Potential Triggers to the Next Economic and Stock Market Collapse…..Trigger #2 European Deflation and Economic Implosion

Europe has been living through austerity since 2009, with Germany being the primary beneficiary as their economy hums along given the relatively weak Euro.  Now they would argue that they are the key backers of all the loans and bailouts that have been made to southern countries including Greece, Spain and Portugal.  This is true, so they win and they have risk of potentially becoming major losers if these loans are ever forfeited on.   Unemployment is a huge problem in all of Europe but especially the south.  Youth unemployment is at levels that are disastrous for the future.  Add to this lack of growth; constant risk of re-entering a recession; and major deflationary pressures and we have a major risk to not only their continent but the rest of the world as well.  Here is a detailed analysis of the risk Europe presents to all of us…….


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Austerity programs, and a reluctance by the European Central Bank to implement Quantitative Easing programs to the same extent as their U.S. and Japanese counterparts. These decisions by EU policy makers have resulted in a strengthening Euro, which has further slowed economic growth, and has caused price deflation among member nations. EU inflationary data shows that, adjusted for austerity, inflation as of April 2014 is running a -1.5%. A deflationary environment threatens to further exacerbate the current debt dilemma that European countries are facing.

In deflationary environments, consumers and investors delay purchases, with the expectation that they will be able to purchase it at a later date at a lower price. This scenario could play out not only in the consumer goods market, but also when evaluating asset prices. With many countries already struggling under debt loads, any deflationary shock to the financial system could not only put banks under stress, but could bring the threat Greek, Portuguese or even Italian default to the forefront yet again. Should asset prices plunge, and financial institutions risk failure, confidence in the bond market could collapse and push yields to unsustainable levels. Yields have been falling to unsustainable low levels in 2013 & 2014.

First let’s have a look at current trends in sovereign debt levels as Europe has made a concerted effort with austerity measures, which include cutting expenses and raising revenues. First a look at the G7 so we can see trends of major economies worldwide:

Every country, other than Canada, has seen a rise in its debt to GDP each year since 2007. We must remember that the most recent data should in theory be improving given all the government initiatives to lower debt but it is not. From an individual country perspective, Japan poses the biggest concerns and risks which we will address later in the paper.

Now let’s narrow things down and look at the Continent where concerns are building all the time, Europe:

The debt to GDP for core Europe at the end of 2012 was 87.3%. By the end of quarter 3-2013, the rate has increased to 92.6%. In terms of actually money goes, that equates to about Euros $312 million or US$434 million. That is a trend that is dangerous. Here is a list of the countries that make up the EA 18 of Europe:

Breaking the 18 countries down, 6 of them have debt to GDP ratios greater than 100; 3 between 90 and 100; 4 between 80 and 90; and the rest below 80. The reason we look at countries above 80, is that those are levels that become concerning and 72% of the EA18 has a debt to GDP ratios over 80%.

So how does one get out of this mess? That is the biggest concern as some of the core means to improve this situation is:

· Austerity measures that slash government expenses and raise revenues – theme in Europe for a few years now but not working

· Increased growth which has been failing and getting worse given debt excesses; a poor employment market; and demographic challenges

· Decrease of currency – may modestly help but any dramatic devaluation will lead to currency wars with other countries

The best way to fix the problem is through growth but reality is that if there was growth, you would see employment and GDP improve. For the year ending 2013, the European community saw a contracted GDP of 0.5%……that is a recession i.e. negative growth. Now the optimistic economists that are paid to be that way believe that we will see growth of 1.2% for 2014. In most scenarios I would say that the forecasters were being conservative as 1.2% is anemic growth, but given Europe and the deep challenges it is facing, a growth rate at this level would be a great success. Interest rates are near rock bottom as seen on the next chart so stimulus from this method should not be anticipated:

European Central Bank Interest Rates

Austerity is a necessary and painful approach to debt but in the end, the chance of failure is significant. Why? Well think of it this way, if you are running a business and you cut expenses all over including marketing and sales, the chances that you will get improved growth are slim. The odds of seeing further erosion of growth and revenues is significant in both a company and for that matter countries or a continent. Government spending is around 20% of total GDP, so simply speaking, if you cut government, you are cutting GDP i.e. growth.

That leaves currency devaluation. This is a form of trade wars such as tariffs, sanctions and embargos. A dangerous path as once you go this way, it is difficult to turn back. The last time this was prevalent was back during the 1930’s great depression, which was deepened by such actions. The by-products of currency wars would include:

ü Potential collapse of emerging economies

ü Escalation causing rapid inflation in many developed countries

ü Would force interest rates up to try to stabilize inflation, pushing interest payment on debt up and stopping growth in its tracks

ü Risk of sovereign default as debts and deficits could escalate in levels where lenders are uncomfortable

ü Derivative implosion sending the world banking system in a tailspin

ü Etc. etc.

I think you get the picture……the risk of a currency war is endless and potentially destructive to the world economy and financial system.

A currency collapse is the end game of this whole process and if history is a teacher, all fiat currency (currency not backed by a hard asset like gold) experiments have ended in failure and resulted in a complete restructuring of the financial system.

Therefore, the only way out of such a deep hold is to write off debt; restructure it; or have it forgiven. This is not an easy task as the world is trying to keep up the façade of debt driven growth instead of allowing governments, businesses and individuals to de-leverage, a necessary component after such rapid growth driven by debt and fiat currencies since 1970’s.

As you can see from the above chart, inflation is falling across all of Europe but on the right side of the 2nd chart reflects areas where deflation has become prevalent. We have to remember that the last time we lived through deflation worldwide was during the great depression. Japan has been in and out of it since the 1980’s and you can see by its record debt to GDP levels above and overall stagnant growth that deflation is more dangerous than any phenomena we could enter into. The only thing to add to that that would be completely destructive would be to see inflation on core living such as food, gas and utilities while seeing asset deflation. The combination would be destructive to all facets of world economies throughout.

In the end, without growth or at least little growth; interest rates near zero; banks not lending or realistically in a position to lend; money supply falling; and governments cutting back on spending, the risk of outright deflation and future sovereign default continues to grow.

With all factors reflecting in little inflation which has become a world trend:

And with further deleveraging in the private sector expected due to stagnant incomes; high unemployment; and lack of confidence, together with sovereign debt remaining at high levels, do not look for a quick fix. The more likely probability is that one of the countries gets into deeper fiscal issues causing a rippling effect within the continent. The risks are extremely high today which is reflected in the ongoing deflationary pressures in Europe and the world.

In summary, once deflation takes hold it is extremely difficult to get out of its grip. There are short term ways to offset it including quantitative easing like we have seen in the United States, but this only postpones the reality of what an economy or in today’s case, the world must enter into: de-leveraging of the excessive debt, both individually and government. Until this occurs, the process will continue with risks of higher short-term inflation via devaluing currencies; trade wars; and continued confiscation of individual’s assets to bail out governments.

It is the winter season…..deflation is the theme and it will be difficult to avoid.



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