Just when you think things could not get worse for Europe, over the past few weeks much of continent has had to endure one of the harshest cold snaps in decades. A recent article in Canada’s National Post recounts some of the damage: 68 people dead in Poland due hypothermia, eight people drowned in a frigid river in Bulgaria after ice broke a dam and a village was washed away, more than 100 people have died in the Ukraine (Source). While many of the weather-related deaths were in some of the poorest parts of the continent, cold weather is also impacting some of the more prosperous countries.
Rome recently experienced its second day of snow in the last 15 years, which caused a closure of the Collosseum. France—where many homes are heated by electricity—set a record for electricity consumption in a single day, which resulted in a spike in electricity rates and natural gas prices (Source). In the UK, gas prices recently reached their highest levels since 2006 due to increased demand which rapidly drew down storage levels.
It is not just the weather that is to blame for the spike in natural gas prices. According to a recent Associated Press story, Russian energy giant Gazprom reduced gas exports to Europe in order to increase supply to domestic consumers. While securing sufficient gas supplies for the remainder of the winter will be a major priority, Europe has more pressing problems. In this issue, I will provide an update on the continent’s other major dilemma, its solvency crisis. I will also review the likely consequences of the torrent of cash that is being unleashed by the European Central Bank (ECB) in its effort to prop up the continent’s economy and how investors can profit from this ongoing money printing.
In what may be a prelude to the upcoming funding crisis in the U.S. and Japan, Europe’s debt woes show no sign of ending. Though the European Central Bank has promised its second long term refinancing operation (LTRO) (basically back door money printing even though the ECB does not call it money printing) that is rumored to be up to 1.2 trillion euros near the end of February, printing more money is not going to fix anything.
The Greek economic tragedy continues to grab headlines and remains a main driver behind much of the volatility in many of the world’s markets. The February 9th announcement that the IMF, ECB and European Union have agreed to supply Greece with an additional 130 billion euros to bailout the country, should it agree to additional austerity measures, which it will never meet, is a complete farce. Even in the unlikely event that the Greek parliament and every European Currency Union member approves of the bailout package, which includes cutting the minimum wage by 20 percent and firing 20,000 public sector workers in return for partial debt relief, Greece will still be overleveraged. The country, which is slipping into a hyperinflationary depression, saw its unemployment rate increase to 20.9 percent in November 2011 up from 13.9 percent in November 2010 and its industrial output contracted 11.3 percent in December of last year, according to a recent article in the Wall Street Journal. Additionally, in 2011, bank deposits in Greece declined 18 percent. There is simply no way out for the Greek economy from its current overleveraged state without a complete and messy default on all of the country’s debt.
Unfortunately for the ECB, Greece is not its only member country that is insolvent. The economies of Portugal, Ireland and Spain are caught in death spirals for which there is no way out. Many in the bond markets continue to watch how the Greek debt issue is resolved since it is widely believed that Portugal is the next country that will be in need of a second bailout. In late January, yields on Portugal’s 10-year bond jumped to a euro-era high of 17.4 percent but have fallen in recent days to just under 14 percent after German Finance Minister Wolfgang Schaeuble was caught on camera at a recent meeting of euro-zone finance minister saying that Germany would consider an adjustment to Portugal’s bailout package once the euro zone had agreed on the terms of second bailout package for Greece. Here is picture of the 10-year and 2-year yields for Portugal over the past couple of years:
Source: WSJ
While the drop in yields in recent days indicates there is some time before the country is forced into default, Portugal’s unemployment rate reached a record high of 13.6 percent in December 2011 up from 12.4 percent in the year ago period according to European statistics agency Eurostat. Also, Portugal central bank estimates the country’s economy contracted 1.6 percent in 2011 and is on track to contract another 3 percent in 2012. No matter what euro-zone leaders might say, Portugal cannot afford to pay double-digit yields at a time of economic contraction. A massive restructuring of the country’s debt is the only answer.
After the Irish government guaranteed the obligations of the country’s six main banks in September 2008—which has amounted to over 100 billion euros—and provided direct capital injections of 3.5 billion euros to both Allied Irish Bank and Bank of Ireland in February 2009, the government itself required a bailout. Largely as a result of its largesse towards its banks, the EU and the IMF were forced to bailout the Irish government to the tune of 85 billion euros in November 2010. Similar to the bailout packages for Greece and Portugal, the money from the EU and the IMF came with plenty of conditions. One of the main conditions was that the Irish banks rid themselves of 70 billion euros of assets—largely real estate loans that have gone bad—by 2013 through selling assets into the market and running down their loan books. According to a recent article in Reuters, the banks are about half way through the process as of the end of 2011.
Now comes the hard part. Though Ireland was held up by German Chancellor Angela Merkel as a “superb example” of how a country can work its way out of a debt crisis, the country saw its gross national product (GNP)—which strips out the earnings of Ireland based multi-nationals—decline 2.2 percent between July and September 2011. Additionally, with unemployment hovering around 14 percent and the country’s export growth expected to slow sharply in 2012, it is unrealistic to expect Ireland banks to shed another 35 billion euros of assets by 2013 without another bailout. The country will likely be forced to nationalize its banks and default on its existing debts sometime in the next 24 months.
