A problem for us all

Europe is the second largest economy is the world. What happens across the Atlantic affects exporting and importing businesses here, which in turn affects stock market valuations. Investments in European equities and governments bonds will be affected not only by the performance of companies at the business level, but by the wider economy, governmental actions taken against the burgeoning debt position, and the strength or weakness of currencies.

With the world a smaller place now than ever before, and so much trade, both in services and goods, across the Atlantic, the effects of the Eurozone crisis are closer than many think.

Too often, investors look at short term returns as a buy/ sell indicator rather than the long term future of the underlying security. Perhaps we should start considering Europe as a security in itself, rather than a trading area, with its companies and debt securities as subsidiaries of the Eurozone, their holding company?

Here I look at how and why the debt problems of Europe have built up, before considering what it all means to your portfolio now and moving forward.

The Euro: bringing a continent into economic and political harmony

When the Euro was created back at the turn of the century, it was held up as the next big step on the path to economic and political harmony across Europe. A single currency, with a harmonized method of interest rates, would force economies moving at different paces to be come into line with each other. The strong economies would feed the weaker, and the weaker would gain in strength. Employment would blossom, businesses grow, exports from the Eurozone would increase, and the region would finally become the economic powerhouse of the world.

To join the club, there were certain qualifying criteria. These were set by various statutes and pacts, the main two being the Maastricht Treaty and the Stability and Growth Pact. In essence these various mechanisms built in limits on certain economic criteria, including inflation rates. Two of the main criteria applied were the limits on governmental debt (now referred to as sovereign debt). These limits were easy to understand, and when first applied were set at a level that ensured all states that wanted to join the Euro could do so with relative ease. These rules stated the following:

The Annual Government Deficit of member states could not exceed 3% of the preceding year’s GDP. Only in exceptional circumstances would this rule be allowed to be broken.

The Ratio of Government Debt to GDP must not exceed 60% of the GDP at the end of the preceding year. This ratio, if more than 60%, must be seen to be diminishing.

Europe allowed its own rules to be broken

The aim of the debt rules was to bring all countries into line with Germany’s economic strength. If all countries could pare debt, keeping budgets under control, then the long term future of the Eurozone would be confirmed and solidified. Growth would follow as debt payments subsided, and the interest on debt decreased accordingly.

The trouble is that no allowance was given to different economies growing at different paces. No consideration was given to Spain’s reliance on tourism and construction as against Germany’s huge industrial base, for example.

Then, in the early 2000’s the Eurozone was hit by recession. Jobs were lost, business activity fell, government borrowing increased. But, no matter because budgets could be balanced over the longer term, and the rules were relaxed to allow this.

But just as Europe’s finances were recovering, along came the global financial crisis of 2007/ 8. European Union leaders agreed on a €200 billion stimulus package to avert a further deep recession, and separate member states borrowed heavily. And debt began piling up.

But isn’t it Greece, Spain, Portugal, and Ireland that are the real problem?

Certainly, these countries have received bailout money in one guise or another, and continue to do so. But, according to official Eurostat Data, out of the 17 Eurozone countries, 12 have net debt above the 60% of GDP level required to enter the Euro. Greece, Ireland, and Portugal’s net debts are all above 108% of their GDPs. But Italy’s net debt stands at 123.3% of its GDP, and Belgium’s is 101.8%. In fact, of those 12 countries with debt levels above the required 60%, Spain is way down the list at number 11 (72.1%). France’s level of debt stands at 89.2%, and Germany’s at 81.6%.

It’s a similar story when budget deficits are examined. Greece’s budget deficit as a percentage of its GDP reached 9.9% in the first quarter of 2012, as did Ireland’s. Italy’s stands at 8%, but not far behind in the mid 7%’s are Austria, Portugal, and Belgium. Even Germany and France have budgetary deficits (of 1.2% and 1.6% respectively), which are likely to increase as their economies falter.

In fact, the only three countries that conform to the original Euro budget deficit and debt level rules are Finland, Slovenia, and Slovakia.

The whole of the Eurozone is beginning to buckle under the weight of debt. With a second recession confirmed across seven of the Eurozone countries, and Germany’s growth stagnating and threatening to turn negative, it is expected that recession across the entire Eurozone will be confirmed this quarter. And that will make any debt repayment impossible.

What has been the European response so far?

Europe has set in motion emergency plans to cope with the fallout of excess debt. Bailouts of Greece, Ireland, Portugal, and Cyprus, have already taken place. Spain’s banking sector has been promised up to €100 billion, and it seems likely that the nation, creaking under recession and 25% unemployment, will require a full bailout by the end of the year. In order to fulfill requirements for bailout monies, those countries receiving financial aid have had to agree to budgets being monitored by central European government, and agree to severe austerity packages. For example, Spain has agreed to cut €65 billion from its budget by 2015.

The IMF, the ECB, and European member states have set in motion several initiatives to fight the Eurozone debt crisis. This includes the European Financial Stability Facility, with a war chest of some $750 billion to fight the crisis.

In addition to this, the ECB has recently announced an unlimited bond buying program designed to reduce bond yields across the Eurozone member states. It will be buying short dated bonds, up to three years maturity, which will allow issuing member states to satisfy creditors and budgets. But at the same time, the ECB will be taking money out of the system. This is being done so as not to increase overall money supply. To do this, it is offering overnight deposit rates slightly above its key rate for the money that banks hold in Europe. This mechanism is called sterilization. At present, the amount it holds on deposit under this mechanism is around €210 billion.

Isn’t this a good thing?

