael J. Cooper
Trading & Investment Strategist

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