What does Eurozone Debt mean for Canadian Equities?

A Potted history of Eurozone Debt.

The Euro was introduced in January 1999 as a virtual currency, and in 2002 was introduced in its physical, ‘real’ form. The overriding aim of the single currency was, and remains, to foster closer political and economic ties between the European Union’s member countries. Several countries opted to keep their own currency at the time of the Euro’s birth, most notably, perhaps, the United Kingdom.

For several years the Euro seemed to be working well. The idea of making European economies to converge and move as one, by forcing equal interest rates on central banks and bringing into line inflation and growth, gathered support. But even before the Financial Crisis of 2008, cracks were beginning to appear. In order to bolster growth to the rates of powerhouse countries such as Germany, the smaller Eurozone nations had begun borrowing extensively to spend and reduce taxes at the same time. The public service workforce across Europe grew, and welfare payments increased. When the Financial Crisis hit, causing recession, conventional wisdom provided that the way out was to promote growth by more centralised spending.

Interest rates fell as governments sought to promote borrowing by the private sector to match its own. Agreed budget deficits, put in place for countries to enter the Euro, were relaxed. Bonds were issued on a daily basis by member countries.  Economies slowed and then recovered at different paces.

Debt Piles Up, Bailouts Blow Out

Now, ten years after the Euro was first seen in the pockets of the man on the street in Europe, the continent is overburdened with sovereign debt. Austerity measures to combat the debt have led to a double dip recession in Eurozone member countries. Unemployment across the region is running at a record high of 11.9%, while countries like Spain whose economy relies on tourism and construction have unemployment rates of 25%.

The Eurozone is creaking under its debts. Greece, Ireland, Portugal, and Cyprus have all had massive bailouts, and most recently Spain has seen its banks receive a bailout (after European rules were changed to allow it) of €100 billion. Increasingly it looks likely that Spain will be forced to request a full bailout (it is already having its budget controlled by the European centre), and Italy is forecast to request a bailout by the end of 2012 also. Just for reference, the national debt of Spain is less than that of Germany, France, and the UK when measured against respective GDPs.

In 2010, the European Financial Stability Fund was set up, and has seen its size increase from around €400 billion to over €700 billion. Essentially this is where bailout funds come from. And the funds for these bailout funds comes from the IMF and Eurozone member nations, who issue bonds (debt) to put funds in. Debt supports debt.

Politician’s pay the Price

Across Europe the political map has been changing, with government change in Italy, Greece, Spain, Ireland, Netherlands, and France, as disgruntled voters turn their backs on administrations that they blame for the mess. Germany has said enough is enough, with its parliament and people unhappy at how much money they are spending to prop up Europe’s weaker nations. France, meanwhile, has said that it now intends to spend its way out of trouble, by borrowing more.

Over the last few months, the major ratings agencies have downgraded not just sovereign debt across Europe but also the debt of all the major banks. They have also put many banks on this side of the Atlantic on alert of downgrades, with the spider’s web of debt spreading far and wide.

So what does this mean for Canada, and Canadian business?

Well, firstly the good news is that Canada’s economy is on a pretty good footing, if outside views are anything to go by. This has been acknowledged by Germany’s Chancellor, Angela Merkel, when she recently said that Europe should take its lead from the Canadian economic approach. She praised the Canadian government for its budget discipline, promotion of economic growth and ‘not living on borrowed money’.  But her comments also have a down side: they were made in response to European pressure to do more to relieve the strains on the region’s finances. In other words, she’s giving a strong hint that Germany will not suffer stumping up more cash for much longer, particularly for what it sees as its fiscally weak neighbors. And that means a greater likelihood of a default by a major nation on its debt, and potentially the breakup of the Eurozone.

The Bank of Canada has its say

Now to the bad news. In June this year, The Bank of Canada warned that a further shock to the financial situation in Europe could severely damage the Canadian market. It cited the high level of household debt and overvalued real estate as chief areas of concern.

Its main concern is that further austerity measures, whether initiated by central governments or as a natural consequence of subdued economic growth would spill over to Canada, hurting Canadian exports to Europe and business confidence as a result. If this were to occur, then jobs would probably be lost, housing market activity and prices fall, and this flow through to a spiral downwards.

It rounded off its report by saying that it believes the Canadian economy is worse placed now than when hit by the 2008 Financial Crisis. Personal debt has risen significantly since then, and it believes that fallout from a dramatic worsening of the Eurozone debt crisis could lead to a rise of 3% in unemployment, which would triple mortgage arrears. This in turn would harm bank balance sheets, making it tougher for them to lend to encourage economic growth.

The Important Numbers

In 2011 the EU was Canada’s second largest trading partner (after the United States).  Canada exported approximately $29 billion to Europe last year, around $10 billion of which was in the service sector. If the recession continues to bite, then these exports will be hit. Consumer spending across the Eurozone rose by 0.1% in June from May, but was down by 1.2% on a year earlier. On a worrying front looking forward, consumer confidence is weakening further as the economic slowdown gathers pace.  If consumer spending in Europe weakens further, then Canadian exports will be hit and this will eventually knock on to equity prices.

Of perhaps even greater concern is the risk to inward investment in Canada from Europe. At around $15 billion, investment flows into Canada are double that of Canadian investment in Europe. This inflow will be hit, should Europe’s wealth deteriorate further.

Turning to the equity market, a lurch down caused by decreasing exports to Europe may be only the start. if Europeans seek to repatriate investment wealth then this could lead to selling of international equities. And at a 2010 total of around $250 billion dollars invested from the EU into Canadian stocks, a sale of just 10% would put a seller of $25 billion into the market. And that would be like King Kong climbing the Empire State and jumping off.

Falling Exports, Decreasing Real Estate Valuations, Rising Unemployment equal Falling Markets

Finally, in its June report the bank said, ‘If the sovereign debt crisis in Europe continues to intensify, it would further weaken global economic growth and prompt a general retrenchment from risk. In turn the weaker global outlook would fuel sovereign fiscal strains and impair the credit quality of loan portfolios.

“Together, these factors would increase the probability of an adverse shock to the income of wealth of Canadian households.’

In other words, with the net wealth of Canadians falling because of real estate valuations falling again then Canadians would be forced to make up the shortfall by pulling back from riskier investments. And that means equities. International and domestic selling pressure could combine with economic contraction to create a rapidly falling equity market.

Since June, the European economy has worsened dramatically. Even German business confidence is at a multi-year low, with industrial production in July collapsing by over 1% in July from June and factory orders crumbling by 1.7% over the same month. Most of Europe is in a double dip recession, which it wasn’t when the Bank of Canada made its gloomy prediction.

And it all adds up to…

I’m not usually one for listening to the views of central banks: they seem to be either too gloomy, or too upbeat. But at this present time, it wouldn’t take much of a shove to push Europe over the edge of its mountain of debt. If that happens, I fear Canadian businesses will suffer, and then the Canadian worker, and this will filter through to what could become a tidal wave of selling of Canadian equities from both sides of the Atlantic. I hope I’m wrong, but the wise investor would take precautions accordingly.