Europe; Coming Unglued

The financial media have, as usual, been watching a different movie.

The financial media have, as usual, been watching a different movie.

A friend recently said in reply to a comment, 'I think we're going to hell in a basket.' She is probably right but not for the reasons she thinks. My friend was referring to the consequences of Brexit. I am referring to the structural issues which are baked into the Eurozone and which are coming unwound at a pace which is very likely to accelerate throughout 2017. Standing close to an exploding bomb is never a good idea. The further away we are the better although it will take more than the English Channel and the political aspiration, if not commitment to leave, to save us from at least some of the backblast.

Political risk in Europe appears to be growing. The truth is, it never went away. It was simply subdued temporarily by successive ECB bailouts which have rescued (some) ailing banks but have done nothing to correct the systemic flaws in the Euro which have ruined southern European economies. Now, as political risk takes front and centre stage with Le Pen soaring in the polls the underlying economic risks which have been fermenting for years are at risk of ripping loose. The means of transmission are again, most likely to be the banks. You see, nothing has really changed.

We saw during the last period of Euro stress in 2011-12 that a sell off in bonds hit the balance sheets of European banks who tend to hold their own governments debt which increased their need for bailouts. In turn, that hits depositor and investor confidence which damage the banks even more creating a death spiral requiring direct central government intervention. As you may have guessed, the three countries with the banking sector most exposed to their own governments debt are Italy, Spain and Portugal.

With the ECB scaling back its bond purchases and the rising incidence of inflation yields have been rising. More importantly, spreads have been widening reflecting growing risk between member states.

Markets have so far placed a low delta on a Le Pen victory in France. Markets are being naïve. The French electoral system is designed to keep the door firmly shut against extremist parties but with the other candidates carrying baggage of their own her defeat is far from certain. Italy’s election meanwhile could result in a government under the influence of the Five Star Movement of the Northern League, both of which are committed to leaving the EU. Markets would not wait for an EU referendum result in these countries. Merely scheduling one will result in financial chaos. Meanwhile another Greek crisis similar to 2015 looks baked in when they run out of money in July.

Investors are hardened to serial crisis in these countries but are broadly complacent in their thinking that after a lot of fuss there will be another bailout and normal business will resume. Italy’s banks still hold 276bn in bad loans and the countries debt to GDP ratio stands at 134%. With 12% of the country’s bank assets being held in national debt there is a financial death spiral just waiting to be triggered. A small issue here is that Italy is the third biggest economy in the Euro block. That won’t be an easy fix.

Portugal meanwhile is back where it started with debt as high as it was in 2010. The 78bn Euro bailout there did not reverse economic trends. It did though, save the banks, for now.

The ever sensible and cautious Germans have been trying for years to neutralise this threat, first with a proposal to limit the amount of domestic sovereign debt that a bank could own. Germany failed. The second German proposal was adopted. That was to require that bank bond holders take a draw down, to zero if necessary, before government money could be used to bail out. Unfortunately, when Banca Monti Dei Paschi ran onto the rocks in December the rules were bent out of shape by using out of date stress tests and reimbursing debtholders saying they had been misled. That prevented a political fuss in Italy but has left the potential financial death spiral in place.

Other ideas, mostly based on the ‘bad bank,’ approach have circulated in recent years and include creating two classes of bonds, pooled together from the Eurozone countries, and divided into ‘safe,’ and lets call it ‘less safe.’ Loosely, that would be Germany plus one or two other countries and the rest. Unfortunately, the Germans are not big fans of either of these plans or any of their derivatives. The Germans in fact have been playing a quite crafty and streetwise game and who could blame them. German banks have pulled back their lending to non-German companies in the Eurozone over the past few years. Their appetite for shared risk is diminishing and the banks preference for keeping their money inside their national borders reflects this.

Germany itself has its own handcart of problems. Germany will of course work hard to keep the Eurozone together but it is not without its critics from both within and from outside. Germany is under constant criticism for having the largest trade surplus in the world, something that has not gone unnoticed by the Trump administration. It is ironic that Germany is the most powerful member of the very institutions that were imposed upon it in post war Europe. Indeed, the Euro was created years later in part to tie a reunified Germany to France and losing the Mark was the price paid for reunification. The trade off for Southern Europe in being unable to devalue was access to Northern European borrowing rates which allowed much needed structural reforms to be put firmly on the back burner.

