Submitted by Lewis Johnson via Capital Wealth Advisors,

“If you go then I’ll be blue cause breaking up is hard to do.” Neil Sedaka “France and Great Britain shall no longer be two nations, but one Franco-British Union. The constitution of the Union will provide for joint organs of defense, foreign, financial and economic policies. Every citizen of France will enjoy immediately citizenship of Great Britain, every British subject will become a citizen of France. “ Proposal from England’s War Cabinet to France in May of 1940 in the hope of keeping France fighting the Nazi invasion “The greatest disappointment of my political career.” French Prime Minister Paul Reynaud expressing his disappointment with the failure of the above initiative “Hell is truth seen too late.” Hobbes “War is horrible…but slavery is worse.” Churchill “The end was contained in the beginning.” George Orwell “I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.” Thomas Jefferson “All political parties eventually die choking on their own lies.” Mark Twain

Chief Takeaway: England’s upcoming vote on June 23rd may be the first of several votes that reveal the deep flaws embedded in the European Union. In particular, Europe’s undercapitalized and overleveraged banks are dangerously exposed to rising political unrest.

Among the best books we have read recently is the Last Lion series in three volumes by William Manchester chronicling the life of Winston Churchill. We are reading the final book of the series now, and are struck by the second quote above. In May of 1940, Churchill’s government, desperate to keep France in the fight against the Nazi invaders, outlined what in retrospect was the first step toward the European Union.



We cannot shake Orwell’s haunting comments from 1984 that “The end was contained in the beginning.” Somehow it strikes us as foreboding when we contemplate the upcoming English referendum (called “Brexit” by the media) on whether or not England should leave the European Union (EU). Will the EU’s end be contained in its beginning? Is it time to think more expansively about how far the cycle may run – in the opposite direction - from the near complete unification now manifest in the existing EU to what may come after?



In our experience, cycles generally overshoot from one extreme to the other. “Thinking the unthinkable” is often the hardest exercise of all in cyclical investing. If the EU’s intellectual genesis was forged in armed conflict, could a vote to leave the EU set in motion a cycle that may, in the fullness of time, complete the cycle and result once again in armed conflict? Surely, that possibility seems laughable - for now. But the ability to ask seemingly radical questions and consider their answers with an open mind are hallmarks of the best investors.



Europe has been at peace for decades. Each major step it has taken in the last 70 years has been to draw its countries ever more closely together. After all, this referendum is, on the surface, nothing more than a simple vote with thoughtful people disagreeing on both sides of a contentious issue. However, we have been watching events in Europe for many years now, and are disturbed at the ever more contentious arguments in the split between Germany and the creditor powers versus the weaker debtor nations in Europe’s south. Angry debtor countries, such as Greece and Spain, feel oppressed by harsh austerity forced upon them by German-led creditors, and are dredging up the darkest memories from World War II. Greece even reactivated an old claim that Germany owed it war-related reparations numbering in the hundreds of billions of Euros. These are painful memories that go deep. They threaten to reawaken long-simmering animosity on the continent. European peace may be more fragile than it appears.



Will events underway mark a trend change in the almost 70 years of European peace and integration? The long, implacable sweep of history has a way of surprising us all, and taking us to places that we never expected. Who knows, when the future of ongoing events has become the written past, maybe textbooks will date as the inflection point that led to the next conflict these votes in England and Spain taking place this month? Stranger things have happened.

No One is Discussing the Real Issue





The real issue should be known to Europe’s politicians and especially understood by its central bankers. The real issue is debt and how its tentacles spread throughout Europe and indeed the world. The Euro as a currency is not just flawed; it’s also the financial equivalent of a thermonuclear debt bomb. Its many and terrible design failures make it dangerous. Its designers and defenders either don’t want to acknowledge its shortcomings or, even worse, are simply unaware of them. Let us explain.



Europe’s banks are bigger, more leveraged, and more indebted than U.S. banks. This means a smaller cushion to guard against unexpected losses. Furthermore, the EU’s fragile financial system of massively overleveraged banks is choking on cross-border liabilities from other banks in a way that almost no one can truly quantify and even fewer understand. Further complicating this issue, the governments that have borrowed in Euros are not free to print Euros to backstop their own banks. Our concern is that this terrible flaw could spread far beyond the limited and understandable issues that divide Britain’s voters. As we have argued many times ( Those in the “leave” or “Brexit” camp are in the headlines citing a long list of understandable issues: economic underachievement, immigration, lack of transparent democratic processes; frustration with challenges seemingly beyond the control of local governments. They fail, however, to mention the real issue that is a risk to today’s financial markets.The real issue is debt and how its tentacles spread throughout Europe and indeed the world.Its many and terrible design failures make it dangerous. Its designers and defenders either don’t want to acknowledge its shortcomings or, even worse, are simply unaware of them. Let us explain.This means a smaller cushion to guard against unexpected losses. Furthermore, the EU’s fragile financial system of massively overleveraged banks is choking on cross-border liabilities from other banks in a way that almost no one can truly quantify and even fewer understand. Further complicating this issue, the governments that have borrowed in Euros are not free to print Euros to backstop their own banks. Our concern is that this terrible flaw could spread far beyond the limited and understandable issues that divide Britain’s voters. As we have argued many times ( “Is Spain the Next Greece?” June 1st 2016 ), those countries with currencies pegged to the Euro are most at risk from its design flaws – Spain, Italy, and France, just to name a few. But the debts of these countries’ banks to other banks, and frankly the debts of those banks to others, create the preconditions of systemic weakness not seen since the days after Lehman Brothers failed.

The Dangers of Reflexivity: Undercapitalized Banks Backed by Weak Sovereign Governments

Is there a cautionary lesson here for the shareholders of other European banks?