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At a recent conference hosted by a major global bank in London I sat on a panel alongside a macro investment strategist who referred to the euro as a ‘Trojan horse’ intended to force fiscal austerity on traditionally profligate countries such as Greece. While that is true, I believe there is also a second euro Trojan horse, this one intended to force through greater fiscal, banking and political integration, enabling the creation of a European ‘superstate’ to rival the US and China in economic and political power. What we are witnessing now is the inevitable battle between the two horses to win over German public opinion, on which the euro’s future most depends. In my opinion the battle will have several national casualties, resulting in a smaller but more competitive euro-area. While this could be negative for European government bonds, it could be supportive of stocks, eventually.
The Foundation of Euro Macro Strategy
Although my career in international finance began in New York, in 1995 I moved to Germany. By that time it was generally assumed that European Monetary Union (EMU) would begin, more or less as planned, in 1999. In my role as a macro investment strategist it thus became necessary to develop a methodology for asset valuation and investment strategy in the presumed future single-currency area.
This required first an aggregate economic statistical dataset for the future euro-area taking many months to develop, with the greatest challenge finding ways to harmonize differing national calculation methodologies for key aggregates. But by focusing as we did primarily on the larger prospective members: Germany, France, Italy, Spain and the Netherlands, the goal was nevertheless achievable and in early 1998 we presented our harmonization methodology, initial dataset, model suite and key investment recommendations on a ‘roadshow’ to major investors in Europe and around the world. (Subsequently I presented regular updates on these data and associated thoughts on European macro investment strategy on a financial television show jointly hosted by the Wall Street Journal and CNBC Europe, The Eurozone Barometer.)
Now it wasn’t exactly easy to get investors’ full attention in early 1998 due to the Asian currency crises unfolding at the time. Nor did it become any easier as the year went on. In August, Russia defaulted. In the fall, the massive hedge-fund Long-Term Capital Management blew up, with the Fed brokering a deal to contain the substantial potential fallout. But there was sufficient interest in EMU as a historic international monetary development that we nevertheless managed to get meetings with senior officials at many major central banks and other financial institutions who would be the amongst the largest future holders of euro-area sovereign debt. They wanted to know how to value and estimate the risks of such debt, issued by sovereign borrowers with the power to tax but lacking a national central bank to set interest rates and serve as a potential ‘lender of last resort’ in a crisis.
This unusual situation required a novel approach to asset valuation and risk estimation. How to determine debt valuations not only for the presumed benchmark issuer, Germany, but also the borrowing spreads to Germany for the other member countries? While it was easy to assume that those economies highly integrated with Germany and with a similar sovereign debt structure, such as the Netherlands, would trade at a minimal liquidity spread to Germany, what about highly-indebted Italy or Greece? At the time, Greece’s debt rating was barely above junk.
And so the process began to find some example or precedent to ground euro-area debt strategy and I found it in Canada, of all places. While in the US much debt is raised at the state and local level, the amount is nevertheless much smaller than the federal debt. Moreover, in the US there are large fiscal transfers to and from the federal to state and local authorities. Canada, however, was structured much more like the euro-area, in that provincial borrowing was large in proportion of the total public debt. Quebec in particular was a useful example as a province with both a large debt and also one at risk of seeking independence from Canada in future. Thus there was both an element of credit and possibly devaluation risk associated with the prospect of Quebecois independence—just what was needed for thinking about the future risks associated with the financially weaker euro-area sovereign borrowers.
As part of my research I traveled to Canada and met with both investors and issuers of central government and provincial bonds. I also had discussions with the ratings agencies to understand their methodology for determining Canadian provincial ratings. What I learned was that there were large perceived variations in provincial credit quality and it was thought unlikely that the federal government would come to the rescue of an over-indebted province. This helped to explain the relatively wide spread divergence. My initial conclusions were thus that, following the launch of EMU in 1999, euro-area sovereign spreads for relatively weaker credits would remain wide enough to compensate investors for the risk of a future funding crisis or possible withdrawal and devaluation. For high-quality sovereign credits however, spreads were likely to converge on German Bunds, although the latter would retain a liquidity premium as the benchmark securities providing the basis for euro interest rate risk management.
