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JakilaTheHun (99.94)

The Eurozone and Its Demise (Some Thoughts)

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May 25, 2011 – Comments (22) | RELATED TICKERS: DB , SAN , FXE

I've been a critic of the Eurozone's basic structure for awhile.  In essence, the Euro is a 17-nation currency peg, that strips away the independence from each central bank's monetary policy.  This is almost like a reversion to the gold standard, in that nations that need to increase money supply can not.  Therefore, they get stuck in a deflationary spiral.  

Some thoughts:

(1) The Eurozone crisis will end ugly.  I originally had some faint optimism that Eurozone policymakers might realize what is necessary to make the Eurozone work, but all signs point to this not being the case.  Instead, we're seeing an increase in populism, nationalism, and radicalism across the Eurozone.  This is frightening. 

(2) If Greece and/or Ireland leaves the Euro and restructures their debts, the German banks are in deep trouble.  Therefore, the German banks would prefer for the German government to keep Greece and Ireland on life support.  This is also why Germany desperately wants Greece to stay in the Eurozone; because the German government might suddenly find itself propping up its own banks. 

(3) The other alternative is that Germany semi-permanently starts paying for Greece and Ireland's government obligations.  While the Euro dramatically helps boost German exports via artificially weakening their currency, eventually, the German government is going to rack up quite a debt if it continues to subsidize the PIIGS.  This alternative, while unappealing, might be better than allowing Greece, Ireland, and others to default actually --- but it's unlikely that the German populace will support this or go along.

(4) The idea that Germany has been responsible and prudent, while the PIIGS have been reckless spendthrifts is complete rubbish (with the exception of Greece). Four years ago, Spain, Portugal, and Ireland had very low government debt.  The financial crisis is what has destroyed them.  You can't fund government oligations with 20% unemployment (as in Spain) or with zombie banks (as in Ireland).  And you can't dramatically cut government spending when you have 20% unemployment and zombie banks; lest you make the crisis even worse. 

(5) If you live in the US, you should be thanking God (or the deity or non-deity or your choice) every day that your nation has independent monetary policy.  Spain and Portugal would probably be alright if they had that.  However, being stuck in the Eurozone will likely doom them without significant reforms or an eventual exit. 

(6) Another solution to this mess would be to start financing all government debt through the ECB.  Part of the problem is that the Eurozone not only artificially boosts exports for the stronger nations; but it also artificially lowers interest rates.  It does the complete reverse for the PIIGS.  However, once again, Germany has steadfastly opposed debt financings through the ECB ... even though it's the most logical solution and the solution that is also least likely to cause disaster.

(7) The Eurozone should also implement current account surplus tax that redistributed money from CA surplus nations to CA deficit nations.   This is necessary because the Euro artificially redistributes wealth from the weaker economic nations (the PIIGS) to the stronger nations (Germany, Austria, Netherlands, Finland).   This will also never happen, but it makes sense economically. 

(8) One of the purposes of the Eurozone was to tie together the European nations closer and to avoid the issues of the first half of the 20th Century with rampant nationalism and economic protectionism.  Instead, the Euro has, ironically enough, re-ignited European nationalism.  

(9) Spain, Portugal, Ireland, Greece, and Italy would all be better off if they left the Eurozone entirely. 

(10) However, the idea that the PIIGS leaving the Eurozone would save it might be flawed.  Rather, a PIIGS exit is more likely to give the Eurozone a temporary stay of execution.  The flaws of the currency union are significant enough so that another decade down the line, we could see the exact same issues.  

(11) I would not invest in Germany right now.  In some ways, it's the most vulnerable Eurozone nation, because the market is already pricing in a lot of distress in the PIIGS, but Germany is considered "safe".  This is completely untrue. Germany is very vulnerable to the changes that will inevitably occur over the next few years. 

(12) In a worst case scenario where the Eurozone dissolved, the German banks would be in deep trouble due to debt restructurings in Greece and Ireland.  Moreover, the Deutsche Mark would dramatically strengthen, thereby killing German exports.    Right now, Germany's economy is held up by an artificially weak Euro (from the perspective of Germany's natural currency) and artificially low interest rates.  Any interruption in that could change things for the Germans. 

