Macro: Will Europe tear us apart, again?

Despite the Joy Division reference, things have been rather upbeat lately. The US recovery continues; many recent Buy recommendations are surging, some after years of waiting; Our China warnings of three years back are bearing fruit; And the performance of our two model portfolios continues to beat the market. We've even got a new website in the offing.

So in the true spirit of Intelligent Investor, let's throw a spanner in the works and give you something to really worry about. Many investors, giddy from the returns of recent years, are downplaying the current threats to their portfolio. That's a negligent position, hence this reminder of one of the major risk factors – Europe.

Even if you do choose to discount these concerns, at least you'll have a ready-made excuse to overdo it this Christmas. If the rellies complain about you kicking over their port as you stumble towards the couch, red wine sloshing, feel free to blame us.

Despite the huge taxpayer-funded bailouts of US banks, a weak stimulus package and free money to the people that caused the crisis, the US policy response to the Global Financial Crisis worked, eventually.

Millions lost their jobs, US debt ballooned and the systemic threats posed by a concentrated, casino-driven banking system remain. But the US has not turned into Japan. The Great Recession was crushingly bad but the US is not facing two lost decades. The same cannot be said of Europe.

So what's the problem?

Remember the PIIGS, the ravaged economies of peripheral Europe that were devastated by the financial crisis? Well, the 'rescue plans' supposedly designed to lift these countries out of recession have failed. Even members of the European Central Bank acknowledge it, saying last year that the Eurozone is 'still engulfed in a severe crisis.'

In Greece and Spain, official unemployment stands at around 25%. Since 2009 the economies of Spain, Portugal, Ireland and Italy are on average 7% smaller than pre-crisis levels. The economy of Greece has shrunk by a shattering 25% in six years. In its second quarter the Eurozone registered GDP growth of 0.1%.

But at least debt is coming down, right?

Nope. The evidence is in, again (see Austerity – The history of a dangerous idea). Huge 'structural adjustment programs' – code for lower wages, fewer jobs and reduced government expenditures - were imposed on the PIIGS in an attempt to reduce their debt. That would restore confidence and recovery would ensue, or so the theory went.

It didn't happen. Between 2009 and the end of last year, Greek government gross debt has increased from 127% to 175%. Spain and Ireland's public debt ratio has almost doubled. Peripheral Europe has paid a huge price for failed austerity policies and the debt is still crushingly high. Greece for example, needs another bailout.

What about the big European countries?

This is the most worrying development. The malaise is now Europe-wide. In Germany, Italy and France the manufacturing sectors are contracting. Chris Williamson, Chief Economist at Markit, says 'there is a risk that renewed rot is spreading across the region from the core.'

Since the 2008 financial crisis the Eurozone has endured two double-dip recessions. A third is now on the cards. And that isn't good news for the one in five European banks that recently failed financial strength tests, many of them in Italy, one of the big three Eurozone countries.

What's the big risk now?

The policies of the past six years were inspired by a deep seated fear of inflation. Their consequence is an even bigger problem; a real risk of deflation. Most of the PIIGS are now running current account surpluses but at the expense of lower living standards. The troika failed to appreciate that if you force millions into unemployment, reduce the wages of those still with jobs and cut government spending, you reduce aggregate demand and prices fall in response.

As Chart 1 shows, 10 of the 18 countries in the Eurozone have experienced declining wages and deflation.

Sustained price falls are dangerous because consumers come to anticipate them, delaying their expenditure. Companies then lay off more workers and spending is reduced further. This is the dreaded deflationary cycle which so damaged Japan over the last 20 years.

It's now a very real threat in Europe. The ECB is targeting an inflation rate of 2% but recent figures suggest the rate is at a dangerously low 0.3%.

How can the deflation risk be avoided?

Getting Angela Merkel to read a copy of Keynes' General Theory of Employment, Interest and Money might help. Failing that, how about a weekend at Ben Bernanke's place, where he could talk her through the events of 1937? The US was just emerging from The Great Crash when Roosevelt prematurely tried to balance the budget and return monetary settings to normal. He killed the recovery.

Bernanke knew his history, staring down the inflation worry warts in the aftermath of the crisis, keeping money cheap whilst the government expanded its balance sheet. The Europeans have done the opposite. The European Central Bank foolishly raised rates in 2011 and austerity reduced Europe-wide aggregate demand.

Now the core countries are suffering. Between 2008 and 2013, total German exports fell by 1%. But exports to other Eurozone countries have collapsed by 17%. The Germans need to boost aggregate demand by taking their foot off the austerity pedal, run budget deficits and run growth-orientated policies. Even those well known Stalinists at the IMF have warned that the Eurozone will slip into recession if 'nothing is done'.

There really aren't any more options. With yields heading towards zero, any extension to the quantitative easing program is just another form of pushing on a string. The Germans need to kick start a proper recovery by boosting demand. They have to spend.

Have the Germans got the message?

Absolutely not. With 10-year German bonds yielding just 0.74% and two-year bonds an incredible minus 0.03%, the Germans could undertake a huge stimulus program at virtually no cost.

Instead, they're shooting for a return to budget surplus and reducing the country's public debt, which is just 80% of GDP. Compare that with Japan; in the 1990s it was on the path now followed by the Germans. Japan's public debt is now 214% of GDP. Policies designed to shrink public debt end up increasing it.

What are the portfolio implications?

Matt Sherwood of Perpetual Investments says that investors are beginning to accept that 'the European economy may be in a malaise for more than a decade with the economic consequences being that wages, productivity, growth and inflation will remain very low, whereas debt burdens and unemployment will stay high.'

That makes the current environment quite different to when we last covered the issues in 2011 (see How to save (or leave) the Euro). The deep-seated problems have moved from the periphery to the core and those countries that accepted austerity measures as the price for staying in the currency union are now less inclined to do so.

Across Europe but especially in Greece and Spain, left and right wing parties are challenging this orthodoxy. In pursuing irrational, ahistorical, punitive policy settings the Germans are putting not just the Eurozone at risk but the very idea of union. No one knows where this will end.

That's not a recipe for investment success, especially with the Eurozone contributing 17% to global GDP. There are cheap European stocks but beware those focused on domestic markets that may carry many unforeseen risks. It may be better to concentrate on non-Eurozone export-led businesses.

Our preference, though, is to stick with local stocks with international exposure - companies such as Computershare, Hansen Technologies and ResMed for example. And if you do want to invest overseas, you might want to stick to US markets where the recovery is pronounced and enduring, albeit you'll probably have to pay higher prices for the privilege.