No economic power without cheap power
No economic power without cheap power
Germany stops powering the EU
How the EU economy works
The EU is by its very nature an economic and political Frankenstein. It merges together an individualistic and very capitalist North with a more collectivist and socialist South. A liberal and progressive West with a traditionalist and conservative East.
When it comes to economics, the heart of the EU is undoubtedly Germany. Since the reunification, the country has enjoyed a steadily growing commercial balance. The core of the EU economic model is:
Germany imports cheap energy and material from Russia. It also employs cheap manpower from Eastern Europe, locally or through emigration.
With these cost advantages, Germany exports high-value goods like cars, machinery, and industrial tech (laser, CNC machines, robots, etc…) while also keeping domestic consumption down.
This financial stability of Germany and of the Euro allows the South of Europe to pretend it is doing fine, despite poor economic performances.
This translates into much lower interest rates for countries like Spain, Italy and France.
This also creates a strong Euro, which destroys further industries in the South in the long run, aggravating the disparities inside the EU.
In the short term, it works. In the long term, it creates masse youth unemployment in the South and prepares the conditions for a massive banking crisis.
The music stopped
This is however suddenly irrelevant. The reason is simple.
Step 1 of the process above is done.
No more cheap gas and oil from Russia.
The German trade balance reacted accordingly, see this graph since the fall of the Berlin wall:
It is almost as if energy, the central input of heavy industry, and especially highly versatile natural gas but also electricity, had gone up 5x-10x …
Today I will look at Germany only, but you can extrapolate this data to almost every European country. Most of the argumentation above could apply to Japan as well, except Japan will probably re-activate idle nuclear power plants.
The Euro’s real value
Suddenly, without the massive German trade balance to keep it afloat, the real value of the Euro appears to the world. Regular readers will not be surprised to discover the EU economy is taking a beating, and so is its currency.
I do not trade forex, but I am sure anybody that does could have made a killing on the USD/EUR pair this year.
This is BEFORE economic activity in the EU takes a real hit and before the next winter arrives.
Where are the damages the worst?
I mentioned heavy industry already. The country’s unions seem to agree as well. But let’s see a bit more in detail.
This excellent Reuters article tells us that a total cut from Russian gas, a growing possibility by the day, would lead to losses just below $200B just for Germany. The decline in production would be dramatic not only economically but also for the supply chain.
The most affected sectors would be glass, food, drinks, iron, steel, ceramics, chemicals, textiles, rubber, plastic, pharmaceutical, wood/timber, base metals...
What ALL of these have in common is being the raw input for OTHER industries. Germany does not export much of those, it uses it to make stuff.
Here is how it will play out:
Do you make beer but cannot source bottles? You will have to idle the factory.
Making specialty pharmaceuticals but cannot source the pharma-grade sterile plastic packaging? Better hope these patients have no urgent needs.
Building houses, but cannot get timber, wood panels, or windows. Fire temp workers until supply gets better.
Have a cow farm, but cannot source the cardboard boxes? No way to reach customers anymore, ditch the milk, and lose money, maybe cull some of the cows.
Make cars but some key chemical, fabrics, or leather are missing for 3 out of 5000 parts? Stop the assembly line.
We were told green energy could replace fossil fuels, even without nuclear.
It does not.
We were told we had enough energy supply without Russia.
We do not.
We are now told it will have an impact limited on specific industries.
It will not.
Really it is not hard to guess. If you get an explosive price rise or shortage in all the base materials (glass, metal, fabric, food, chemicals), every industry is affected. This is reflecting already A LITTLE in the PPI, the Producer Price Index, aka the cost to produce stuff.
+35% so far.
This is BEFORE Russia cut the gas. With every day of ongoing war and escalating weapon deliveries by NATO countries, this day is getting closer.
For now, German CPI inflation is official “just” 7.6%. Considering the inflation on actual production, expect CPI to keep going up and start reflecting actual production costs.
So German inflation in the 20%-50% range is not impossible. Estonia where I live is already at a 22% CPI inflation. I would not be surprised to see a 40%-80% inflation rate before the end of 2024.
How to invest for it?
As always, I will mix the (unfortunately gloomy) observations with actionable investing ideas to profit from them.
First, avoiding the blast radius
Obviously, the first takeaway is a list of negatives. Stay away from the imploding sectors. No EU industries, non-necessity consumer products, etc… But this is not a great way to make money, just how to not lose.
The currency opportunity
The second takeaway is that European exports are getting dramatically cheaper. Imagine you are a buyer in another currency than the euro, let’s say the dollar for example.
