Reasons to be fearful… The German economy

Since the onset of the eurozone crisis in 2011, and the ensuing austerity across the Mediterranean, the health of the eurozone economy has been dependent on Germany and the desire of the German consumer to buy goods and services from the rest of Europe. Given the German cautious savings mentality and aversion to spend this has rarely been a winning economic strategy, but in fact the strength of the German labour market has given some succour to the eurozone economy in recent years.

This strength came from the jobs and pay from the German capital goods and autos sectors, demand for which held up due to strength from two key export markets, China and the Middle East. Over the last eighteen months, however, both of these economies have seen significant weakness. The Chinese government has reversed course on the massive public infrastructure investment programme it undertook from 2009 onwards and is now looking to rebalance its economic demand away from exports and investment and towards domestic consumption, where apart from autos, German industry is not well represented. While the oil price was comfortably above $100, then the oil exporting nations of the Middle East had lots of money to finance investment spending in their economies, but now that oil is trading below $50, this spending has dried up.

So these cyclical trends were already pointing to a slowing in demand for German goods and a consequent impact on German consumer confidence. In recent weeks there have two further hits to the German economy.

First, the extraordinary response of the country, led by Angela Merkel, to the refugee crisis, which will see 800,000, or 1%, of the population, immigrants allowed into the country in the near future. In the long term, as these people find jobs and pay taxes, this will be seen as supporting the German economy that was beginning to worry about its ageing population, but in the short term the economic impact is more likely to be a burden to the German government, since it will widen the budget deficit and this will likely lead to a tightening of fiscal policy elsewhere to remain with the balanced budget rule that Germany has now put in place.

Second is the Volkswagen scandal which erupted last week over the software coding in VW’s diesel cars that was designed to deceive regulators testing the emissions of these cars. This appears to drive a stake through a core German industrial USP, that of reliability, trustworthiness and quality. VW is the country’s largest employer and embodied much that the Germans felt good about themselves. It is too early to judge the effects of this scandal but they could be very significant not just on export demand for VW cars, but all German cars and possibly other German products too. Aside from this is the neagtie impact on the psyche of the German worker and consumer, who has never needed much excuse to feel they must save more now and spend less.

The new balanced budget rule means that a weaker German economy now leads directly to German austerity, and a further hit to the outlook for the eurozone economy.

The world economy needs more German spending not less. The German and Chinese economies are the two major creditor economies left in the world today – with the other major world economies running trade deficits, new demand in the global economy needs to come from consumers in these creditor economies. Without it, as is now looking increasingly likely, the global economy will remain very weak, and policy makers have few policy levers left to pull to boost it.

Greece – one month on

It is now one month since Syriza came to power in the Greek general election. Much has been said across Europe, many meetings held but little has changed.

Syriza said, both ahead of and immediately after the election, that they would immediately and unilaterally throw out the Troika (the term for the EC, ECB and IMF group that oversaw Greece’s adherence to the bailout conditions imposed) to regain sovereignty over economic policy and end austerity. They said that they would demand a haircut on the amount of debt owed and that the rest of Europe would agree to this because it was (a) fair and just and (b) Europe would be scared that Greece might pull out of the euro and set off a chain reaction amongst other members that would call into question the very existence of the single currency.

Over the last few days Syriza has backed down from all of these demands, with apparently very little gained in return. Europe has stated very clearly that any write-down in the value of the outstanding debt is unacceptable to them, and Europe has continued to demand that the same trio of institutions (though now called the institutions rather than the Troika) determine whether Greece is complying with its obligations under the original bailout agreement. Also rather than anything happening immediately as Syriza demanded further discussions will take place over the next four months and conclude just before Greece is required to repay the next tranche of its debt.

It seems difficult to argue anything but that Syriza has failed miserably to deliver what it had promised the Greek voters – and indeed the risk now is that Syriza is unable to get its own MPs to give parliamentary approval to what it has agreed with Europe – which would lead to a new crisis.

With a finance minister who was formerly a professor of game theory, everyone was interested to see the negotiating techniques that Syriza adopted. At the time, and even more so with hindsight, they do not seem to have been very smart. The first acts of Tsipras and Varoufakis (the prime minister and finance minister) seemed designed to upset and offend the Germans, which may have good for domestic politics, but not ideal for bringing on board the key decision-maker in reaching agreement with Europe. They also made significant concessions very early – within a few days of coming to power, Tsipras was saying that Greece intended to repay every euro of its debts. Syriza’s maximum leverage was always likely to be immediately after the election, when “democracy” was on their side – by allowing discussion to go on for another four months they will lose that benefit. Finally it became clear as time went on that the “disaster” scenario of Greece pulling out of the euro, was something that Germany was quite prepared to live with (indeed many Germans are actively campaigning for it) whereas Syriza did not have a mandate to allow that , given that 70% of Greeks want to remain in the euro.

