Don’t Invest in Europe’s Debt

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Talk about an interesting contrast. There were two different but important investment stories over the weekend. But only one of them got any real press coverage. Not surprisingly, the one that didn’t get much coverage is the story that could make 2012 a much better year for Aussie investors than 2011. But for old time’s sake, let’s start with the old news.

Europe is sinking. On Friday the 13th, Standard and Poor’s cut the credit ratings of nine European countries. S&P’s biggest scalp was France. France has lost its AAA credit rating and been put on a “negative outlook”; the financial equivalent of the naughty corner.

The downgrades weren’t all that surprising. After all, on December 5th 2011, S&P warned the Europeans to get their divided house in order. Almost nothing constructive or helpful to solve Europe’s debt problem has happened since then. In the currency markets, the euro made new lows against the Australian dollar.

In its Friday announcement S&P said, “Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policy makers in recent weeks may be insufficient to fully address ongoing systemic stresses in the euro zone.” You don’t say?

Austria was also relieved of its AAA rating in Friday’s action. This poses a problem for Europe’s bailout fund, the European Financial Stability Facility (EFSF). France and Austria have signed up to provide about €180 billion to the EFSF. Subtract €180 from €440 (the original total funding of the EFSF) and you get €260 billion – the current capacity of the fund minus French and Austrian contributions.

Remember, though, that the EFSF is already on the hook for contributing €130 billion to the second Greek bailout (because the first bailout of €109 billion worked so well). That would leave the fund with €130 billion to bail out the rest of Europe, which hardly seems like enough at this point. It won’t be long before the EFSF has its own credit rating cut.

Incidentally, the Greek’s had their own mini-crisis on Friday. The Greek government is in talks with private creditors to restructure Greek debt. Because creditors are talking about taking a voluntary 50% loss on their government bonds, a deal would not result in a technical default. It would, however, reduce Greece’s total government debt by about €100 billion and unlock the next €130 billion in bailout funds.

The trouble is, talks between Greece and its creditors broke down on Friday. A large chunk of Greek debt matures in mid-March. But it’s possible the Greeks could default before then. That would certainly spice things up. And in any event, even if the current restructuring deal is reached, it would only reduce Greek debt from 160% of GDP to 120% of GDP.

In other words, the Greeks – and all of Europe – still have the problem of how to grow out of decades of Welfare State debt. This is especially hard when the Welfare State and the common currency have rendered huge parts of southern Europe economically uncompetitive, with high youth unemployment, poor demographics, and large government debt burdens.

You’ve heard all that before, though. In fact, all of this is old news for the equity market, which is why we don’t expect the Aussie market to react much today. We could be wrong, of course. But Italian and Spanish banks were down last week in anticipation of the S&P action. What’s more, the Long Term Refinancing Operation (LTRO) by the European Central Bank (ECB) late last year was designed to make the EFSF less important. How?

The ECB hopes that if banks can refinance long-term loans for 36 months with the ECB, it will ease liquidity concerns in Europe’s banking system. That might inspire the banks and private investors to buy up government bonds. And you don’t need a bailout mechanism (EFSF) if the banks and private investors are willing to buy European government bonds again.

But why would you buy European government bonds right now? You wouldn’t! You’d rather invest in the asset class that’s going to be behind the next 50 years of growth. It’s not debt. It’s energy. Just ask the Chinese and the Saudis.

Regards,

Dan Dennning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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