Saturday , August 18 2018
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Why A Euro Break-Up Doesn’t Scare Me

Summary:
Sensible investing requires understanding to avoid overreaction. We are inherently afraid of things we don’t understand. Being in a foreign environment, for instance, is sometimes scary. Not because foreign environments are necessarily scary, but because we don’t understand them. Investing, for most of us, is a constant state of a foreign environment because it involves so many things that we don’t understand. That exposes us to a perpetual state of behavioral biases due to misunderstanding. One of the reasons I write so much about macro investing topics, economics and other arcane monetary topics is because I try to provide people with a better understanding of what is a foreign topic for most people. And by having a better understanding of these topics you have a better grasp of the

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Sensible investing requires understanding to avoid overreaction. We are inherently afraid of things we don’t understand. Being in a foreign environment, for instance, is sometimes scary. Not because foreign environments are necessarily scary, but because we don’t understand them. Investing, for most of us, is a constant state of a foreign environment because it involves so many things that we don’t understand. That exposes us to a perpetual state of behavioral biases due to misunderstanding.

One of the reasons I write so much about macro investing topics, economics and other arcane monetary topics is because I try to provide people with a better understanding of what is a foreign topic for most people. And by having a better understanding of these topics you have a better grasp of the investing environments we’re likely to encounter and therefore a higher likelihood of succeeding since you won’t get scared out of the market just because of the unknowns.

Now, I think most people misuse “macro” investing. Most people look at macro as some sort of strategy where you need to constantly be on top of market trends so you can take advantage of them. I view it as mostly the opposite – you want to be on top of the market trends so you can know that most of what’s being pumped out by the media is stuff you should ignore. Understanding the daily macro noise actually makes your plan more feasible because your increased knowledge makes you more comfortable with your process that’s in place and helps you avoid overreacting to everything.

This brings me to the scary topic of the day – Europe. The potential demise of the Euro has a lot of people on edge as the risk of an Italian defection from the Euro rises. I’ve written quite a bit on the Euro in the last 10 years and what needs to be done for it to succeed. In a nutshell, the European Monetary Union is analogous to the USA with a bunch of states that use a common currency but without political and fiscal unity. The USA works, in part, because it is fully united on the political and monetary sides. Mississippi, which is much like Greece, doesn’t go bankrupt every 10 years because they get a significant amount of fiscal transfers from the other 49 states. In other words, we don’t worry about Mississippi going bankrupt because there is essentially a profit sharing system in the USA that spreads the wealth and virtually eliminates the risk of a state default. Eliminating this risk of default is good because then it means that Mississippi doesn’t have to impose excessive austerity on its own citizens and expose the other 49 states to potential default risk.

There’s no easy fix to this issue in Europe. Europe didn’t come together in the same way that the USA did so it’s easy for an American to look at Europe and just say “why don’t you just unite and get on with it!” Of course, there’s huge cultural disparities in Europe and they make unity much more difficult than it is in the USA. We’re seeing the impact of this play out all over the world today.

Now, the collapse of the Euro sounds scary. And it is potentially. If the Euro were to unwind in a rapid fashion then things could get rather scary as uncertainty takes over the second largest economic region of the world and Europe’s banking system is plunged into financial panic. But what are the odds of that happening? My guess is pretty low. After all, the EMU is essentially 75 years of diplomacy headed in the direction of unity. You can’t just unwind 75 years of diplomacy overnight. So, if the Euro starts to get dismantled my best guess is that it will take a VERY long time to happen. In other words, it will be a rather orderly unwind as no one involved in the Euro is interested in seeing a self imposed Financial Crisis 2.0.

As evidence of the muted impact of slow unwind, just consider that it feels like just yesterday that Greece was about to leave the Euro and drag us all into a double dip in late 2011. Ever since then the Euro has been on a sort of life support where the European Central Bank was implementing pseudo-fiscal support and Brexit style populism has increased. I remember how scary some of those moments were and look at the global stock markets since October 2011 – the MSCI All World Index is up 100% since then and the US markets are up 165%.

Now, I am cherry picking the time horizon, but the point remains – a slow unwind is unlikely to be that frightening for the following reasons:

  1. Eurozone leaders are not going to let a disorderly collapse of the Euro occur as it would be a mostly self imposed financial crisis. Central Bankers in Europe, in particular, will be very careful about any impact to the banking sector and they have the tools in place following the 2011 scare to support banks as needed.
  2. It will take years and probably decades to unwind all of the political and trade agreements that led to the Euro. This could occur at a country level over time, but this will take a significant amount of time in all likelihood.
  3. The countries that are mostly likely to leave the Euro in the coming years and decades just aren’t that economically important to the world. Italy, for instance, is 2.5% of global GDP and has been detracting from global GDP in relative terms for the last 10+ years.
  4. Since a banking crisis is an unlikely event (given political and monetary support already in place) most of the Euro’s dismantling will involve relative losses instead of aggregate losses. After all, this is really a currency crisis in relative exchange rates. So if Greece brings back the Drachma they probably win in relative terms to the rest of Europe, but that doesn’t mean Europe as a whole will contract in aggregate terms.

Make no mistake – there will very likely be times where a Eurozone crisis looks like the second coming of the Great Financial Crisis. A series of defections from the Euro would be highly disruptive to growth and given the boom in asset prices it would likely come at an inopportune time for the global financial markets. But I have a hard time applying common sense to this situation and concluding that this will be a fast and highly disruptive/disorderly unwind. So while Europe remains a big risk if things unwind quickly it is less meaningful to global GDP and global financial markets if it unwinds slowly. And that in my view is the most likely scenario in the case that an unwind does indeed occur.

Cullen Roche
Former mail delivery boy turned multi-asset investment manager, author, Ironman & chicken farmer. Probably should have stayed with mail delivery....

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