By contrast, Europe, led by Germany but strongly encouraged by both other Northern countries such as Finland who share the German approach to economic discipline, and by Southern countries such as Spain and Portugal, who have been through similar austerity programmes to Greece without (much) complaint and did not see why Greece should get any special treatment, played their hand in a very robust style. Schauble, the German finance minister seemed to revel in the role of “euro-enforcer”, and has insisted on Greece backing down on almost every substantive element of their demands.

The lessons from the last month seem to be (i) when going into a negotiation you need a credible fall-back position if you can’t get what you want – Syriza rather put a gun to their own head and threatened to shoot, (ii) Syriza, by conceding externally in Europe, may well have lost credibility internally, disappointing both many of their own party members and many Greeks who voted for them and (iii) Europe does not recognise democracy as an appropriate reason to go against past agreements and the rule of law (Juncker has made this point explicitly) – it should now be abundantly clear that being a part of the euro means a substantial loss of sovereignty for a nation, especially if they have a weak financial system.

Not much has changed in the last month. Greece is still stuck with debt it will never be able to repay, the Greek government has almost no say in how its economy is to be run, and the European political class have asserted their right to ignore the results of democracy in their quest to maintain the structurally-flawed single currency. This is not a long-term equilibrium – there are more crises to come.

“Alptraum” – German for nightmare

Recent events in Europe have seen many of Germany’s worst fears come true.

  • January 22 saw the ECB finally agree to initiate a policy of Quantitative Easing despite the objections of the German members on the Council. The ECB, supposedly created in the image of the Bundesbank, is now committed to a policy of money creation whose deliberate target is to increase in the inflation rate. Both the policy and its objective are in violent opposition to all that German monetary policy has sought to achieve over the last 70 years.
  • January 25 saw the Greek election result in Syriza polling far higher and thus gaining many more seats than had been expected. Instead of choosing to go into coalition with a more moderate centre-left party, Syriza formed a coalition with the far-right Independent Greeks, with whom they disagree completely on most issues but are agreed on one key policy – the tearing-up of the bailout agreements. The Independent Greeks are strongly anti-Germany and wish to reclaim war reparations they claim Germany owes to Greece. Today Greece now has what is arguably the most anti-German and authentically communist government in the European Union. The coalition are committed to tearing up the bail-out agreements signed by previous Greek governments and are demanding that much of the debt they owe be written off. Germany was a necessary, but very reluctant, party to these agreements as they appeared to compromise the key “no bailout” clause of the Maastricht Treaty.
  • January 26 witnessed Tsipras’ – the newly sworn-in Greek prime minister – first act paying a visit to the Kesariani rifle range, the site of a memorial to 600 Greek resistance fighters who were executed in a single day in 1944 by German occupying troops. The symbolism of Greek resistance to German subjugation today through opposition to the hated bailout agreements was clear and very deliberate.
  • Following this visit, the first ambassador that he decided to meet with was the Russian ambassador, who re-affirmed Russia’s readiness to provide financial support to Greece should they require it. The EU’s policy of sanctions on Russia, of which Merkel was a key influence and driver last year, has to be extended in the summer and requires unanimity from EU members.
  • The first domestic policies that the new government intends to enact are an end to planned privatisations, a large increase in the minimum wage, the re-establishment of thousands of public sector jobs that have been cut in recent years and increases in pensions. All of these will make meeting the targets for the Greek budget deficit impossible to achieve in the short term – they will also hit the competitiveness of the Greek economy and threaten to undo the gains that have been made in this area in recent years.

Though both the German and Greek governments are saying they do not want Greece to leave the euro, the possibility of this occurring is now very real as the halving of the prices in Greek bank shares since Syriza’s victory is indicating (Greek banks would be immediately bankrupt should they lose the liquidity support of the ECB). Many Germans are now quite prepared to take the risk of another eurozone crisis should Greece leave the single currency, and in domestic political terms, Merkel has little in the way of compromises that she can offer. Until quite recently Syriza was calling for Greece to leave the single currency, but in recent months softened their rhetoric as polls show that three-quarters of Greeks wish to remain in the euro. Being effectively thrown out of the euro by the EU for standing up for Greek interests may well be seen by many in Syriza as a good outcome.