When asked by a Wall Street Journal reporter to place some numbers on these predictions, I suggested that Dutch government bonds would trade at low double- or even single-digit basis-point (bp) spreads to German Bunds. Italy, however, I suggested would need to pay from 50-100bp above Bunds in 10y borrowing costs. As it happened, while Italy did trade in this range in the first 1-2 years of EMU, spreads subsequently tightened considerably, falling into the low-20s by the mid-2000s. Spanish government bonds traded even tighter. Greece, joining with a delay in 2002, saw spreads tighten inside of 40bp by the mid-2000s.
This spread tightening was primarily due to what appeared to be a material, sustainable improvement in peripheral sovereign finances. Spain in particular achieved a dramatic decline in public deficits and debt by the mid-2000s. The ratings agencies rewarded Spain, Italy, Ireland and Portugal with upgrades. Greece was also rewarded, although we now know that much of the ‘improvement’ in Greek finances was due to opaque swap structures that disguised the true size of the official deficits.
As the Periphery Lost Competitiveness, the Potential Crisis Grew Larger
At the time I was among those who were skeptical that these peripheral fiscal improvements were sustainable. While regional property and stock markets were booming, reflecting widespread economic optimism, in fact the entire southern periphery of the euro-area was becoming less competitive. Real unit labor costs, while holding stable in most of the euro-core, were rising rapidly in the periphery, harming competitiveness. Indeed, by the mid-2000s, Germany had undergone nearly a 20% real devaluation of wages relative to the periphery. In the past, such large swings in real effective exchange rates between European countries had triggered currency crises, as in 1992 and 1995, for example. The ‘Trojan horse’ of stable money, intended to bolster rather than erode peripheral competitiveness, was failing in its mission.
This, alongside booming, bubble-like peripheral asset prices led me to recommend to clients, beginning in mid-2006, to initiate short positions in Spanish and Italian government bonds. The cost of doing so, either outright or through credit-default swaps (CDS) was so low it was a cheap option.
The Lehman Brothers ‘EMU Breakup Probability Calculator’
In order to support this investment recommendation I constructed an ‘EMU breakup probability calculator’, which I presented to the Lehman Brothers Annual European Hedge Fund conference in fall 2006. The idea was the following: In the event that a country withdrew from EMU, reintroduced a national currency and devalued to the point of reversing the entire rise in the real effective exchange rate vis-à-vis Germany, what borrowing spread would fully compensate investors for the devaluation? By then comparing this implied spread to the actual, market spread it was possible to calculate the implied breakup probability.
At the time, due to narrow spreads, the implied probabilities that Italy, Spain, Portugal or Greece would leave EMU within five years were tiny, sub-10%. I then asked the audience if they thought that this was a fair pricing, with only a few hands rising in response. Far more hands went up when I asked if they thought the probability should be higher.
The most interesting part of the ensuing discussion was when I asked those investors who thought the pricing was fair why they held that view. Universally they held that, in the event of a peripheral sovereign debt crisis, some combination of the ECB and EU would come to the rescue. Bailouts would be forthcoming, notwithstanding their explicit prohibition under the 1992 Maastricht treaty. These investors thus had strong faith that, while a crisis might indeed be on the way, the second euro Trojan horse would prevail in any future battle with the first.
It was less than a year before spreads began to widen, slowly at first, then spectacularly as the events of 2008 unfolded to the horror of those who had been riding on and profiting from the euro-area ‘convergence trade’. And yet, as some of those fund managers had predicted correctly, the ECB and EU did come to the rescue, albeit in exchange for varying degrees of ‘austerity’. And so the first phase of the Trojan horse battle ended in something of a stalemate.
The Second Trojan Horse Counterattacks, but Will Fail
The recent Greek elections and subsequent attempts by the new government to substantially renegotiate the terms of the 2010 debt restructuring with their EU counterparts threaten to break the stalemate. While debt forgiveness for hopelessly over-indebted Greece is entirely reasonable, to proceed in this way would provide a precedent no doubt highly desirable for other over-indebted euro members, present and future. With their support, in time a more formal mechanism of automatic transfers and universal euro-area bank deposit insurance could follow.
Thus those who have always pinned their hopes on a sovereign debt crisis catalyzing a major step towards greater political union see a huge opportunity in Greece. But this counterattack by the second euro Trojan horse forces against those of non-inflationary fiscal sustainability is highly risky, because it takes the fight to what is the ultimate support for the euro itself: German public opinion, sharply divided over the issue, which cuts across traditional party lines and is thus difficult to control.
