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.




From Heroes to Zeroes – 21st Century Central Banking

At the beginning of this century, the reputation of Central Banks in the West was at its apogee – over the previous 20 years inflation had been wrung out of the global economy by maintaining interest rates consistently higher than the rate of inflation. If inflation threatened to rise too sharply then raising rates by a few hundred basis points was sufficient to choke off consumer demand (since their mortgage repayments formed such a significant part of their disposable income) and slow the economy and inflationary pressures. Once this had been achieved, often requiring a quick recession, rates could be cut again and the restoking of consumer demand would reignite the economy. In short, it was apparent that Central Banking that had as its main target the control of inflation could be successful at only a small cost to growth. Politicians found themselves able to give up their desire to control interest rates for electoral purposes and give independence to their Central Banks. Central Bankers became Heroes!

The recession in the US following the bursting of the internet bubble and fears for the US economy following 9/11 however, saw the Fed cut US rates right down to 1% in 2002 and hold them there until 2004. 1% interest rates were much lower than seen in previous cycles and in hindsight were responsible for a massive inflation of the US housing market. Whilst the internet bubble was essentially financed by equity, since the new companies had no cash flow, the housing bubble was financed by debt. Debt-financed bubbles we now know inflate far further than equity-financed bubbles and then burst in a far more devastating fashion. Central Banks meanwhile, focussing only on the Consumer Price Inflation targets did not spot the bubble in the debt markets and so did not increase interest rates sufficiently to manage things better.

Following the 2008 meltdown in the global financial system and subsequent recession, Central Banks found that even interest rates that were effectively set at zero no longer helped to boost consumer demand. This was for two reasons, first consumers realised that they had already got too much debt and no longer wished to borrow more, even with low interest rates and secondly the all economic agents (banks, companies and consumers) had lost confidence in the future growth prospects of the economy that they did not want to lend, borrow or spend.

The Central Banks went back to their old textbooks to search for policy tools when interest rates can no longer be reduced and discovered Quantitative Easing (QE) which pushes money into the financial system in an effort to boost the demand for financial assets and thus stimulate the real economy. Many Zeroes of dollars, euros, yen and pounds have been created in this way. QE has almost certainly worked in the sense that economic growth in 2009, 2010 and 2011 would have been much worse without this policy, but it has not been enough to boost growth back onto a sustainable path. Worse still, repeated applications of QE seem to be less effective at doing this than the first effort. The scale of these interventions has brought forth much criticism of Central Banks in the US and the UK for creating the risks of hyperinflation from the creation of so much money. In Europe where monetary orthodoxy of the Bundesbank is enshrined in the ECB’s mandate, the Central Bank is criticised (outside Germany) for not doing enough to support the Eurozone economy.

For politicians, who are policy-constrained by huge fiscal deficits and debts, the only hope is that Central Banks solve their problems, but whilst Central Banks have the tools for fighting inflation, they do not have the tools for fighting deflation. They have done what they can (zero interest rates and QE) but have little more to offer bar providing liquidity to keep troubled banks alive and adding more zeroes to the money supply. The Age of the Heroic Central Banker is now behind us.