Monetary union with fiscal union blocked potential wealth distributing mechanisms and acceptance of risk sharing required Southern Europe to gift their fiscal policies to Brussels. The Eurozone crisis and subsequent austerity measures have created fertile ground for growing resentment which has fanned the flames of populist movements which are gaining traction across the Eurozone. The refugee crisis and local political scandals have poured kerosene on an already politically volatile state. Growing recent civil unrest in France, (not much reported in the UK), and less violent demonstrations in Germany, reflect the heightened political volatility.

Political and economic structural tensions in Europe will continue to rise across the Continent in the coming months. They may well be contained and then abate. Protectionist rhetoric from Washington however complicates matters somewhat and are anathema to Germany’s export led economy. How the global economy, which has been designed and built around the free movement of people, goods and services reacts to fundamental changes driven by Washington remains an open question. Certainly, a much stronger dollar would be deflationary and wipe out the glimpses of inflation we are now seeing and that has a world of implications starting with Emerging markets and the $9tr of foreign dollar denominated loans which are ticking away.

With, for the moment, inflation at the gates and with bond yields rising in France and the periphery, the increased cost of debt repayments will do nothing to stabilise matters. Equities meanwhile have been skipping along without a care in the world. They may be about to stumble. For what it is worth, I firmly believe that the whole rotten construct is closer than most believe to coming completely unglued. Let’s hope that the financial boffins at the Bank of England are earning their money and are stress testing the banking and clearing system to destruction. It won’t be so very long before risk managers across the City are once again obsessed with counter party risk.

As a quiet postscript, those investment banks such as HSBC and Morgan Stanley who are making noises about moving some staff to Frankfurt and Paris, good luck. You are going to very much need it.

Euro Exit; An Elegant Solution

 

 

Markets have been preoccupied all week with how the trauma in European debt markets will be resolved. Will Germany capitulate from their hard line stance and allow the ECB to print, or will France capitulate and be drawn in to stronger German led political union? Meanwhile, the Southern European members are being squeezed hard as global investors derisk their exposure throughout the Euro zone with a commensurate deterioration in trust and confidence. There is at this point, little clarity about the outcome. 

One enquiring mind has popped up with an elegant solution. Mark Tinker at Framlington Asset Management, and occasional contributor, takes the lead, 

 

 

“My tone is somewhat light hearted, but the intent is very serious. 

An obvious analogy is China and the US. We know that China, as a manufacturing nation, has pegged its currency to the US, an economic zone running a large current account deficit and has benefited to the extent that there are regular calls to have it named as a "currency manipulator". The resulting capital account surplus of China was then recycled through the debt markets of the US as Germany's has been through the convergence trade in the Euro zone. Is not Germany then guilty of exactly the same thing as China? If we agree that it is so, then should we not expect Germany to float the DM in the same way as China will float the RMB? 

Germany should with immediate effect re-denominate all assets into a new DM, which would almost certainly appreciate rapidly against the "Old" euro, probably by around 25%. It could then do as the Swiss have done and make it quite clear that it will target a new informal peg of around 120 (hence my flip comment about pegging itself to the Swiss Franc). This would then enable a lot of the capital currently hiding in bunds to flow back into the eurozone and relieve the liquidity crisis there, for

that is the real issue in Italy and Spain, a fear of a Euro break up meaning a 25% haircut in all assets. 

The German population would love to have the DM and the Bundesbank back and while the Eurozone would have slightly higher yields than now, so long as the ECB makes it clear that ultimately it will print to guarantee repayment of principal - as every other sovereign nation can - there is no reason why their bonds should trade worse than, say the UK. 

The euro survives, just with Germany now in the same position as the UK and Sweden, in Europe but not the Euro. The only losers are German Banks with assets now denominated in a depreciated currency, but as we know, the solvency issues of Greece, Portugal and Ireland are more than accounted for in Banks balance sheets already. This was never a solvency crisis, it has been a liquidity crisis triggered by fears of a currency crisis. Remove Germany and all your problems are solved. If they won't leave, then the other 26 should vote them out.” 

One can only hope that this cracking originality in approach also catapults Mr Tinker to the front of the pack for consideration in the Wolfson Economic Prize which will be awarded “to the person who is able to articulate how best to manage the orderly exit of one of more member states from the European Monetary Union.” With a prize of £250,000 we can simply be certain that his will not be the only entry!