Europe's two tipping points

PORTFOLIO POINT: Crunch time comes to Europe on the economy and on energy. The decisions of the continent’s leaders in the coming weeks will have crucial importance for years to come.

With fears that the US might be re-entering recession, worries over the strength of fiat currencies and concerns surrounding China’s model of economic growth, it’s no wonder that market volatility, as measured by the Chicago Board of Options Exchange’s VIX index, closed last week at a higher level than any since the GFC.

But beyond secondary queries about Ben Bernanke’s upcoming speech at Jackson Hole, Wyoming –the latest spat of market volatility ultimately comes down to one question: will the European Union do what it takes to keep its weaker banks and member countries from failing?

That the EU has the ability to do so should not be questioned – when taken as a percentage of the region’s €13 trillion aggregate GDP the bailouts in question are wearable – but it’s the willingness and readiness that’s under a cloud.

In recent days, German Chancellor Angela Merkel and French Prime Minister François Fillon have hosed down calls to create a system of “Eurobonds” (shared sovereign debt obligations) to provide a single pricing point for European government credit.

Eurobonds have been proposed to eradicate the spread between German Bunds, seen as the de facto risk-free benchmark for the region, and yields of peripheral government debt instruments, notwithstanding the existence of the newish European Financial Stability Facility (EFSF) (which may be upgraded slightly to something called the European Stability Mechanism (ESM) and the Euro-Plus Pact (EPP), also known as the Pact for the Euro.

France and Germany have balked at the idea, saying that such a measure would hurt the most hard-working of European economies, punish thrift and prudence, and push up borrowing costs. Current measures however, including the EFSF/ESM, which aims to assist eurozone states in economic difficulty with a €440 billion, possibly up to a €500 billion line of credit, and the austerity measures of the EPP, have not been enough to keep so-called “bond vigilantes” at bay.

First, there are concerns that the EFSF/ESM is not enough for the collapse of a major, or several minor, economies. Of the EFSF’s existing war-chest, €120 billion has been provided by Germany and €90 billion by France, but despite their own alleged risk of default, €79 billion and €52 billion has been pledged by Italy and Spain respectively. Is this a case of a failed bank writing its own cheque?

Second, there are serious fears in the case of the EPP that austerity measures will actually make the crisis worse, dragging down any chance of sustained recovery and miring Europe in a Japan-style state of near-recessionary paralysis that could last for years if not decades (see The long deleveraging). Angela Merkel’s "hard and arduous path", as she described it on Sunday, could be less a heroic struggle, worthy of Germanic saga, than a dead-end.

But this challenge, while great, is not the only one facing European leaders today. Below the European Union’s southern limits, a six-month civil war in Libya is facing its own day of reckoning with rebel forces last night entering the suburbs of the nation’s capital, Tripoli.

Coupled with the recessionary concerns in the market over Europe and America, this is likely to lead to lower oil prices, as Gaddafi’s last oil refineries come under rebel command. Yet what Europe also knows is that this could be a pyrrhic victory on two fronts.

On one side, it is highly probable that Libya’s rebels are not the peace-loving children of Voltaire and Jefferson that Europe and NATO have hoped. The assassinations of prominent leaders within their ranks signal tribal and religious divisions, not unity, in a post-Gaddafi state.

On the other, it is highly possible that a rebel victory in Libya will give a second wind to the wider Arab uprising, which could again threaten other Middle Eastern oil-exporting states. Add to that the likelihood of governments in Syria and Yemen falling in the coming months and worries of a “domino effect” – whether real or imagined – could make energy both more difficult and more expensive for Europe to come by.

And here, at the interface of Europe’s economic and energy troubles, is where we might infer Europe’s next move and make some guesses as to market direction. Europe was created as much to provide a balance to the then Soviet Union as it was to prevent the types of wars that plagued the continent in the first half of the 20th century. To drop the ball on energy policy or economic integration then, the European project runs the risk of running afoul of its original aim: prevent Russian dominance.

Russia is hardly in a position to dominate Europe economically, with its own fiscal imbalances plus even greater problems of industrial inefficiency and demographic decline. But with the Middle East possibly entering a new period of turmoil, it is in a position to reassert itself on the energy front, considering that it is the world’s alternative energy superpower and that the three pipelines being built into Europe either originate in Russia or Central Asian states within Russia's sphere of influence.

For the first time since the Saudi-led economies of OPEC made a deal with the United States in the 1980s to provide oil at sustained, cheap prices – ruining Soviet finances in the process – has Russia been at such an advantage to reclaim its geopolitical birthright.

Russia has the world's largest reserves of natural gas and, outside the Middle East, it has the world's largest share of oil reserves after the tar sands of Canada and the disputed figures of Venezuela. Russia comes second to Saudi Arabia in total fossil fuel exports and first in excess primary energy production, at 23,617 trillion BTU, taking into account such things as nuclear and hydroelectric energy.

The European Union, by contrast, comes second only to the US for total oil and gas consumption per annum, yet without the reliable and stable reserves of Canada and Alaska to the north, or the Gulf of Mexico to the south. And despite the EU's world-leading policies on carbon and energy efficiency, Europe will continue to operate a dangerous energy deficit for many years to come.

These facts, along with fiscal and banking solvency, occupy the minds of Europe’s leaders more than any other and this is why I believe Europe will ultimately move constructively to seek closer integration and economic cooperation despite the opposition of its populace. And although I don’t believe this will lead to a particularly dynamic continent, or one that will drive global economic growth of the coming years, I do believe it will mean disaster will be diverted, whether that’s through Eurobonds or a European fiscal union (see Continental drift).

The European fear of being divided in the face of Russia should ultimately trump the fear of being taken for a ride by profligate member states such as Greece, or paying a slightly higher yield on the international money markets. The fear of allowing an internal funding dispute to end a 50-year project of closer economic and political cooperation should therefore concentrate minds in both Brussels and Berlin.

Yet these are “shoulds” and while I believe these things will happen, until they do I expect the markets will remain skittish and I believe you should be cautious in how you invest, lest Europe not make the right decision (as it tragically has too many times in history) and go down the path of populism, leading to the collapse of the euro or even the collapse of the EU.

As for energy, while I believe oil prices will slide this week, I am still an oil bull in the medium to long-term, even if consumption does fall temporarily on the back of deleveraging and recession. The Middle East remains at risk of increased, not decreased, volatility and the shortfall is hardly going to be picked up by Russia, Venezuela or any other exporter for below-market prices.

Either way, it’s crunch time for Europe’s leaders, lest it be crunch time for Europe itself. Considering the magnitude of the issues we face, it’s difficult to provide directional strategy other than to avoid being in the market if you can.

While certain deep-value and small-cap equities will retain attractions, recent falls in global markets and the risks of a fresh banking crisis suggest that further declines are possible. Similarly, while gold is looking overbought and US Treasury yields are stupidly low, it’s hard to see “risk” plays such as commodities or the Australian dollar rebounding without clear positive news from Europe.

The next week could, economically, be one of the most important we’ve had in recent years. If you are looking for clues as to which way the markets move next, I urge to watch the news.