A Stagnant Europe

The outlook for returns from European shares for the next few years is not exciting, though the level of dividend yields is likely to support current prices, thereby limiting the downside risk in these markets.   The investment implications are to remain VERY LIGHT in European equities, where domestic growth is expected to be disappointing and exports outside of the Eurozone are likely to remain under pressure from a strong Euro.

As in the US market, the earnings growth in the Eurozone for 2014 (that is already expected by analysts) is strong, despite the lack of revenue growth expected from most companies. Further, again as in the US, the valuations on these optimistic earnings forecasts are at the high end of the normal range. Core European bond yields are likely to remain low but risks certainly remain in peripheral bond markets.   Political developments need to be monitored closely for any indications that the rise of the anti-EU factions in the peripheral countries begins to change the current support within them to stay in the Euro.

The EU parliamentary elections – According to the opinion polls, the anti-EU, UK Independence Party (UKIP) could emerge with the most votes in the UK’s forthcoming elections to the European Parliament. This apparent rise in nationalist sentiment is not just a UK phenomenon, with the French National Front, Italy’s Forza Italia, Greece’s Golden Dawn, and the Freedom parties in Holland and Austria all scoring highly in opinion polls. Though these disparate parties do not all get on with each other, it is possible that they could, between them, win about 20% of the seats in the new Parliament. This is not likely to be enough to change the path towards greater integration within Europe, but is enough to be a very vocal nuisance within European politics.

Austerity – The peripheral economies (generally understood to be Spain, Portugal, Greece, Cyprus and Italy) have undergone harsh austerity in recent years, leading to very high levels of unemployment (and youth unemployment in particular), in the cause of remaining in the Euro and receiving support from EU bailouts and the ECB. It is perhaps surprising that anti-EU sentiment is not even greater in these countries, but there appears to be a grudging acceptance that the German-prescribed policies of economic orthodoxy must be adopted. These are (i) lower government spending and (ii) smaller budget deficits together with (iii) lower wage levels to regain competitiveness. The stark alternative for these economies is to come out of the Euro and allow currency depreciation to ease their problems, by creating inflation and reducing living standards. Even France, led by a Socialist president, has now succumbed to German orthodoxy on its budget, acknowledging that its levels of taxation and budget deficit cannot be allowed to go any higher, and that spending cuts are necessary.

There are however, two problems with extending the German approach to economic policy to the whole of the Eurozone. First, most of the Eurozone’s exports are to other Eurozone countries, so reducing domestic demand through austerity in one part of the Eurozone merely reduces export demand for the rest of the Eurozone. Second, the peripheral countries’ greatest need is to regain competitiveness against Germany. This would be much easier to achieve if Germany were prepared to become a little less competitive, by having some price and wage inflation. A few years of German inflation at 4% with 0% inflation in the periphery would ease the Eurozone’s problems considerably. However, if German inflation remains at 2%, then inflation at –2% might be required in the periphery; economically such deflation is particularly harmful, keeping unemployment and budget deficits high.   There are few signs that Germany would be prepared to tolerate a 4% inflation rate.

Following the Japanese – The Eurozone is currently edging towards deflation, with the current inflation rate at 0.8%. With its other issues of ageing populations, high levels of government debt and high welfare spending, it shares many similarities with the Japanese economy of a decade ago. There, the economy has, until very recently, been mired in a long period of economic stagnation in which the nominal size of the economy has not changed – there has been some real growth, but this has been offset by falling prices and wages.

Stagnation – Our concern is very much that the Eurozone, following orthodox German policies, with an absence of stimulus from fiscal policy or from monetary policy and with an ECB extremely reluctant to implement QE, may have entered a period of structural economic stagnation, with high levels of unemployment, similar to the experience of Japan. This would be negative for economic activity and indeed for social cohesion in the weaker economies, and, in time, the support for the anti-EU parties may be strong enough to lead to more radical change than the forthcoming elections are likely to create. This might mean a change to policies that were incompatible with continued membership of the Euro.

Just as the UK’s exit from the Exchange Rate Mechanism in 1992 and sharp fall in Sterling marked the start of a new period of growth in the economy and a new bull market in stocks, any country that did exit the Euro would be likely to derive the same benefits. However, for now, continued adherence to the orthodoxy of German economic policy ideas is expected to lead to a period of economic stagnation for the Eurozone economy.