Traders are trading Europe in four increments based on the latest headline – or event – coming across the pond. Investors are now debating whether Europe has hit bottom and whether there are opportunities in Europe that are cheap enough to buy.
Europe is cheap – European stocks are cheap – and they should get a lot cheaper, for the continent is barely out of the first inning of what could end up being an extra-inning ball game. Forgive the baseball analogy; it seems appropriate given how little baseball there is played in Europe and because baseball is the only major team sport that does not use a clock. And European political leaders have been acting as if a financial crisis does not have a clock – that time is an independent variable. Financial crises become economic crises when time is ignored as Europe and its leaders have done to date.
Ben Bernanke, Hank Paulson and Tim Geithner acted as decisively as they did during the financial crisis for they understood – and understood well – the importance of time during the crisis. The longer the crisis took to unfold without a sense of resolution, the more trust eroded. The word credit is derived from the Latin credo – the word for trust. They knew that. Europe has yet to learn that time, trust, and the availability all work in lockstep.
What happens next
My point? This crisis is going to get a lot worse – perhaps critical – before it gets better. That will put a whammy on business and consumer confidence, killing spending – and economic growth. The typical answer to short-term dips in confidence and spending is government spending. And that is being cut back. The fiscal policies demanded by Germany – and the irreversible math of unsustainable public deficits and debt – has pushed most countries into austerity mode, or at least what passes for austerity on the Continent. The economic slowdown caused by a lack of confidence is being exacerbated by cutbacks in government spending, which not only reduce the amount of income available to be spent but further weaken consumer and business confidence.
And, as economies slip into recession, revenues will fall, creating larger deficits that in turn require more austerity to get closer to being in balance. Fun stuff, eh?
This is only part of the equation – the other is the intractable political situation in countries that matter—Greece does not – and how local politics make all of this far worse for Europeans and for potential investors.
European voters, even more than in the U.S., do not want government monies to be spent on those evil twin pillars of capitalism, banks and business. At least I am separating them – voters typically lump them together. They will lose their mind if their banks need to be bailed out. But if the crisis is to be resolved quickly and permanently, that is exactly what must happen. As in the U.S., the heart of the crisis are banks – banks everywhere, banks in Greece, banks in Italy and yes, even banks in Germany.
Local banks have loaned money to their governments through the purchase of sovereign debt. To keep the money to governments flowing, central banks in each country and the European Central Bank (ECB) have said all sovereign debt is rated high enough for the banks to use it as collateral for loans from the ECB. The ECB is not allowed to bail out busted governments – but they can fake their standards and loan money to banks using the debt of busted governments as collateral. This is not a problem if governments can pay off those loans. Greece has failed to do so. Its voluntary restructuring of bonds was in reality a default – and Greece is small enough that capital has been made available, indirectly, to account for this default.
That is Greece – Spain and Italy are too big too fail, too big to bail out, and interest rates on their debt are rising because investors not backed by loans from ECB are demanding more for loaning them money. And, at some point in time – yes, time – those interest rates will rise to a point where the cost of serving the debt will become unsustainable for Spain and Italy. That is the end game.
What does that mean for investors? Europe is in recession and it is going to get quite bad, especially in Spain, Portugal, Greece and to a lesser extent Italy, but the entire Continent will see slow, no or negative growth for several years. Excuse me, several more years. Companies – European, American, Asian, whatever – with significant market exposure to Europe will suffer unless they have products purchased independent of recession, such as iPad or an Hermes scarf. And European banks will be re-capitalized with governments becoming large shareholders – even in Germany – in part because Europeans don’t mind their government owning banks. In fact, the banks probably the worst off on the entire Continent are the German state banks, the Landesbanks. Do not look at charts of crushed banks shares and think they are bargains. I remember debating Ben Stein– on television, it was fun – whether Fannie Mae and Freddie Mac were bargains during the crisis. He said buy, I said shoot them and put them out of our misery, they were taken over a week or two later. This was after Bear Stearns was bought for two bucks but well before Lehman Bros. went bankrupt. That was about the first or second inning of the financial crisis on our side of the pond.
Ignore charts, pundits out of their depth and the pull of the crowd screaming “Value.” Time is not on their side, it is on yours. Wait.