The last week has seen each side harden their positions. Whilst the history of the EU tends to be one of finding the minimum necessary compromise at the last possible minute, the philosophical differences between the German and Greek governments are ultimately not reconcilable and one or both of them will have to give way on key points of principle for Greece to remain in the single currency.

The German dilemma

Within the Eurozone, Germany is coming under increasing pressure to approve and adopt policies designed to stimulate the Eurozone economy. This is because (i) Germany is the largest economy in the Eurozone, (ii) since the global financial crisis, Germany has enjoyed the strongest performance within the Eurozone based mainly on exports, which has led to a very substantial trade surplus, (iii) German public finances are in a very healthy state compared with most in the Eurozone and (iv) they are rich and have the policy flexibility to act.

Many in the rest of Europe are calling on the German government to launch a large debt-financed fiscal boost through public investment spending, creating, it is hoped, jobs and demand throughout the Eurozone. The Germans are resisting this strongly because they have worked very hard in recent years to get their government finances back onto a solid footing, and are expected to get close to a balanced budget in 2014. German politicians are stoutly resisting European calls for them to spend more and move back into deficit.

It is though in monetary policy where the greater controversy is being generated. Through his public utterances over the last six months, Mario Draghi has sought, to maintain market confidence by positioning the ECB as about to introduce a US- or UK-style QE programme in its efforts to boost demand and inflation. However the actual policy steps agreed at ECB meetings have not lived up his words – QE is always just a few months away. It is clear that, behind the scenes, the Bundesbank and several ECB members are fiercely opposed to such a policy, with many in Germany believing it to be illegal. They are angry at the way that Draghi has sought to bounce them into such a policy by his public statements.

To many in Europe (and indeed the world), the Germans are the bad guys, doggedly blocking any moves to boost the moribund Eurozone economy due to their particular economic ideological fixations around sound government finances, conservative monetary policy and a strong currency. Being so out of step with their Western allies is not a position in which post-war German governments have wished to find themselves, and in any other field than economic policy, they would have made adjustments to their position and found a compromise.

It should however be recalled that Germany never asked for the single currency, and when it became inevitable, did their best to restrict membership only to those economies that were happy to embrace German economic orthodoxies, for precisely the reasons that are now being played out within the Eurozone.

In 1990, Mitterand’s price for accepting the re-unification of Germany was monetary union. In permitting Germany to become a much larger, and thus more powerful nation, he sought to maintain France’s significance by sharing the all-powerful Deutschemark. Kohl accepted this provided that all those involved in monetary union were prepared to manage their economies according to German orthodoxy. Thus the ECB’s mandate was constructed along very similar lines to that of the Bundesbank – very independent of politicians, with a mandate of low inflation delivered through conservative monetary policy. Similarly, the Maastricht Treaty constrained the size of government deficits and public debt that individual countries would be permitted. With these in place, the only economic solution for countries finding themselves in economic difficulties is for export-led growth, with the private sector becoming more competitive in global markets through cost control, innovation and structural reform. There would be no room for short-tem fixes generated by lower interest rates, weaker currencies and debt-financed government spending.

The criteria for membership of the euro were deliberately designed to exclude what are now known as the peripheral economies. Only the “core” European economies were expected to qualify, who understood and were prepared to accept German economic thinking. However everyone wanted to qualify and through a combination of the long economic boom of the 1990s and some very creative accounting, the euro began life both with many more members than Germany had ever intended, and with much weaker (though disguised) public finances than Germany would have countenanced.

Since 2008, the Germans have continued to espouse the policies that they believe were written into the monetary union. Thus they expect countries to embrace public sector austerity to reduce budget deficits and bring their giddy debt levels back under control, they expect their Central Bank to adhere to policies of sound money by control of money supply growth and they have a particular fear of Central Banks who buy government debt with newly-printed money. This is the economic and monetary union Germany insisted on, signed up to and has always believed that others had agreed to.

To date they have not relented on these principles, but it is leading to great pain and bad will across Europe, where the peripheral economies which previously resorted to policies of devaluation and government spending to boost their economies in times of trouble, cannot understand why these should not be adopted now. Germany now faces its greatest dilemma – whether to abandon the economic principles which have been the foundation of its economic success since 1945 and remain on good terms with the rest of Europe, or, remain true to its economic ideals and be the cause of the break-up of the monetary union as weaker economies are forced to leave.