The ECB think so, and when it was first announced the markets held the same view. But sometimes realization of what actions really mean take a while to sink in. Banks are currently hoarding around €770 billion, so the unlimited bond purchases that the ECB has initiated could potentially go on for some time. However, there are €390 billion of Italian bonds due in the next three years, more than €200 billion in Spanish bonds, and a further €50 billion in Portuguese and Irish bonds. Then there are Greek bonds, too. And this is before any other countries run into problems with their current net sovereign debts and the inability to service those debts by diminishing tax revenues caused by a deepening recession. And remember that during periods of recession social welfare payments tend to rise. The sterilization program could easily quadruple from present levels.

Of course, when the short dated bonds that the ECB have bought mature, then the ECB will have to be repaid by issuing countries. They won’t be able to do this unless they have the tax revenues to cut debt.

No way out

This whole process threatens to become a never ending merry-go-round of debt being used to pay for debt.

The ECB has released vast funds into the financial system, which have been passed to banks to help the economy grow. The banks have been unwilling to pump that money into the economy, because the economy’s largest customer (government) has run out of money. Government has stopped spending on programs that would aid economic growth.

Meanwhile, governments across Europe are finding social welfare bills rising, and the cost of health, education, defense, and other services needing to be met. In an aging population, pension payments are rising, too. Costs going up, income falling – to make up the shortfall governments borrow more. Now they borrow from the ECB (in itself a statement of the inability of Europe’s member countries to borrow from elsewhere).

The ECB gets the money to buy these bonds from the banks that have hoarded the bailout and rescue money given to them by their own central banks, which received that money from the ECB in the first place!

In effect, the ECB is itself borrowing money to lend money, and that borrowed money originated from the ECB. The massive quantitative easing and money printing program that it carried out over the last few years has found its way back home.

The monetary easing programs put in place have had no effect. The necessary austerity programs to reduce debt have led to recession. The house of cards that is known by the name of Eurozone Sovereign Debt is waiting for a final gust of wind. Only after it has been blown down can Europe’s finances and economy be properly rebuilt.

Until Europe’s leaders, the ECB, and the IMF, confess this truth then Europe will not be able to begin the rebuild. And even when this process finally does begin, the ghost of Eurozone Sovereign Debt will haunt the world and its financial markets for many years.

Shaping an investment portfolio to cope with the Eurozone

Government bonds that yield 7% and more do so because the risk of default by the bond issuing nation is higher than bonds that yield 2%. Banks that hold European sovereign debt have seen the value of those investments fall. One of the simple rules of investing is that higher returns require a higher level of risk. ‘Too-good-to-miss’ bond yields are usually the very reason they should be missed.

Beware of securities that offer such a high yield in an environment where inflation is creeping, demand subdued, and interest rates remain low. This goes for equities as well as bonds.

As austerity measures take hold across Europe, governmental spending retracts and public contracts are cut. This is bad news for companies that cater to infrastructure and social projects. Businesses that build roads, hospitals and schools will see revenue contract. Defense and aerospace companies will see orders delayed, or pulled, or renegotiated.

Capital goods manufacturers and exporters to Europe will suffer. Natural resources companies will see demand for their product fall, and this will cause commodity deflation, and profit margins squeezed.

In Europe, taxes will rise and welfare payment levels be cut even though the overall payment rises in response to increasing unemployment. This will place a squeeze on consumer spending that will respond either by retracting or by private sector debt increasing. Government deficits will rise as taxes fall and welfare bills increase: this is why spending in other areas will contract.

A vicious cycle of falling tax revenues, rising personal taxes, decreasing consumer spending, and collapsing government spending may tip the scales toward a full scale depression in Europe, and that will undoubtedly be bad for the rest of the world, especially investors.

This of course, sounds like a doomsday scenario. And perhaps it is. But it will be wise for investors to position accordingly. Portfolios should be repositioned to a more defensive stance. Invest in businesses that will do well through a more severe downturn than we have seen thus far.

Potential winners

Utility companies, paying good dividends, may fare well. If input costs fall, then margins may eek a little higher. Domestic energy usage may rise, and industrial energy usage is notoriously difficult to cut without closing factories and plants.

Businesses that cater to needs rather than desires will likely hold up. Supermarket chains that aim their sales toward the masses will see profitability hold up. Banks that have a more community focus, and act ethically in the market, will have a lower propensity for losses than those that concentrate on investments in hard to understand financial instruments.

People will need insurance, but insurance claims tend to rise in a downturn. So look for insurance companies that have good premium flow where premium margin is strong.

Travel isn’t going to die a death, but travelers will look to save money. Perhaps discount airlines will fare better, looking to make extra profit from add on sales to a seated audience that is heavily sold to?

Companies that use technology within their business, or that bring innovative products online that will make a difference to peoples’ lives may also win out. Consumers will still seek entertainment, but be more cost conscious. How about companies that stream film to pcs and laptops?

For international portfolios, look at investing in stocks that have an international scope in the defensive sectors mentioned. This will help defend profits from currency devaluations.

There may be capital growth opportunities in precious metals, as central banks and investors seek to hedge against systemic inflation creeping into the economy and being stored up by the massive quantitative easing programs being initiated. Gold and silver could prove to be attractive investments at current levels as currencies go through rounds of devaluation.

The bottom line

I hope my negativity is proved wrong. I really do. But there will be plenty of opportunity to adjust a more defensive portfolio to one for growth, less so realigning the other way. The debt problem in Europe is real, unemployment is at an all-time high and increasing, and the effects of austerity only just beginning to ripple out to the wider economy. This ripple effect may well cross the Atlantic: let’s hope it doesn’t turn into a Tsunami. But at this time, investors should be prepared for the worst and hope for the best.

Michael Barton

Michael Barton

Michael Barton has a career of 25 years covering global financial markets. Having worked for companies large and small, trading and advising on assets from equities to derivative products, Michael now writes about the opportunities and markets that matter to investors. He contributes content to several keenly followed investment blogs and websites.