17 June 2022

Be warned, a full-blooded European sovereign debt crisis is coming


Welcome to the age of divergence! A new long-term trend is upon us. Buy Dollars, Sell Europe. Unfortunately, it’s likely to play into Putin’s hands in Ukraine.

Hurts to say it, but Europe is going to struggle most with what’s coming next. It’s got limited choices between galloping inflation, economic misery, and political instability. Being Europe, there is a significant risk it’s likely to reap the non-benefits of all three.

After the US and UK hiked interest rates this week, the global inflation threat is so pronounced that even the Swiss National Bank surprised markets by joining the central bank tightening trend. The Bank of Japan – well, they have a different view, keeping up QE and zero interest rates, but they have a different demography, and a tumbling yen that doesn’t particularly bother them.

Thus far, central banks are struggling in this crisis. Addressing the massive exogenous inflation shock of the Ukraine war, following the exogenous shock of the pandemic with 50 basis point rate hikes, feels like treating a gaping flesh wound with a kid’s sticky plaster. It isn’t going to stop inflation. The Bank of England is now predicting Q3 inflation of 11% and raising interest rates is a massive problem for markets.

Reading through acres of market research, the credibility of central banks is being called into question around the globe. They face a devil or the deep blue sea choice – how to a) preserve jobs and economic stability by avoiding a market crash, or b) slash inflation? And/or is not an option. It’s a thankless task, made more complex by the consequences of the last 13 years of monetary experimentation.

The ECB? It exists in the same economic world as the rest of us. But being a committee of 19 national members makes it somewhat unwieldy. At the best of times, steering an economy with imprecise monetary tools is challenging. For the ECB, it’s a compromise at best. That’s a major reason that 10 years after the last European Sovereign Debt Crisis, absolutely nothing is fixed about the debt-raddled south.

In the aftermath of the last ECB meeting European rates have risen; from negative to less negative. The collective economy remains precarious as inflation bites. But the real problem is the ECB is still a-dither on how to tell the Germans they’re going to be paying for Italian pensions after all.

The key for the ECB holding Europe together is avoiding the ‘fragmentation’ of southern European sovereign credit spreads. We don’t know how their new ‘anti-fragmentation instrument’ will do it – and neither do they, yet. They held an emergency ECB meeting to agree about talking about it. (And yes, I use the word ‘credit’ deliberately because they are not sovereign issuers. All Euro members use a currency they don’t have financial sovereignty over. Having a vote at a table of 19 members is not the same thing.)

A full-blooded European Sovereign Credit Crisis is coming, and perversely it will give us a clear investment winner! I am not for one second suggesting Italy is an attractive investment proposition, but it’s a screaming speculative opportunity! Buy Italy!

That’s because keeping Italy and several other debt-stressed members in the Euro remains the defining policy of the ECB, and thus the European Union.

So buy Italy, sell Germany, and ignore anyone who says sell dollars. Why would you? The US may longer be the globally trusted world policeman, but it’s still the global hegemon. There is not a credible dollar replacement. US Treasuries remain the ultimate safe haven, and if folk sell Treasuries, it’s because they need dollars to pay as the benchmark for all commodity and finished goods trade.

The respective outlooks for the US and Europe are very different. Recession is coming. In the US it will be short, sharp and painful. It will give Donald Trump or his successor the opportunity for a landslide blaming ‘Sleepy’ Joe Biden for destroying the economy.

The US is energy-secure and will feed itself. Inflation will hurt but has hurt before. The US economy will bounce back. There will be wobbles. Higher rates mean thousands of US zombie over-indebted corporates will fail. Just look at Revlon, which went for bankruptcy protection recently.

For Europe it will be not so much a swiftly resolved shock as a continuation of long-term pain. The economy – which never really recovered in southern Europe – will prove even more definitional. The coming stagflationary crash will hurt. It will crush savings.

The European Investment Bank – the EU’s lending arm – forecasts that some 17% of European corporates risk default over next year. If that many firms do go under, jobs will crash and rising social tensions will see gilets jaunes on the streets from Paris to Riga, and a renewed refugee crisis caused by food insecurity across North Africa will inflame populism. The last time Europe looked this economically weak was in the aftermath of World War 2, when the then new global hegemon, the USA, used the Marshall Plan to bail out, rebuild and restructure Europe as a bastion against the Soviet Union. It took foresight and vision.

This time? Europe and the US are no longer aligned on the Russian threat. President Biden sees the clear necessity to stop Russia at Ukraine’s borders and he has the support of most Democrat voters to do so. The next Republican administration is likely to be far less supportive of Ukraine, and if it’s a Trump Mark 2, there is a widespread assumption he may pull the US out of Nato.

Meanwhile, the economic weakness of Europe is likely to crystallise the current stalemate in Ukraine. Putin has time on his side. He can wait.

Europe is divided on multiple levels. Sanctions on Russian energy exports are inflicting pain across the Euro economy, while southern and eastern Europe are particularly susceptible to Russian propaganda and kompromat. According to some reports, over 50% of Slovakians now support Russia and, apparently, believe their crass propaganda.

What happens next? Europe and the ECB realise their weakness. That’s why they are doing the usual European thing, seeking a compromise. That will inevitably mean playing to Russia so they can reopen the energy taps. Sadly, such an agreement will likely see Ukraine left a bit like Czechoslovakia after Munich in 1938. Forced to accept a compromise where the Nazis got the ‘disputed’ Sudetenland and the whole nation shortly thereafter.

The alternative for Europe is a very bleak energy-scarce Winter of 22/23 – and the likelihood the US will be focused on its own affairs from November onwards. 

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Bill Blain is market strategist and head of alternative assets at Shard Capital. He writes a daily market commentary called The Morning Porridge (www.morningporridge.com).

Columns are the author's own opinion and do not necessarily reflect the views of CapX.