In 2012, Angela Merkel opted to bail out Greece rather than risk the break-up of the euro, though by all accounts the decision was close and arrived at only after months of consideration. When the ECB finally votes to adopt QE (almost certainly sometime in early 2015), there will be vigorous opposition within Germany including legal challenges. Once again Mrs Merkel’s leadership will be key in determining the future for Germany and for Europe.

Nippon Europe?

Angela Merkel’s favourite set of facts about Europe are that it represents 7% of the world’s population, 25% of the world’s GDP and 50% of the world’s social spending. It is this that informs Germany’s insistence that the rest of the Eurozone meet their budget deficit targets.  In recent years, through harsh austerity, the peripheral economies have made good progress in reducing their budget deficits.  Progress has been very disappointing at the core of Europe and in particular France and Italy, which together represent almost 37% of the Eurozone economy.  These countries still have much painful restructuring to come, which will continue to depress demand in the Eurozone as a whole: Europe’s economy is likely to continue to stagnate and it increasingly resembles the Japanese economy of 10 – 15 years ago in terms of high levels of public debt, poor demographics and weak policy action.  We believe Europe offers few opportunities for profitable investment in the next few years, and therefore remain VERY LIGHT in Europe in our model portfolios.

The second quarter data for Eurozone growth was disappointing, showing zero growth for the Eurozone as a whole, and of great concern for the health of the core, all of the three largest economies (Germany, France and Italy) reported negative growth:

  • Growth in Germany has been hurt by the switch and slowdown in spending in China, away from investment and infrastructure spending towards consumer spending, and also by the sanctions imposed on Russia – two trends that seem likely to persist for some time;
  • The French Government has been forced to admit that their economy will not grow this year, and they expect only 1% GDP growth in 2015, with the result that France will not be able to meet the EU targets for budget deficit reduction, which have already been extended by two years from the original target dates. Though Francois Hollande accepts the need for French austerity and reform, many of his Socialist Party colleagues are opposed to the necessary measures and are unlikely to vote for them in parliament. The recent dissolution of the cabinet highlights the growing division within the Socialist Party;
  • In Italy the economy has already endured a lost decade. The size of the economy in real terms has not grown since Q1 2000, and in nominal terms has not grown since Q3 2007. The budget deficit remains large, but Prime Minister Matteo Renzi has effectively warned his Eurozone partners that he will seek to ignore the EU budget and fiscal rules designed to reduce Italy’s debt/GDP ratio. Italy’s finances would be in far healthier shape but for the interest that has to be paid on Italy’s €2 trillion government debt.

The stage is now set for a major argument within the Eurozone between Germany and the Northern economies (mainly Finland, the Netherlands and Austria) who are currently demanding that France and Italy reduce their deficits and the countries themselves, which appear very reluctant to take the necessary measures. This is likely to lead to a long period of drift amongst the leaders of the Eurozone, and create uncertainty about the future direction of European economic policy.

Meanwhile, clear evidence of progress in the periphery can be seen in the record of both Ireland and Spain’s private sectors, which have been at the forefront of efforts to make their industries more competitive with Germany since 2008.  From 1998 to 2008, Irish and Spanish Unit Labour Costs (“ULCs”), which represent the average cost of labour per unit of output, rose steadily while German ULCs were unchanged, and so the former became increasingly uncompetitive. Since 2008, German ULCs have risen but Irish and Spanish ULCs have fallen back, bringing their economies back to the competitiveness relative to Germany last seen in in 2005.

In France and Italy, in contrast to Ireland and Spain, ULCs have continued to rise since 2008 – there has been no improvement in competitiveness relative to Germany. The core of the Eurozone economy is steadily becoming less able to compete in global markets, which has negative implications for the potential for these economies to grow.  Both France and Italy need the austerity in both public and private sectors that the peripheral economies have been undergoing in the last few years.

Europe’s economic problems – (i) excessive public sector debt, (ii) poor demographics and (iii) a banking system suspected to be hiding considerable bad debts, leaving banks unwilling to lend – are eerily similar to those of Japan over the last two decades, an economy which has seen zero nominal GDP growth over that period, and is now embarking on one of the most extraordinary policies of money-printing ever seen in a developed economy. There is also a fourth problem, which is the existence of the Euro with its flawed construction that seeks to deliver a monetary union without a political union.  For many countries, remaining in the Euro requires strong deflationary policies, while coming out of the Euro would be seen as a hugely negative political loss of face.