The importance of German public opinion cannot be overstated. Without this support, the euro and possibly even the EU will fail. There is no other large, successful economic anchor for the common market and currency. France has become the elephant in the EU room no one will talk about: Its economy is in structural decline. One can easily imagine the EU surviving the withdrawal of one or more members but if Germany goes, the EU as we understand it today could well dissolve entirely.
Some fear that Europe would then descend into the perennial nationalism that has plagued Europe for centuries: The German Reformation; the Dutch Revolt; the 30yrs War; 1848; the Napoleonic wars and the dismemberment of the Austrian and German empires post-WWI that would lead to the supremely devastating WWII. In my opinion it is difficult to imagine how, in an age of nuclear weapons and unprecedented economic and social integration, Europe would today choose to take such a suicidal course. Those warning that a German refusal to fund euro bailouts will result in WWIII are scaremongering in my opinion, not to be taken seriously. But the fact remains: The survival of the euro ultimately rests on the support of German public opinion.
To be sure, the new Greek leadership understand this: They launched a clearly well-planned German public relations campaign the moment they assumed office. This included pulling some emotional strings, such as reminding the Germans of the devastation they wrought on occupied Greece in WWII and of Germany’s own devastation and substantial debt forgiveness during and following the war. They are doing all they can to win over an understandably skeptical German public wary of anything that could add to the moral hazard they increasingly suspect was created along with the euro in the first place.
In my opinion, however, the irresistible force of Greece’s demonstrably unserviceable national debt will soon meet the immovable object of German public resistance to further, arguably undemocratic European integration. If so, then in the long battle between the two euro Trojan horses, Greece will default, withdraw and devalue, and those fighting for greater integration will have tried and failed to cross a bridge too far by forcing a common currency on a community of nations that simply did not share a sufficiently common economic and political culture to enable it to succeed. If there is not a retreat soon by a core group of euro members that can close ranks around a defensible position of low public debts and deficits, the entire project is at risk of failure.
Strategies for a Euro Restructuring
In all probability, the euro-area must therefore either shrink, or dissolve entirely, placing the EU itself at risk. In any variation, this will initiate a series of major macro events not only in Europe but around the world; a cascade of crisis-driven opportunities for those who establish the right positions in advance.
First, if and when Greece faces the music, defaults and/or withdraws and devalues, this will trigger a general peripheral earthquake that will shake loose multiple other member countries, possibly including Spain and even Italy. No, that won’t be the end of the world for either—remember they’ve been through far worse over the past century—but it will lead to substantial losses for those investors directly exposed to their domestic bond markets. Their stock markets should fare somewhat better by comparison, as the devaluations will help to restore competitiveness and profitability. Keep in mind, however, that corporate debt servicing costs will rise along with domestic interest rates generally and leveraged corporations competitive in a low interest rate environment might find they struggle to service debt, much less generate profits amid higher rates. Also of serious concern for these stock markets is that capital controls are imposed for a time. This has been the case in Iceland and Cyprus, for example, and is almost certainly going to be the case with Greece before long.
Second, large German, BeNeLux and French banks are going to take a huge hit, highly exposed as they are to the periphery, if no longer through large holdings of government bonds, then through the interbank or corporate loan markets. In multiple cases I expect banks to be partially if not completely nationalized. This will require increased sovereign debt issuance. But as long as the ECB stands ready to provide the necessary liquidity assistance, as I believe it will, then this need not have a material impact on government bond yields.
Third, the bank recapitalizations within the euro-core will place temporary downward pressure on the euro relative to other major currencies. (The UK may well find its banks need another round of recapitalizations too.) I say temporary because the leaner and meaner euro-core will run a large trade surplus, implying future currency strength.
Fourth, and here I will speculate a bit more freely, I honestly can’t imagine that the above could possibly unfold without multiple large macro hedge funds being caught blindsided in leveraged, positive-carry trades of various kinds. Long-Term Capital Management was taken out by the aftershocks of the Russian debt default of 1998 and, given far higher overall system leverage today and the risks associated with modern financial weapons of mass destruction, including ‘collateral transformation’, I would expect the interbank markets in not only euros but also in sterling, dollars and possibly even yen to seize up in varying degrees, with wide-ranging implications for liquidity generally. This nearly occurred in 1998; it did occur in 2008 following the Lehman bankruptcy. While I’m not claiming that a euro restructuring will necessarily trigger something as spectacular as 2008, the possibility certainly exists. In any case no two crises look exactly the same and for all I know things could well be worse, especially in the event that not only Spain but also Italy decide to default and/or withdraw, re-introduce national currencies and devalue.