To put into perspective how difficult it will be for Irish banks to rid themselves of real-estate loans gone bad, consider the case of Chicago’s Spire lakefront tower. In 2006, Anglo Irish Bank loaned Garrett Kelleher, an Irish national who got his start in Chicago real estate while managing his house painting business in the 1990’s, million to purchase the land along Chicago’s Gold Coast to build a 120-story ultra-luxurious condominium project. The project is now dormant and Anglo Irish’s loan is virtually worthless. While the Spire may be one of the highest profile projects to flop, I suspect it to be representative of the quality of loans in the portfolios of Ireland’s banks.
Anyone who thinks Europe can muddle along indefinitely through temporary fixes should take a hard look at the problems facing Spain. The country’s National Statistics Institute recently announced that 5.3 million of the country’s citizens are now unemployed. Spain’s unemployment rate, which now stands at 22.8 percent, is the highest in at least 17 years. Similar to Ireland, the country is now recovering from an epic real estate bubble. GDP contracted .3 percent in Q4 2011 as austerity measures and shrinking credit are pushing the economy into another recession that may be rather severe. According to a recent Bloomberg News article, lending fell at an annual rate of 2.9 percent in November 2011, the biggest drop since the Bank of Spain started keeping records half a century ago. Irrespective of whether new Prime Minister Mariano Rajoy is able to get Spain banks to adequately increase reserves against 175 billion euros of troubled real estate assets and get them lending again—an unlikely scenario—credit is certain to tighten further in the country as banks try to shore up their balance sheets.
Even France, a country that many consider central to keeping the European monetary union (EMU) together, is well on its way to further downgrades and financial difficulties. Should socialist Francios Hollande defeat Nikolas Sarkozy in the country’s upcoming presidential election, its fiscal problems are certain to get worse. Hollande has promised voters more deficit spending by increasing outlays for social programs and will attempt to pay for this additional largesse by raising taxes on workers in the private sector. Good luck with that.
Despite efforts by David Cameron over the past two years to reduce the UK’s budget deficit through tough austerity measures and get the economy growing, the country’s economy continues to struggle. Unemployment is at a 17-year high, 1 percent GDP growth is forecast for 2012 and inflation remains over a 4 percent annual rate, down from a peak of 5.2 percent in September 2011. After posting a deficit of 10.6 percent of GDP in 2010 and a similar amount in 2011, slow growth, inflation and austerity measures will make it very difficult for the British government to meet its goal of eliminating the deficit by 2015. Additionally, the country’s enormous cost to bail out its banks puts it debt at an unsustainable level of nearly 150 percent of GDP when support to financial institutions is included. Below is a chart displaying how costly the bailout of the Royal Bank of Scotland, Northern Rock, Lloyd’s and others was in terms of additional debt for taxpayers:
Source: https://www.economicshelp.org/blog/334/uk-economy/uk-national-debt/
[Note: The U.S. debt-to-GDP ratio would be over 130 percent instead of approximately 100 percent if Fannie Mae and Freddie Mac debts were consolidated onto the U.S. federal government’s balance sheet.]
There are several important take-aways from Europe’s winter of discontent that investors should pay close attention to. First, Europe is a great example of how natural gas prices can spike to devastating levels at times of significant economic weakness. Though the combination of bitter weather and reduced imports caused prices to spike throughout Europe, gas prices had largely recovered to their pre-2008 levels even before the spike occurred. Below is a chart of UK gas between 2007 and mid-2011:
Source: https://blogs.telegraph.co.uk/finance/rowenamason/100011174/what-now-for-gas-prices/
Now that the drilling of woefully uneconomic shale gas wells is coming to an end in the U.S. (see the February 1 issue for more information), I fully expect North American prices to return to their pre-2008 crash levels and be susceptible to violent weather related spikes similar to what Europe experienced in recent weeks. Second, Europe’s gas crisis is an excellent example of the limits of reliance on LNG imports. Italy, Spain, Germany, France, Belgium and the UK have all built a huge fleet of LNG import terminals in an effort to increase imports of Middle Eastern natural gas and reduce their reliance on Russian gas. However, even with Qatar’s export capacity up to its maximum rate of 10.4 bcf/d, the world LNG market continues to tighten. With Japan significantly increasingly its imports after the Fukushima disaster, Australia still several years away from becoming a major exporter of natural gas and numerous countries—such as the U.S.—under the delusion that they will be able to import material amounts of LNG when needed, I see world LNG prices continuing to rise over the next several years barring a worldwide depression.
Lastly and most importantly, Europe’s winter of discontent should be a clear sign that investors should position themselves to profit from money printing. With the ECB, the Swiss National Bank and the Bank of England printing vast quantities of money, hard assets, such as oil and gas and precious metals, are nearly certain to outperform every other investment class over the short and medium terms. It is not just Europe’s central banks that are printing money. Both the U.S. and Japan are running enormous fiscal deficits and are showing no signs of bringing spending down to levels that will allow for the avoidance of a complete loss of confidence in their respective currencies.