The peripheral economies have taken their medicine, with frightening results in terms of youth unemployment and living standards in recent years. The same, however, cannot be said of France and Italy, and when the dose is taken, given the size of their economies it will lead to far greater repercussions on the European economy, than was seen with the peripheral economies.  With a strong currency, high unemployment and weak wage growth, the medium term outlook for the Eurozone economy is bleak, and returns to investors will be challenging to find.  The ECB is the one institution that could break the logjam, but to do so would require a QE programme on such an enormous scale that Germany could never accept it.  If the ECB does resort to a policy of QE, it will likely be too small to be effective, and will merely lead to disappointed financial markets.   We therefore remain VERY LIGHT in Europe in our model portfolios.

 

 

 

The German dilemma

Since the drama of the Italian election in the spring, European politics have been remarkably quiet.  This has been by design – the countries who would like Germany to provide money or ease policy to support their beleaguered economies have understood that it is very important not to scare the German voters ahead of their general election on September 22.  There was a fear that “bailout fatigue” amongst Germany’s electorate might force the politicians to make promises not to provide further support to weaker economies.

In two senses, the result is not in doubt – (i) Mrs Merkel seems sure to remain as Chancellor following the election, as her party is odds on to have the largest share of the votes and (ii) in that event, she will have to lead a coalition to form a government.  What is uncertain is that this coalition will either be a continuation of the current coalition (of Merkel’s centre-right Christian Democrats with the Free Democrats should they reach the 5% threshold of the total vote required to get any seats in the Bundestag), or, if they don’t, there will be a “grand” coalition with the Social Democrats, the large centre-left party.

Whatever the shape of the resulting coalition, the next German government faces a huge dilemma between its two major policy objectives.  It can choose to do all that it can to keep the Euro intact, which will achieve its foreign policy objective of being at the heart of an ever-closer European Union, but at the expense of its economic policy objectives of low and stable inflation and balanced budgets.  Or it can choose to insist that Europe’s economic policies reflect those of Germany and watch as the rest of Europe suffers from economic stagnation until the option of withdrawing from the Euro becomes impossible to resist for some, threatening the survival of the Euro.

To achieve both of Germany’s key policy objectives, the optimal solution is a continuation of the current German stance where they provide the minimum in bail-outs to prevent a default,  in return for a commitment to continued austerity at an agreed pace.  This achieves their dual goals of keeping the Eurozone together, whilst maintaining a German –style attitude to fiscal policy and thus low inflation and a sound currency.  It delivers the “stability” that is so prized by German politicians.  However, this is an inherently risky policy for most of the rest of Europe, delivering a graveyard type of stability.  It will ensure near zero growth, high unemployment and weak banking systems across the Eurozone, for a long time to come.  It is eerily similar to the policy adopted by Japan which led to two decades of stagnation.

To escape this stagnation, countries in the Eurozone have three options: (i) leave the eurozone and repay their euro-denominated debt in their new (and devalued) currency – this would dramatically improve their trade competitiveness and reduce their national debt, but badly damage their relationships with their European neighbours; (ii) persuade the ECB to engage in Quantitative Easing in an effort to create inflation, which would reduce the real value of their debts and might also encourage some growth; or (iii) construct the necessary  banking, fiscal and political unions to go alongside and support the existing monetary union.  At an aggregate level the economy of the Eurozone does not have great budget and trade deficits.  It is only at a national level that the problems appear, which implies that a deep and real economic union between the countries can be successful.

Of these three options, the first is seen as suicidal by incumbent politicians, not only for their prospects for domestic re-election but also for their chances of any future European roles in Brussels.  The second is hard to imagine, since it would require both the ECB and the Germans to support a higher inflation objective.  The third is very complicated to achieve – in 2011 the German Constitutional Court pronounced that the German constitution does not permit further significant political integration without a German referendum.  It would also probably require referenda in several other Eurozone states.  This is though the most logical solution to the Eurozone’s problems.

The banking systems across the Eurozone remain very weak, with the OECD recently estimating that since the crisis began, Eurozone banks have reduced the size of their balance sheets by €2.8tr but have a further €3.0tr still to go, from total balance sheets of approximately €32tr. The banks, particularly in the peripheral countries are in no position to support growth by increasing their lending.  The outlook for economic growth in the Eurozone is thus very restrained, meaning that unemployment will remain very high and that governments will continue to struggle to deliver deficit reductions.

The implications for investors are that Eurozone growth will be very sluggish (even though in the short term growth may be improving), and will remain so as long as Germany’s preferred policy approach continues to hold, since no further fiscal or monetary stimulus will be supplied to the eurozone economy.  We remain very cautious on European equities, which do appear cheap, but that cheapness is concentrated in banking shares and in the markets of the peripheral economies whose prospects remain very challenging.

