Briefing on European economy and stock market
Though the financial crisis of 2008 was created in America by the collapse in value of US sub-prime, mortgage-backed securities, its consequences have been far more damaging to the European banking system than to those in the US or the UK. This is due to (i) the much lower levels of equity capital to total assets that European banks maintained, (ii) the surprisingly large holdings of sub-prime securities that they had bought, (iii) the Eurozone sovereign debt crisis caused by long-standing Greek public accounting irregularities and the problems caused by housing booms in Ireland and Spain and (iv) the feedback loop that has appeared between a troubled sovereign country’s funding problems and that of its banking system.
The sovereign and banking debt crises have highlighted the fundamental design flaws of European Monetary Union. The euro was established as a currency without a government or a lender of last resort. This, it has now been demonstrated, means that all government bonds issued by the Eurozone countries were effectively foreign currency debt. In Japan, the US and the UK, Central Banks had little problem in creating money to finance the exploding budget deficits of their governments as the crisis took hold and saw yields collapse. In the Eurozone, countries with similar deficit problems saw yields rise dramatically.
Germany is the key decision-maker as the largest creditor within the single currency area. Mrs Merkel appears to have decided that the single currency project would be very badly damaged by the exit of any country and is prepared to pay some financial price to avoid that occurring, provided that those countries make the necessary economic adjustment. However the German philosophy of economic adjustment, through firm control of both government finances and the money supply, always seeks a deflationary adjustment to economic imbalances, meaning that competitiveness is generally restored by downward adjustment to labour incomes. Germany itself has achieved this twice in recent times, once after re-unification, and secondly after joining the Euro, which it entered at an uncompetitive exchange rate. The history of Southern Europe in such situations has generally been to restore competitiveness via devaluation. This option is no longer available inside a monetary union - the policy of internal devaluation is a very painful challenge to these economies.
The German economy has in recent years been driven by exports to China. As a major exporter of capital goods, the heavy long term investment spending that China pursued from 2009 onwards in response to the 2008 crisis, was a fantastic opportunity for German businesses. However, the slowdown in the Chinese economy seen in 2012 has also been evident in the peaking of German growth.
Following German orthodoxy, the emphasis of most Eurozone governments on fiscal austerity, and in the cases of the weakest countries, rapid fiscal austerity, has severely affected domestic demand in these economies. The pressure for further austerity in the next few years is likely to continue, as Germany’s price for providing the finances to bail out other European nations.
The performance of European equity markets corresponds very clearly with the performance of their national economies in recent years, with the Northern European markets generally performing well and the Southern European markets performing poorly.
The ECB decision in September to buy potentially unlimited amounts of government bonds, does now mean that the Eurozone has a lender of last resort. In addition, the aim of creating a single European banking regulator will, when in place, allow a separation between financing insolvent banks and financing insolvent governments. This though is unlikely to occur before the 2013 German elections.
Germany has understood that for the Euro to be a viable monetary union in the long term requires a much deeper level of integration towards political and fiscal union, and is now developing the plans to put this into place. The price for Germany underwriting the rest of Europe’s finances is effective control over national budgetary policy. Those countries that choose not to accept this will have to leave the Euro in due course.
European equities are very attractively valued by historical comparison in terms of P/E ratios and dividend yields and very long term investors are now seeking opportunities to buy. However the German nature of the current policy settings for the Eurozone, mean that many years of restructuring lie ahead for the weaker economies, leaving growth prospects to come solely from global demand for their exports. In addition, the banking system is still replete with assets still to be written down, which will inhibit the recovery process. It is however possible that the worst expectations for European companies are now in the past, and that a long and slow recovery process has begun.
The future for Europe
The most likely scenario for Europe’s future is a continuation of Mrs. Merkel’s policy of steady perseverance in re-educating its fellow Eurozone members in how to manage an economy the German way. As countries get their budgets back under control and the new institutional structures are put into place so Germany will be increasingly prepared to use its strong credit rating in support of weaker countries. This is a very long and tortuous path to go down, and together with the necessary restructuring of the banking system means that Europe’s economic growth will be severely constrained for many years to come.
Such a long path to economic virtue may prove too hard for one or more of the Eurozone members such as Greece or Spain and they may decide to leave. Such an action would lead to an immediate crisis and every remaining country would have to make clear its commitment to remaining in the single currency very quickly.
A feasible but lower probability scenario is that Germany comes to realise that continued austerity in the Eurozone will take too long to work and require more German bailout money than it can afford. In this scenario, the ECB may print the money required and Germany will have to accept that the principle of a strong currency that was inherent in the Deutschemark cannot be maintained with the Euro. This reflationary policy would enable higher growth and higher inflation than in the steady austerity scenario above and provide much better performance from European equities.