Europe

Back after a parents trip to Auschwitz-Birkenau. It does make you think about many things…. Europe amongst them.

A visit to any of the camps is always going to be emotionally challenging. It does though, give pause for moments of reflection on many things, the current state of Europe and “could it happen again?” amongst them. Of course genocide has indeed continued to be inflicted on people across the world since 1945 and there seems to be no end, or sense, to the steady stream of racial, religious and ethnic murder and cruelty in the world. Growing divisions in Europe will not take us back to the 1930’s but the shadow of the Second World War is never far away and traditional cross border suspicions are again bubbling under the surface and are not helping; not one little bit.

Angela Merkel took office ten years ago in 2005 when Europe was enjoying the pinnacle of its success. German integration was complete, the Russians were picking themselves up off the floor, Europe was united with a queue of new entrants to the EU project and the global economy was blazing. The world though has very much changed. Europe is in crisis with many members blaming Germany for their problems. Few countries now want to join the EU and the EU doesn’t want any new members. Ukraine is plunging deeper into the abyss and fear of Russia is growing. US politicians are discussing arming the Ukrainians and storing arms for US troops in the Baltic States.

The combination of economic and political stress has led to an increase in nationalism. Those flames are being fanned by the actions of extremist Islamic terrorists. Germany then, finds itself in the unwanted and uncomfortable position of being forced to take a leading economic and political role. The good thing about that is there is no other country more unlikely to change a political problem into a military one. The bad thing is that institutionally, Germany is not experienced or adept in the handling of cross border crisis.

Reluctantly, probably the most important politician in the world today but with no easy options.

Playing in the Russians backyard and encouraging demonstrations was never going to have an elegant end. As is often the way with liberal minded democracies when shots were fired the Germans backed off and instead of supporting the Ukrainians they joined in with sanctions. Germany will not ever get involved in military action in the East but is now being forced because of its earlier political engagement to seek compromise and to cool the situation down, much to the chagrin of a number of US politicians.

Merkel’s US visit was designed to persuade the US to soften its approach to Ukraine but a deep rooted suspicion of the Russians and their intentions does not easily change in Washington and Putin meanwhile, has his own constituency to serve which will not easily accept Russia backing down without significant concessions.

Equally, the Greek situation is creating unease in Berlin. The Germans have massively benefited from free and open markets with more than 50% of GDP going to export. Growing nationalism and protection may come to threaten Germany’s dominant export position, especially if the Euro is threatened by a Greek default and expulsion with others following. Germany has been forced to adopt a tough public stance with Greece yet the new Greek government was elected specifically with a mandate to challenge Germany.

From a German perspective, they’ve been doing all the right things, including lowering their leverage ration from 80% to 76% of GDP in the last four years. The rest of Europe though has its foot on the floor and is accelerating toward the fiscal cliff edge. Of Greece’s $350bn debt, a mighty $210bn is owed to the Eurozone bailout mechanism. Germany’s share of that is some $57bn. The problem is not the burden which may be placed on German taxpayers, it’s the share which other countries have signed up to and their ability to pay. Italy for example has a debt to GDP ratio of 132.6% and so is borrowing to pay interest. But Italy’s share of the Greek liability is $37bn while France is on the hook for $42bn. France is well down the road of becoming a financial basket case with the state taking 60% of GDP and with a debt to GDP ratio of 92%, (Maastrict supposedly limited debt to GDP at 60%). The problem with these stats is that a Greek exit will be met with a storm of protests from voters when they figure out what the bill means for them and there is little doubt the political map of Europe will undergo further rapid change.

None of this is good for markets. Increasing numbers of strategists are going underweight US equities and overweight European equities. These people don’t learn quickly. In fact, they probably don’t learn at all or are so glued to their valuation models they just don’t see the storm clouds rolling in. True and transparent price discovery of debt instruments in Europe is currently non-existent. That will happen when a central bank quadruples its balance sheet over ten years as the ECB has done. This of course was a necessary requirement to save European banks which had become insanely leveraged into the 2010-12 peripheral debt crisis, (DBK @ 56x for example with $1.9tr of assets and only $36bn of tangible equity).

As I wrote at the time, the unwillingness to force speculative investors to take losses and to underwrite them would simply store problems for the future. The future has arrived but paying the piper is now going to have a political cost and not just an economic one. Of the two alternatives, allowing Greece to go and watching the whole experiment unwind at great cost to the German taxpayer, or appeasing Greece, and subsequently other countries, at great cost to the German taxpayer neither is particularly palatable. The problem with both is that Germany probably ends up stronger and that is as unwelcome in Berlin as it is outside. Germany will probably allow Greece to go, if only because the domestic political cost will be lower than allowing them to stay.

It will however, set in train a sequence of events that none of us can know the outcome of. According to a new McKinsey study, global debt has grown by $57tr since the crisis. Government debt has grown by $25tr and only in the UK, US, Ireland and Spain has domestic, (but not government), debt deleveraged. China meanwhile went postal and increased leverage by 4x and now has a debt to GDP ratio at a stomach churning 282%. Zero interest rates will not hold the wall forever and disruption from FX markets resulting from political breaks are one likely route to what we refer to as real “price discovery.”  You could though, just call it an almighty crash, harsh bear market and economic depression and it’s that last word, depression, that haunts historians and anyone else who has had a reflective thought at any one of the camps.