Eur-out

For the last quarter of a century, Germany has been open to monetary union with the rest of Europe, provided that three conditions were satisfied.  These are (i) no bailouts of other countries who were also in such a monetary union, (ii) the Central Bank that sat at the centre of this union was heavily modelled on the Bundesbank and its operation of monetary policy and (iii) all participating were subject to clear rules with regard to budget deficits and total government debt.  With all three conditions in place, then Germany felt that all other countries in the monetary union would be forced to manage their economies in the same way that the German economy was managed.

Since the crisis, all three of these conditions are being severely tested, causing increasing angst to many in Germany.  With regard to the first condition, it is currently true that no country has been bailed out by transfers from the other countries. However, Greece has stretched this interpretation to the very limit.  Huge amounts of money have been lent to Greece by the IMF, the EU and the ECB (and so not directly by other countries), which are officially repayable.  All non-official holders of Greek debt have had their arms twisted to agree to their holdings being substantially written off.  Most investors expect the official holders also to agree to write-offs (at which point the money is no longer lent but in reality given), but this will not occur until 2014, after this year’s German elections.  Germany’s first condition (no bail outs) will be breached next year.

Under its first two Presidents, Duisenberg and Trichet, the ECB did, in fact, model itself heavily on the Bundesbank in its operation of monetary policy. Draghi, however, took over at the height of the crisis.  His first act was to provide a trillion euros of extra liquidity for weak banks from the peripheral countries, in exchange for collateral of very dubious quality, a tactic which drew criticism from the Bundesbank, but great acclaim from most other quarters.  Then last summer, as Spain appeared to have lost the confidence of markets to issue its debt, Draghi invented the concept of Outright Monetary Transactions, which permitted the ECB to intervene in government bond markets to an unlimited extent. The Bundesbank, saw this (rightly) as tantamount to the printing of money, as was being practised in the US, Japan and the UK, but was the lone vote against within the ECB Council.  Crucially for Draghi, Merkel decided to over-rule the Bundesbank and gave Germany’s blessing to this very un-Bundesbank action.  Germany’s second condition has already been breached.

The third condition is the one which matters most, and which Germany will least be prepared to see breached.  To emphasise the point, Germany has brought forward its draft of the 2014 budget, demonstrating that it continues to cut government spending to meet its target of a balanced budget in 2015.  The message to the rest of the eurozone is unambiguous – they too must meet their promises of cutting government spending to achieve balanced budgets in the medium term.

The forthcoming EU summit will contain no Italian government, following the post-election stalemate in which over half of the voters voted for parties which explicitly rejected the EU-led austerity programme initiated by Monti.  The French government has just announced that it now expects a deficit of 3.8% of GDP this year, compared with its EU target of 3.0% – it seems unlikely that President Hollande will make any great attempt at further government spending cuts.  In Greece, the latest tranche of official loans is dependent upon clear plans for Greece to cut 150,000 civil servants from its headcount in the next eighteen months. Greek politicians are very reluctant to agree and even more reluctant to implement such plans.  Both the Spanish and Portugese have promised their people that they have had the last round of cuts, but their budget deficits remain too high due to the continuing recession in these countries.

Austerity in the Mediterranean countries is reaching its political limits.  If Germany continues to insist on its third condition (the control of budget deficits) as Merkel will want to be seen to be doing ahead of her election in October, then the possibility of a country falling out of the euro in the short term is once more very real.  In the longer term, even if Germany gives a little ground now, it will continue to insist on governments reducing their budget deficits at a rapid pace that will mean little or negative growth in many eurozone countries for years to come.  This price will prove too high for some economies.

The investment implications of this are to maintain low exposure to euro-denominated assets until more reflationary policies are being actively pursued in the euro area – if Germany continues to stand on its principles, this may be never.

Weak Yen weakens Germany

Germany, the powerhouse economy of the Eurozone, recently announced 2012 GDP growth of only 0.5%, and that it expected 2013 to deliver only 0.4% growth.  At a time when most of rest of the Eurozone is undergoing policies of austerity and reductions in private sector wage costs, they are looking to Germany to be the source of demand for their goods and services, which their own economies are currently unable to provide.

With a balanced budget, near full employment, and a trade surplus of 7% of GDP, Germany is ideally placed to pursue policies designed to boost German consumer incomes and spending, which the rest of the Eurozone could supply.  Yet, aside from some very modest pre-election tax cuts, which have already been announced, there is no indication that German politicians wish to go down such a road.