In July 2021 you had a local supplier selling you product X for $10. And a European supplier selling it for €9. At the time, this meant around $11. The price difference made it a no-brainer when adding extra delivery time, maybe customs, etc...
Now in July 2022, the same €9 product looks a lot different. At $9, this means 10% more margin for you. You might start looking again but still hesitate.
If in 2023 the Euro keeps crashing and the €9 is now worth $7, the US supplier will have lost a client and the European supplier got a new one.
Short of the Ukraine war stopping tomorrow AND pressure on Russia stopping as well, the Euro is going much lower.
As investors, we want to position our portfolio to benefit from it. So we want to find companies making the product X in the example above.
What kind of product?
Obviously this only works for a product that STAYS at €9. If it is a product requiring a lot of energy input, it would likely already go toward €11 or €12.
But not all products are like cars, bottles, and heavy machinery. Here is a list of products that would benefit from the Euro crashing:
Software: virtually no production costs on a per unit basis.
IP and other intangible assets: Licensing patents or IP do not consume gas or oil.
Services: salaries might (at some point later) rise if counted in euros, but not in dollars because of the current crash. And mass unemployment has a nasty way to keep salaries down.
Some tourism companies: only some, because a luxury spa or a cruise ship will probably suffer greatly when its power bill arrives. But others will see no increased cost and an influx of tourists happy with a 20% discount year-to-year. Especially with covid lockdown frustration boosting demand.
Light manufacturing: As the owner of jewelry e-commerce, I experiment with it firsthand. My personal costs are up (a lot), but business costs are relatively under control, maybe up 10%. Definitely not up 30%-40% like the overall PPI, at least yet. As I sell mostly to US customers, I can hope to beat US-based competitors with the Euro decline.
Software
Software is actually the most obvious candidate, but the harder to find a target for. On one part, ALL tech stocks were pretty overvalued these last years. And are getting hammered worldwide for months.
In addition, this is the field I am the least knowledgeable about. But if you want to invest in tech, post-crash China and Europe is likely the place to go.
The only idea that comes to my mind is CD Project Red, the Polish videogame developer. Its brand has suffered from mismanagement lately and its stock crashed by 75%. At this price, it might have reached an overreaction even if P/E is still very high.
(I must thank my friend Aaron from Value Investing Substack to have suggested the idea to me some weeks ago. Great newsletter as well, I warmly recommend it.)
IP and Services
This is an interesting sector, although I am not sure where to start. Open to suggestions to share with this community.
R&D heavy industry would make the most sense. In my case, this indicates I need to get back at European biotech, as a biochemist by academic training, I could probably find some valuable startup here that will benefit from licensing international deals in dollars, but paying salaries in euros.
Tourism
This might be my favorite for this idea to bet on the Euro weakness. Europe is the largest tourist destination in the world. I just need to find a company that will not see its cost structure affected by energy and food price.
Ecotourism is probably a low-energy consumption solid option. Local food sourcing and bio-agriculture can help keep margins in control as well. After a lengthy search, I, unfortunately, could not find publicly traded ecotourism stock.
Temporarily, my sight is on Booking.com, as they would take their cut on any hotel or travel booking in Europe and trade at a cheap enough price. But this is not really focused enough on this idea to make me really happy with it yet.
Light Manufacturing
One sector I am curious about is the luxury market. Premium branding gives pricing power. And anyway, a $4000 leather bag price tag does not come from the cost of the leather.
French or Italian luxury brands might benefit from an afflux of American tourists. The return of Chinese tourists would help a lot as well. So European luxury brands are a bet on tourism at the same time.
This is a bit complicated because if the global stock market crashes because of rising rates, the sector might be hurt anyway. And again, the previous overvaluation makes it hard to find a cheap enough target. For example, LVMH is close to its all-time-highs.
Premium/Niche specialty products and crafts, like kitchenware, knives, or other items of the sort could work as well. Again hard to find publicly traded companies.
Conclusion
I wrote this article because I think this is a good idea even if difficult to execute in practice. Maybe some readers will still benefit from it.
After writing this article, I feel that some niche, undervalued (B2B?) software could be a great option, but I am a bit out of my water in that sector. Suggestions welcomed.
Publicly traded tourism stocks tend to be highly exposed to oil prices, like airlines and cruise ships. Hotel chains might suffer from the decline in EU consumers’ spending. Maybe Asian airlines, but with the complications of Covid outbreaks?
I will keep looking for a potential target along those lines for future reports.
Until next time, stay safe.