While Trump’s tweets grab the headlines, Europe’s perils are becoming harder to ignore. Greece’s fiscal follies have surfaced once again, but that’s not the EU’s biggest threat at the moment. That award goes to Italy’s banks.
Currently, around 18% of Italian bank loans are nonperforming. For some context, nonperforming loans in the US only reached 7% at the height of the 2008 financial crisis. The same level of bad loans in the US banking system would equal $3.8 trillion.
Political will has forestalled these problems for the last seven years. However, with German Chancellor Angela Merkel the only member of the old guard left standing, 2017 could be the year the EU collapses under its own weight.
As George Friedman has stated, “The EU is merely a treaty between nations, not a federation. As such, there is nothing holding it together except the promise of prosperity. When that prosperity is no longer forthcoming, people will leave.”
So, what does an EU breakup mean for the future of the Continent’s economy?
De-Facto Defaults
As uncertainty about the EU’s future grows, European bonds will sell-off sharply. During the 2011 European debt crisis, yields on sovereign debt spiked to record highs. This effectively locked countries out of credit markets. Defaults were only averted because the IMF and ECB stepped in.
Europe’s problems are now much larger, and bailouts won’t hold the EU together during the next crisis. So, how might this mess play out? As history has proven, governments prefer soft defaults over hard ones. Therefore, re-denomination back into national currencies is the likeliest outcome.
To avoid a hard default, fiscally weak nations—like Italy and Spain—could markedly devalue newly issued currencies. While creditors will be paid, it won’t be to the value of what was agreed upon.
After new currencies are created, bank deposits would be automatically converted. With estimated devaluations of 60%+, the value of savings would be destroyed overnight. Capital controls would have to be enacted to halt bank runs. This would be akin to what happened in Argentina in 2001.
For fiscally strong countries like Germany, things may play out differently. If reinstated, the Deutschmark would likely appreciate. This would actually benefit Germany as it would lower the value of their liabilities. However, given their huge credit exposure to weaker nations, they wouldn’t escape unscathed.
There’s another major issue for the Germans—trade. Germany exports 47% of its GDP, and most of that is within the Schengen Area. This area has no border controls and stretches the length of Europe, covering some 420,000,000 people. As a member, Germany can export throughout the bloc without the added cost of tariffs and other trade restrictions.
As detailed above, there would be severe economic implications for European nations if the EU collapsed. In such an event, it’s likely that countries will take steps to protect domestic industries, like reinstating borders and tariffs. This would raise the cost of trade, thus lowering demand for exports. The fact that every 10% drop in Germany’s exports means its GDP would fall roughly 5% is cause for concern.
Having explored how a collapse may play out, can investors profit from this scenario?
Investment Implications
The global economy is tightly connected, so nowhere will be completely sheltered from the collapse of the world’s largest economic bloc. However, some markets will be hit harder than others. As European assets will be shrouded in uncertainty, avoiding them is prudent. This includes equities, bonds, and currencies.
US markets will probably be the main beneficiary of Europe’s perils. Firstly, the US has small trade exposure to the EU. Exports only account for 13% of US GDP. Of this, around 50% is with NAFTA partners.
Also, US financials have reduced their European liabilities since the 2008 crisis. Currently, the top 10 US banks hold $1.7 trillion in liquid assets. Those same banks have around $700 billion in exposure to the EU (excluding the UK).
Besides having limited exposure to the problem, US markets will likely experience massive inflows as investors search for safety amid the chaos. This trend has been in motion since the US elections.
Looking at US equities, avoid those that have large exposure to Europe. This includes companies like McDonald’s and Coca-Cola who generate around 40% of their revenues from the Continent. It could pay to focus on firms that earn a large portion of their revenues domestically.
Since the US election, the share price of firms that get 90% or more of their revenue from inside the US have gained 5.2%. Those with large exports have only edged up 2.2%. Small caps tend to generate most of their earnings domestically.
Since November, the S&P SmallCap 600 has gained 15%, while the S&P 500 is up 9%. January’s Global Fund Managers Survey also found that a record number of respondents think small caps will outperform large caps over the next 12 months.
Source: Bank of America Merrill Lynch
Another asset class that investors should consider is Peer-to-Peer (P2P) lending. P2P lending is a new method of debt financing that lets individuals borrow and lend money outside the formal banking system.
The P2P sector has grown rapidly in recent years and is an excellent new source of fixed income. In 2016, P2P investors earned net annualized returns north of 7%. Even those who took the most conservative approach saw returns of at least 5%.
The industry is also home grown. It doesn’t have to fret about potential shocks from a breakup of the EU as P2P lending platforms only cater to US borrowers and lenders. While the headline returns may be enough to entice you, there is much more to learn about P2P lending.
Investors should also consider adding gold to their portfolios. The yellow metal is up 8% since the US election. Nicknamed “the fear trade,” gold has performed well in times of uncertainty. Coincidently—or not—gold reached its peak of $1,896 amid the EU debt crisis in 2011.
Prepare Your Portfolio Before It’s Too Late
With Europe’s problems melting up, it could be a good time for investors to recalibrate their portfolios. PIMCO and Blackrock, two of the world’s largest asset management firms, are both currently overweight US equities.
While no market will be left unharmed, given recent signs of strength, US exchanges look set to benefit from ‘’the continents’’ demise.
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