This is for two reasons.  Firstly, they take the view that the reason for their economic success is precisely because they have not, historically, pursued such short-term stimulatory policies, but have instead concentrated on ensuring they have globally competitive private-sector industries and a structurally balanced public-sector budget.  Secondly, the German Finance Ministry has realised that in the next few years they will need to provide funds to meet their obligations to the EFSF and the ESM, which have been set up to provide the bail-out monies for the weaker countries. They are thus already planning for offsetting public sector spending cuts in 2014 and beyond – in sharp contrast to all other countries, who are hoping further bail-outs won’t be needed, or will seek to borrow the funds from the markets if they are.

So, domestic spending is unlikely to be driving the German economy in the near future.  As usual, Germany will be hoping to benefit from global demand for its exports. Here though, the actions of the ECB and Japan may thwart those hopes.

Despite the Eurozone sliding back into recession, at its last two monthly meetings, the ECB has not cut interest rates when many commentators thought that it could and should have done.  Indeed after the last meeting, Mr Draghi made clear that the ECB had done as much as it could to promote growth, and it was now the role of governments to produce pro-growth policies.  The markets interpreted this as saying that no more rate cuts or easing of monetary policy would be forthcoming, in contrast to the $85bn each month of QE from the Federal Reserve.  Since then the euro has been the strongest of the major currencies, making German exports less competitive.

In Japan, the focus of the new government to stimulate the economy by all possible means including weakening the currency has seen the yen fall sharply in recent weeks.  Against the euro the yen is 20% weaker over two months and 26% weaker over six months.  These are dramatic moves for any major exchange rate, but the euro-yen exchange rate is particularly important for Japan and Germany.  This is because their strengths are in very similar industries, and competition is hard-fought in sectors such as automobiles, power plants and high-technology capital goods.

In early 2009, the exchange rate was 140 yen to the euro, and over the next 3 years the yen strengthened to 95 yen to the euro, making Japanese companies very uncompetitive against European (but most importantly, German) companies. German exports performed very well in 2010 and 2011, particularly to China.  This was also helped by a diplomatic row between Japan and China about sovereignty rights over some small islands lying between their two countries, sparking popular anti-Japanese sentiments inside China, and consumer boycotts of Japanese goods.

Japan is now deliberately weakening the yen further to stimulate their economy – the recent 20+% fall in the exchange rate will be a particular problem for German competitiveness, and will hold back export demand this year.

The investment implications of this are to remain wary of the European economy and light in European shares, to expect the euro to strengthen , and to be heavy in Japanese shares, but to avoid the yen exposure by, for example, owning currency-hedged share classes of Japanese funds.

The single currency – making Germany more European or Europe more German?

Following the fall of the Berlin Wall when Kohl wanted to press ahead with the reunification of Germany, the price of Mitterand’s acceptance of this was to demand that Germany share the power of its currency with the rest of Europe (or more particularly France) in a monetary union. Germany agreed provided that the guardian of the currency, the ECB, was made in the image of the Bundesbank, with its rigorous implementation of policies to control inflation. Both were happy because Mitterand believed he was making Germany more European, Kohl believed he was making Europe more German and the Bundesbank believed that it had the right to criticise and have a special influence over the policies of the ECB.

Until last year, the ECB did indeed operate in much the same way as the Bundesbank would have done, tending to be quick to raise interest rates and rather slow to cut them. After a Dutchman and a Frenchman, it was to have been a German, Axel Weber, who was expected to take over the ECB Presidency. However, he resigned following the introduction of the ECB policy of limited buying of the bonds of troubled peripheral governments, which in retrospect was a fairly minor breach of Bundesbank monetary orthodoxy. The man selected to take over the Presidency was Mario Draghi, an Italian and a former investment banker.

By the time Draghi took over as President in November, Europe was in deep crisis, and the ability of the politicians to respond with bailout money funded by the other governments was almost nil. If the Euro were to survive it would require extraordinary monetary policy measures. Draghi understood this and introduced two Long Term Repurchase Operations, lending unlimited money to any Eurozone bank at 1% for 3 years. Much of this was used by the Spanish and Italian banks to buy their own government bonds trading at much higher yields. For the Bundesbank this was pretty close to the direct funding of government deficits, which is illegal – they were unhappy but did not oppose it.

The crisis has worsened during this year and Spain has become close to joining the ranks of those on the bailout list. Doing so would use up most the capacity of the bailout funds (which were designed to be so big that they would never need to be used). Over the summer, Draghi has come out with a new bond-buying plan for which he has garnered substantial support. Under the plan, if the politicians agree to a sovereign bail-out with conditions, and use some of the bail-out funds set up for the purpose, then the ECB will buy bonds of those countries to maintain their deficit financing costs at a reasonable level, in potentially unlimited amounts.

