Europe is Getting Worse: Here’s How to Protect Yourself

Every few months, the crisis in Europe rears its head, only to fade back into the background once again. Unfortunately, signs are emerging that Europe’s troubles are deepening anew, so investors need to tread cautiously with stocks until the market digests these newest concerns. Adding to the mix, another key trading partner — halfway around the world — is stumbling badly.

From south to north
For much of the past few years, economists have been talking about the PIIGS (Portugal, Italy, Ireland, Greece and Spain). Though Greece is in the midst of a crisis with no end in sight, the other countries face ample stress as well. The biggest fear: The Greek contagion spreads to the far larger economies of Italy and Spain.#-ad_banner-#

Yet many investors have been able to take solace in the relative resilience of Northern European economies. Economic activity in Scandinavia, the Netherlands and Germany has continued apace, despite the storm clouds gathering to the south.

But now those clouds are overspreading Northern Europe as well. In Germany, for example, economists have just lowered their 2013 gross domestic product (GDP) forecast from 1.7% to a mere 0.8%. How important is the German economy? It accounts for 5.1% of global GDP, according to PriceWaterhouseCoopers. That’s 50% larger than all of the PIIGS combined — excluding Italy. Including Italy, the PIIGS are about 6% of the world economy. 

In France, economic growth is also expected to fall below 1% in 2013. But it could get worse: Economists at Societe Generale say the French economy is slowing at such a rapid rate, it may not grow at all next year.

Taken together, Germany and France collectively account for half of all economic activity in the euro zone, or about 9% of the global GDP. You can already see the continentwide malaise set in. The pan-European Purchasing Manager’s Index (PMI) slid from 46.1 in September to 45.7 in October, the lowest level in three years, according to economic research firm Markit. Any reading below 50 implies a contraction in economic activity. Surveys of business and consumer confidence in Europe also hit three-year lows in October.

Germany’s PMI also slid to a two-month low, coming in at 47.7. The country’s contraction has clear roots: Orders from European trading partners for Germany’s manufactured goods fell 10% sequentially in September, according to the German government. This is the downside of a deeply interconnected economic bloc such as Europe. Weakness in one part of Europe crimps demand from its neighboring countries, which in turn see a slowing economy and need fewer goods from the already-weak neighbor. It’s a negative feedback loop that can only be ended with some sort of jolt. Trouble is, it’s unclear where this jolt might come from, short of massive government stimulus.

Although European Central Bank President Mario Draghi continues to pursue fiscal discipline while counseling against too much austerity, he may soon have to speak of a much more aggressive game plan. Until and unless that happens, the slowing European economies will continue to weigh on stocks. Indeed we may soon be hearing from major U.S. multinational firms about lowered 2013 sales forecasts for their European divisions. 

The Asian anchor
Much has been written about China’s economic effect on the broader Asian region. But don’t forget about Japan, which is still the third-largest economy in the world, representing more than 8% of global GDP (compared to the United States’ 22% share and China’s 10.5% share). For a bit of context, the Japanese economy is larger than the economies of Australia, India, South Korea and Indonesia combined.

So the global economy is bound to feel the consequences of a Japanese economy that is also under duress. On Thursday, Nov. 8, the Japanese government announced that orders for machinery fell 4.3% in September from the prior month. At this point, the rest of Asia has to watch out for this negative feedback loop that is already besetting Europe.

Of additional concern: Japan’s government debt has now become so large that the country is increasingly likely to need to unload foreign bond holdings in order to raise cash and pay its bills. It may even seek out foreign investors for its own bonds. This could create a crowded field for government borrowers in 2013, altering the current dynamic of ultra-low global interest rates. 

Risks to Consider: As an upside risk, these slowing economies may compel the respective government to take action with new stimulus plans, which can give a boost to global markets.

Action to Take –> A slowdown across Europe and Asia won’t necessarily force the U.S. economy into recession. But it’s likely to create at least a moderate drag on our own growth in 2013. So even as you focus on the near-term challenges associated with the looming “fiscal cliff,” you need to also track events in Asia and Europe. Though the current U.S. markets are starting to reveal deep bargains, we will likely be hard-pressed to see any upside until the global economic picture has been fully digested. 

You can hedge against the effect of a slowing German economy on U.S. companies by shorting stocks and exchange-traded funds (ETFs) focused on Europe. For example, the iShares MSCI Germany Index ETF (NYSE: EWG) looks increasingly vulnerable to the scenario outlined above, as it continues to trade near its 14-month highs.