(13) I'd be terrified to invest in most Eurozone banks.  The only Eurozone investments I have considered are telecom companies and big international firms (e.g. ABB, Siemens).  Only a few banks might be worthwhile.

(14) Banco Santander is my one and only Eurozone investment right now.  Even Santander is not immune, but they hold about 30 billion in Spanish government debt securities with around 80 billion in equity.  Their capital levels are significantly higher than most Eurozone banks and they have much greater diversification, with a huge Latin American presence, as well as a US and UK presence.  I'm betting that Santander can survive the worst-case Eurozone scenario, but I could be wrong.  I would not make this bet with any other Eurozone bank. 

(15) The thing that makes the Eurozone situation so difficult to invest in is that no one really knows what's going to happen in the end.  The ultimate outcome will be driven by a combination of political considerations and economic realities and it's difficult to predict where the two will meet.  The Euro, itself, could be saved if the Eurozone nations eventually decide it's in their interest to change the mechanisms behind it.  If not, the Eurozone will either dissolve, a few nations will split off from it, or it could just become a big zombie for the next few years. 

(16) If I had to wager, I'd bet that within the next five years, at least two nations will leave the Eurozone.  But this is a shot in the dark, given the potential number of outcomes.  My main reason for believing this will occur is that I see virtually no desire to cooperate within the Eurozone in order to make the Euro sustainable.  So what seems more likely is that eventually, some populist movement in particular nations push the government to end austerity policies and exit the Eurozone. 

(17) Btw, austerity is only making things worse.  People like to think of governments like individuals, but this is a poor comparison.  Here's the problem:  the PIIGS have artificially overvalued currencies because the Euro includes stronger economic nations like Germany, Austria, and Finland.  This means that assets in the PIIG nations are artificially overvalued.  This means there are downward price pressures until equilibrium is hit, so there are major deflationary pressures.  Austerity means higher taxes and lower government spending.  Higher taxes mean that assets are worth less.  Lower government spending means that assets produce lesser cash flows, and hence are also worth less.  So you can't solve an issue of artificially overvalued assets by beating down the intrinsic values further.  

That's all for now.  Or at least, that's more than enough for one post. 

22 Comments – Post Your Own

#1) On May 25, 2011 at 4:30 PM, PeteysTired (< 20) wrote:

2) If Greece and/or Ireland leaves the Euro and restructures their debts, the German banks are in deep trouble.  Therefore, the German banks would prefer for the German government to keep Greece and Ireland on life support.  This is also why Germany desperately wants Greece to stay in the Eurozone; because the German government might suddenly find itself propping up its own banks. 

1) How would Greece/Ireland restructure their debt?  Though the Fed Reserve?
2) Why are the German banks in trouble couldn't the German gov't then focus their "stimulus in their own banks?

It seems to me the German gov't is in a no win situation.

I am not sure why you seem so against austerity?  I call it living within ones means versus devaluing your currency to the detriment on the poor and fixed incomes. 

All this worldwide debt smells very bad and "printing" money to cover the debt smells even worse.

 

 

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#2) On May 25, 2011 at 5:05 PM, JakilaTheHun (99.94) wrote:

I call it living within ones means versus devaluing your currency to the detriment on the poor and fixed incomes. 

The tens of thousands of young Spaniards on the streets protesting would beg to differ with your interpretation of economic reality. 

High inflation can hurt the poor, but so can deflation.  Deflation results from too little money supply.  Spain is in risk of deflation --- not high inflation. 

This insane belief that everyone is headed towards hyperinflation is sheer nonsense.  Excess debt is deflationary. 

 

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#3) On May 25, 2011 at 5:18 PM, TMFAleph1 (94.91) wrote:

A first-rate post, Jakila. Very interesting stuff, and I suspect you are correct with regard to most of the points you make.

In addition to Santander, I think it may be worth looking at the Swiss banks, too (I realize they are outside the Eurozone -- that's partly the point.) They are well capitalized and they could benefit from any flight away from core Eurozone bank stocks; I'm not sure what the valuations look like, though.

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#4) On May 25, 2011 at 5:33 PM, JakilaTheHun (99.94) wrote:

In addition to Santander, I think it may be worth looking at the Swiss banks, too (I realize they are outside the Eurozone -- that's partly the point.) They are well capitalized and they could benefit from any flight away from core Eurozone bank stocks; I'm not sure what the valuations look like, though.

