What to buy as Europe nears its sub-prime moment

With the banking system dangerously exposed to bad debts, the eurozone crisis is starting to look like the subprime crisis of 2008. John Stepek looks at what it means for you, and how to protect your wealth.

The US is on the verge of a bear market.

Yesterday, the S&P 500 closed down nearly 3%, hitting its lowest level since last September. The market has now fallen 19% since April, when it hit its post-2008 peak. That's a shade off the 20% commonly defined as a bear market.

Meanwhile, currencies from the euro to the Aussie dollar slid against their US counterpart. The dollar remains the haven of choice in a panic.

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What's the problem? You could reel off a list as long as your arm. But it boils down to one thing it's those pesky banks again.

Our economic woes summed up in one word

It's easy to lose track of what lies at the heart of the global economy's current woes. Currency wars, Chinese inflation, Greek crises, Tea Party activists, Peak Oil so many different buzzwords, so many different problems.

Forget them. Here's the critical issue in one word: debt.

It's what's missing in this whole debate between spenders and cutters (neo-Keynesians and Austerians, if you must). The spenders think you should spend more money. They ignore the fact that at a certain level of indebtedness, adding more debt doesn't help anything it may even hinder.

They're also impossible to reason with. If the first batch of spending doesn't work, they just recommend spending more. It's hardly what you'd call a scientific approach.

The cutters want to slash spending. I've more sympathy with this view. If nothing else, at least it has an end point. You can't cut below zero.

But it's incomplete. The cutters ignore the fact that if people still have to service debts accumulated during the boom years, then cutting government spending alone isn't going to do anything to encourage the private sector to step in. It'll just make the debt servicing all the harder, because you'll have a weak economy to contend with too.

You have to deal with the debt. Bad decisions were made during the boom years. Loans that seemed affordable, and projects that seemed sensible during those times, have been revealed to be ridiculous.

But rather than acknowledge this, and write those debts off, we've been distorting the economy so that these debts can be serviced. So you end up with households and countries that are only producing in order to service debts that have already been revealed as unaffordable.

The banks have us running scared

Why have we done this? Because we're scared that if we make one wrong move, then another bank will blow up, and we'll end up with Lehman Brothers all over again.

And why am I telling you this? For two reasons. Firstly, as investors, if we know what the real problem is, we might start to get a handle on which countries could come out of this most rapidly.

For example, we're keeping a close eye on Ireland here at MoneyWeek. If Ireland manages to rebound from this crisis more quickly than other countries, it won't be primarily due to austerity. It'll be because it dealt with its bad debts and shoddy banking system more quickly than anyone else. We'll look at this more in a future issue.

Secondly, understanding that the banks and their bad debts are at the heart of this makes it clear why markets are tanking right now.

Everyone now knows that Greece is going to default (that may not be the official name for what it does, but that's the end result). The question now is, how big a haircut will the bondholders have to take?

A deal has already been agreed at 21%, but it now looks overly favourable given the current market price of the bonds. So some countries think it should be revised, particularly now that the Greeks have admitted that they won't meet their budget targets for this year.

Private sector lenders aren't keen to reopen the deal, for obvious reasons they won't get as much money. But that would leave the door open to Greece just flat-out defaulting, rather than negotiating a halfway house, which would cost them even more.

And in turn, what precedent will that set for other sovereign debt defaults? And what would that then mean for bank balance sheets?

This is looking more and more like the sub-prime crisis

That's one reason why Franco-Belgian bank Dexia was hitting the headlines yesterday. Credit rating agency Moody's said it was reviewing the bank for a possible downgrade. The bank has €20.9bn in sovereign debt issued by 'troubled' countries. The bank is already part owned by the French and Belgian governments having been bailed out after 2008. It's also been hurt by the increasing reluctance of eurozone banks to lend to one another.

This fear is also spreading to banks outside the eurozone, who either have exposure to sovereign debt themselves, or have exposure to European banks who are exposed to sovereign debt.

This is very similar to what happened after sub-prime. No one knows what this bad debt is worth, and no one is sure exactly who is exposed to it. And that makes banks even more reluctant to lend.

What does this mean for your investments? There's no way of telling exactly how the eurozone crisis will pan out. I was lucky enough to attend a discussion at Kleinwort Benson yesterday with historian Niall Ferguson. His view was that Europe will eventually come to a deal that basically involves Germany bailing the rest out, because the costs of not doing a deal are too high. But he also reckoned it might take until next year to reach that point. Between now and then, there'll be more "bloodshed" in the markets.

This means investors will be putting a premium on safety, and safe balance sheets in particular. We'll be looking at how to find 'bullet-proof' stocks in the next issue of MoneyWeek magazine, out on Friday (if you're not already a subscriber, subscribe to MoneyWeek magazine). Meanwhile, my colleague Bengt Saelensminde gave his take on this topic in his free Right Side email yesterday you can read it here.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.