Rather neatly, everyone, except the Bundesbank is happy with this. The German politicians can claim that any bail-out requires German approval and will be subject to strict conditions, thus making Europeans more German, whilst the rest of Europe sees the ECB being publicly prepared to print large quantities of money to support the weaker European economies even though this creates the risk of inflation in Germany, making Germany more European! The Bundesbank reject it because the ECB is now no longer operating in the Bundesbank’s image.

The history of the crisis in Europe is that at each step Germany talks tough and finally gives in and pays up to keep the Euro alive. It has reached the end of contributing to bail-out funds with taxpayer funds and future bail-outs need the money to be printed by the ECB. Draghi’s plan allows this to happen, once the politicians agree to a bail-out. Despite their talk, German politicians always do seem to agree to them, and so, ineluctably, the Germans are giving up on the sound money orthodoxy, which has served them so well over the last 50 years. It is the Germans who are becoming more European rather than the Europeans becoming more German.

The implication for markets is that the pattern of markets is set to continue on a loop: creating crises in the bond markets of weaker countries, followed by those counties requesting assistance from Germany and Germany demanding more austerity from them before acquiescing, leading to a rally in markets before the cycle starts again. Draghi’s plan is a good solution for today but doesn’t solve the fundamental problems. However, if German politicians continue to become more European, the clearest market implication is to sell German government bonds, because Germany will either take on the debts of the rest of Europe in some way or the money printed by the ECB will create inflation in Germany.

Mario Draghi – boiling the German frog!

The anecdotal boiling frog story holds that if you throw a frog into a pot of boiling water it will immediately jump out, but if you place it in a pot of cold water and slowly boil the water, it will not perceive the danger and will be cooked to death. The recent announcement by Mario Draghi, the President of the ECB, of how the ECB believes it can bring the Eurozone crisis under control, smacks of these tactics.

By the end of July, as many of Europe’s leaders had set off for their holidays, Spanish bond yields hit critical levels, which if maintained would shortly leave Spain unable to raise money in the financial markets and requiring a full-scale bailout from the other governments. Spain is however too big for the other Eurozone countries to bail out without considerable help from the ECB in the form of printing money.

Mr Draghi has carefully constructed a plan of action that garners just enough political support to be workable. First, a country must ask for assistance from its fellow Eurozone governments, which must be approved (thus achieving full political buy-in) unanimously. They and the ECB will then set out the conditions for such assistance (achieving the strict conditionality criterion demanded in particular by Germany) and the ECB will then be free to buy short and medium-dated debt in any amount in the secondary market.  That should, in theory bring down yields and enable the country to continue to fund itself in markets. Draghi has promised that he would also deal with the issue of ECB priority in the repayment of debt which bedevilled the Greek bailouts.

As an idea this has the support of the “moderates” within the Eurozone, essentially most of the political leaders and Central Bankers with the sole exception of the Bundesbank, which firmly opposes any Central Bank buying of government debt. The Bundesbank though is a greatly weakened institution today. On the ECB it has only vote out of 17, and only has influence to the extent that the German government agrees. In this case, both Merkel and Schaeuble have come out in favour of the Draghi plan – the Bundesbank is therefore rather isolated. Draghi has successfully driven a wedge between the Bundesbank and the German government

The realpolitik logic of such a plan however is where the boiling frog appears. Once one starts buying up the debt of credit-challenged countries, one begins to incur a large cost should it cease. Since the ECB can create money at will, the cost to it of buying more debt (if conditions do not improve) is zero, but the cost of stopping buying more debt will be considerable if the country defaults on the debt already owned. The German politicians may choose to believe that by imposing conditionality on a country before the ECB starts buying its debt, they are not creating an inflationary problem, but they are the frog being placed into tepid water. Every successive purchase of debt will be the equivalent, in the eyes of the Bundesbank, of raising the water temperature another notch.  

Europe continues to march ever closer to a denouement to its crisis, but the ultimate choice to be made is still the same. Germany has to decide very soon between the lesser of two very large evils.  Should it maintain its foreign policy objective to be a good European and keep the euro together, it will have to accept massive money printing to bail out the sovereign debts of the other countries, and suffer the consequent inflation. Alternatively, should it maintain its key economic policy objective of a sound currency with tight control of the money supply, it will have to accept the break-up of the euro and possibly of Europe as other countries find themselves politically unable to cope with the resultant economic depression..