Good point on the Swiss banks.  I haven't really looked at them to thoroughly.  I have considered the UK banks, however. 

My main issue --- it's really difficult to predict how places like the UK and Switzerland will be affected by all of this.  Obviously, even if they are outside the Eurozone, they are still heavily dependent on Eurozone trade.  (Of course, the UK has its own issues, as well.)

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#5) On May 25, 2011 at 5:48 PM, TMFAleph1 (94.91) wrote:

They are well capitalized and they could benefit from any flight away from core Eurozone bank stocks

Not to mention the flight in assets out of Eurozone banks, although I suspect many of the wealthy have already taken their precautions.

You're quite right regarding the unpredictability of second-order effects.

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#6) On May 25, 2011 at 6:39 PM, Option1307 (29.73) wrote:

Another great post, thanks!

(11) I would not invest in Germany right now.  In some ways, it's the most vulnerable Eurozone nation, because the market is already pricing in a lot of distress in the PIIGS, but Germany is considered "safe".  This is completely untrue. Germany is very vulnerable to the changes that will inevitably occur over the next few years. 

I'm pretty sure Port is going to go crazy when he reads that but it definitely makes some sense to me.

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#7) On May 25, 2011 at 6:42 PM, portefeuille (99.60) wrote:

Europe in trouble again. I see, hehe ...

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#8) On May 25, 2011 at 8:43 PM, ChrisGraley (29.86) wrote:

Excellent analysis.

Especially the unerpriced risk that Germany carries right now.

 

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#9) On May 25, 2011 at 9:57 PM, TheDumbMoney (38.90) wrote:

I have never even heard the idea in your item number 7 before.  All around a very interesting and excellent post, thanks.

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#10) On May 26, 2011 at 2:37 AM, ikkyu2 (99.29) wrote:

Well stated, all quite thoughtful and useful; except that you clearly think you're smarter than I am where Banco Santander's concerned.  But that's all right; maybe you are.  Are you just going off their public reports or is there some 3rd party analysis that was valuable to you?

Thanks for the post. 

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#11) On May 26, 2011 at 9:31 AM, dbjella (< 20) wrote:

High inflation can hurt the poor, but so can deflation. 

If people are on a fixed income, get subsidies from the gov't or are working poor with a min wage, then how does deflation hurt the poor? 

Deflation results from too little money supply. 

How do you know what the right supply of money is? 

 

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#12) On May 26, 2011 at 11:47 AM, Momentum21 (95.96) wrote:

Thanks for the post...well constructed ideas here. 

(13) I'd be terrified to invest in most Eurozone banks.  The only Eurozone investments I have considered are telecom companies and big international firms (e.g. ABB, Siemens).  Only a few banks might be worthwhile.

I would take quite a few over some of the domestic Microcaps you like... ; )

(14) Banco Santander is my one and only Eurozone investment right now. 

I have a large position here too and (was fortunate to get a good entry point) but it is ironic how their diversification in latin america has been crushing them for the past 9 months or so. Check out BSBR...

(15) The thing that makes the Eurozone situation so difficult to invest in is that no one really knows what's going to happen in the end. 

After the political posturing ends I think it will still be the best option for all involved. You think any country will opt for the trauma of a currency change in the short-term?

Btw, austerity is only making things worse. 

This is true but I think we will have to wait to see how austerity is ultimately defined.

From what I understand BNP Paribas would seem to have pretty good downside to a "default" in Greece but their PPS hasn't suffered much as a result.

If I had to wager (and I am doing that) I would bet that the outcome is not as bad as the majority thinks right now (18 to 24 mos out). That wager gives me more wiggle room... : )

Overall I think that the political noise around this matter is creating the uncertainty. The EU might not be perfect but I think we have learned some lessons over the past 3 years that will help create a more orderly solution to play out.

OK...commence with the rolling of the eyes now... : )

  

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#13) On May 26, 2011 at 12:07 PM, TMFAleph1 (94.91) wrote:

I suggested this post for 'Post of the Day' yesterday and it looks like the editorial gods listened to me, see here (the link just takes you to a re-post.)