Regardless of its magnitude, this cascading liquidity shock would infect risky assets across the board. Sure, central banks would respond, pumping reserves into their respective banking systems. But the velocity of these reserves could well be even lower than in 2008. Governments might then step in to provide various forms of direct financial assistance to their financial systems and possibly even large non-financial corporations. But in some countries they would almost certainly meet with some resistance, given how the public in many countries has come to believe—quite rightly in my opinion—that similar actions in 2008-09 favored the wealthy and well-connected over the working middle-class.
What happens though, when the government in question is broke, as Greece admits? One mooted possibility is to seek financial support from Russia or China, which really opens Pandora’s geopolitical box. Might not only Greece but other euro members in debt trouble seek assistance in Beijing and Moscow, if debt forgiveness is not forthcoming from Brussels or Berlin? As it stands now, the EU is already split over how to deal with the situation in Ukraine, which threatens to escalate into a major military confrontation between NATO and Russia, right on the EU’s doorstep. Imagine how it would complicate things were one or more EU members to cozy up to Moscow, in particular those that are also NATO members. The entire European post-WWII settlement and associated institutions could be at risk.
Germany and France appear to have sensed the danger and recently broke ranks with the US, seeking to find a way to de-escalate the situation on their own initiative. The result was the second Minsk accord. Many defense analysts are skeptical that it will hold, and rightly so. Just this week there is yet another dispute over Russian gas supplies to Ukraine, which Moscow threatens to cut off if it is not assured that gas will continue to flow specifically to the breakaway regions of Luhansk and Donetsk.
[Related: Geostrategic Implications of a Grexit]
This context makes it increasingly likely that at a minimum Germany and France and probably other EU member countries will consider it necessary to increase their defense budgets in the coming years, as they sense an urgent need for a strategic deterrent independent of that provided by the US via NATO. But financing larger defense budgets alongside likely bank recapitalizations and other burdens associated with sorting out the mess the euro has become will only serve to increase the debt. Notwithstanding Germany’s prodigal economic and export competitiveness, should rational investors really accept near zero bond yields for the myriad risks associated with the future of the euro: economic, political and even national security?
The better bet is to take a good look at quality European companies trading at what are low valuations when compared to their US or global counterparts. Yes, the German stock market may be at an all time high, but with the euro now somewhat weaker and with the valuations of some peripheral markets clearly distressed, there are almost certainly opportunities. As written above, I consider it highly unlikely that even a general breakup of the EU would result in a return to pre-21st century conditions of rabid nationalism and war. Indeed, one could argue that it would ignite a period of more aggressive competition amongst European countries to attract foreign and retain domestic capital with a general rationalization of economic policies. The structural reforms associated with austerity seen to date may only be the beginning of a more thorough European economic renaissance.
Am I being too optimistic? Perhaps. But economic competition is without question a good thing. People used to believe the EU promoted it. Many now believe the opposite. Perhaps a good shaking up of European institutions is exactly what is required to unleash some healthy, Schumpeterian creative destruction. As long as it is not of the militaristic variety, investors in European companies would almost certainly benefit from it.
If you would care to comment on this report or to learn more about Amphora please feel free to contact me at: john.butler @ amphora-alpha.com
 In my opinion much of which is presented as ‘austerity’ is really just a slowing or stabilisation of expeditures, rather than real cuts. If you want to know what real austerity looks like, Bulgaria is a prime example. See here for a description.
 I have long held that were only Germany, the BeNeLux, France, Austria and Finland to have formed the initial monetary union, this would have incentivized the periphery to implement far more thorough structural reforms to improve competitiveness prior to joining at some unspecified point in the future. While this would have resulted in a more sustainable currency union I appreciate that, EU politics being what it is, this idea just couldn’t fly politically in Brussels. It may yet see its day, however.
 George Kennan, arguably the most famous and influential American career diplomat of the 20th century, warned many years ago of the grave danger of expanding NATO eastwards, with a specific warning not to include Ukraine. He claimed this would result in a new Cold War and possibly something even worse. So far he has been spot on. Kennan’s prescient warning can be found here.
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