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#14) On May 26, 2011 at 12:35 PM, JakilaTheHun (99.94) wrote:

If people are on a fixed income, get subsidies from the gov't or are working poor with a min wage, then how does deflation hurt the poor?

Debt. 

What group do you think is the most indebted in any given society?  

If the value of money is increasing (as it is with deflation), yet your interest rates stay the same, that increases the likelihood that you will go insolvent. 

The "free silver" movement of the 19th Century was started precisely becuase deflationary pressures were bankrupting farmers. 

It's actually much more common for deflation to hurt the poor than hyperinflation in the developed world.  Other than Weimar Germany, there aren't a whole lot of examples of the latter. 

Hyperinflation is more of a problem in third world nations, with poorly developed markets, highly corrupt governments, and that tend to be dependpent on agriculture. 

 

However, it should be noted that many instances of hyperinflation were actually caused by deflation.  Once deflation increased debt loads and made them unbearable, hyperinflation might've become the only way out.  Hyperinflation is almost always a political decision and it results from the crushing debt of deflation. 

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#15) On May 26, 2011 at 12:41 PM, JakilaTheHun (99.94) wrote:

I would take quite a few over some of the domestic Microcaps you like... ; )

My microcap  basket has not performed well admittedly.  It hasn't performed as poorly as people think, however.  I'm actually beating most of the bank ETFs.  I'm down to the S&P, though. 

Overall, it's not so much my selections that have been bad, but my overall thesis (and the banks I chose to write about --- I had terribly poor luck there as many of the ones I did not write about took off, but the ones I did floundered).  I've actually exited most of my bank positions and have changed my thesis over the past few months.  Now, I'm only investing in highly capitalized banks in the Northeast, Midwest, and West.  We'll see how it goes. 

For the most part, I've been focusing on other investment ideas at this point.  You win some, you lose some.  So long as you don't lose too much, you can make out OK. 

 

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#16) On May 26, 2011 at 12:42 PM, JakilaTheHun (99.94) wrote:

BullInBear,

Thanks for that.

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#17) On May 26, 2011 at 1:50 PM, Schmacko (68.48) wrote:

@ #12) (14) Banco Santander is my one and only Eurozone investment right now. 

I have a large position here too and (was fortunate to get a good entry point) but it is ironic how their diversification in latin america has been crushing them for the past 9 months or so. Check out BSBR...

This statement on Santander's Latin America operations isn't true.  Check out SAN, which has outperformed the S+P by a good deal more than BSBR has underperformed it.  BSBR has grown revenue and operating profits year over year.  The reason their ADRs are getting beat up is because they've been more conservative and grown slower than other brazilian banks in the same time frame.  They're a profitable segment of Santander and aren't dragging the parent firm down. 

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#18) On May 26, 2011 at 1:53 PM, whereaminow (34.29) wrote:

I liked your analysis, especially the part about Germany.  What evidence do you have that any part of Europe has been in a deflationary spiral, and how would you define that?

David in Qatar

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#19) On May 26, 2011 at 1:54 PM, JakilaTheHun (99.94) wrote:

Good catch, Schamako.

To my knowledge, as well, Santander's Latin American operations are one of their (if not the) best performing segments.  I'm more worried about their Spanish and German exposure. 

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#20) On May 26, 2011 at 3:19 PM, Momentum21 (95.96) wrote:

This statement on Santander's Latin America operations isn't true

Yes, that doesn't read right, my bad. One of the reasons I invest in STD is because of the diversification. And the growth out of Brazil has certainly been big for them overall. The comment should have been more clear about the Eurozone vs Brazil (not the banks themselves).

The overall guidance going forward due to inflation and rising costs in Brazil seems to be another driver for the BSBR share price. See presentation here

My point was simply that the Eurozone might have more upside than Brazil for STD going forward despite the dire predictions we hear daily. Comparing the 2 ADRs doesn't really add value to analyzing the operations for the Group.    

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#21) On May 26, 2011 at 10:02 PM, portefeuille (99.60) wrote:

some data (from here).

German Economy (pdf)

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#22) On May 27, 2011 at 11:45 PM, portefeuille (99.60) wrote:



enlarge

(from here)

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