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Positions in Europe: Long Germany (EWG)

"Free movement is to Europe what foundations are to buildings. Remove it and the whole structure is undermined."

- Jose Manuel Barroso, President of the European Commission

With the European diaspora an ever-present and important topic, over the last month we’ve witnessed a few critical policy decisions and events in Europe that are worth revisiting: 1.) Denmark’s decision to close its borders with Germany and Sweden (in opposition to the Schengen agreement); 2.) the lifting of restrictions on foreign workers from Eastern Europe by Germany and Austria; and 3.) unemployment protests in Spain this week.

Certainly, the global recession and current austerity programs throughout Europe have left governments and citizens with less jobs, purchasing power, confidence, and increasingly we’re seeing rising nationalism and populism in response. Concerning Denmark—but more broadly in relation to all European countries—we believe the decision to guard and limit movement across borders is the wrong tact: not only are immigrants increasingly critical to head off demographic headwinds and promote growth, but with the EU the largest trading partner of most member countries, tighter borders threaten the exchange of goods and services.

The Germans, despite their haste in opening its borders to the East, should understand the need for immigration the best—they have the oldest population across the region, followed by Italy, and need a younger workforce and generation to pay for its social welfare state.  Separately, the case of unemployment protests in Spain reveals the importance of managing growth within an economy. The boom to bust housing bubble in Spain created tremendous growth (and a large influx of immigrants), but now the country is faced with the longer term prospects of low growth and high unemployment. Our chart of youth unemployment shows the tail impact of these imbalances.  

Where appropriate within these topics we also splice in analysis from the European Commission’s 2010 Demography Report, which offers a wide breadth of analysis but critically notes that Europe’s population growth is, and will remain, predicated on net migration. While the ultimate challenge for governments remains creating the right mix of an open door immigration policy to fuel growth while not straining the social system, a main take-away of the report is that as Europe’s population ages (think Baby Boomers), younger generations of foreigners will be increasingly needed to support them.


A Danish Fort: Porous Borders Assaulted

Late last week Denmark made a bold move in the eye of many European officials—it decided to reinstate guards on its borders with Germany and Sweden. The decision went against the open border principle of the Schengen agreement, a treaty signed in 1985 by five of the ten member states of the European Economic Community that officially went into effect in 1995 (and was later adopted by all EU countries, excluding the UK and Ireland) and holds the Schengen Area as a single state for international travel with border controls for travelers entering or exiting the area, but with no internal border controls.

In Denmark, the decision on border controls became a political bargaining chip: the right-leaning Danish People’s Party agreed to sign off on PM Lars Lokke Rasmussen’s center-right minority government’s plan to raise the retirement age, cut retirement benefits and issue additional austerity measures. 

The agreement was branded by the Danish government as a necessary measure to “fight the rise in cross-border crimes.” Yet the European community quickly called foul, stating that while under Article 23 of the Schengen Borders Code, a member can in fact reintroduce controls at inner EU borders "in the event of a serious threat to public order or national security for a maximum of 30 days or as long as the "serious threat" persists”, there was no evidence of a “serious threat” in Denmark. 

Importantly, Denmark’s pronouncement came in the context of heightened worries about immigration across Europe in recent weeks, mainly from Italy and France, two main destination countries of an estimated 25-30K Northern Africans, mainly Tunisian, fleeing unrest at home. France and Italy clashed in mid and late April after France stopped a train from Italy carrying Northern Africans and tensions again flared after Italian authorities gave undocumented migrants (many of them French-speaking Tunisians with their eye on France) temporary residency permits, effectively allowing them to travel freely to other European countries.

Relations have improved since Italian Prime Minister Silvio Berlusconi and French President Nicolas Sarkozy signed a joint letter to the EU in late May to demand that the Schengen agreement on border controls be amended to take into consideration the "exceptional" migration from North Africa, yet an agreement remains in limbo until a formal decision is concluded at a summit meeting of EU leaders on June 24th.   

Hedgeye’s Take: We’re of the opinion that the migration of Northern Africans is an “exceptional” event. Temporary border controls must be considered to control this influx and the EU must shoulder the burden for funding additional personnel. Ultimately, discussions must include funding for temporary and permanent shelter and resettlement facilities as well as quotas for arriving migrants. Clearly, no one country, due to its geography, should solely be responsible for dealing with these exceptional circumstances, however, unfortunately it looks like it will be some weeks before we get clarity.

Returning to Denmark, we do not think there is credible evidence of serious threat from its borders with Sweden or Germany; the move is solely a populist concession to the Danish People’s Party. Interestingly, the European Commission’s 2010 Demography Report notes that in 2009, there were about 1 million cross-border workers within the EU, representing 0.4% of the working population. While the number of persons crossing borders for work appears de minimis, the transfer of goods and services is not, with the EU the largest trading partner of most member countries.  Temporary to permanent borders controls for anything less than a “serious threat” within the EU/Schengen Area would hugely impact trade. 


Looking East and Germany’s Demographic Drivers

On May 1, Germany and Austria lifted restrictions on migrant laborers from Eastern Europe, which will allow the “new” (post 2004) EU member states of Poland, Czech Republic, Slovakia, Hungary, Estonia, Latvia, Lithuania, and Slovenia access to the labor markets of Germany and Austria.

Stepping back and looking at the 2010 Demography Report, what’s clear is that the population of the EU -27 is growing, while the age structure of the population is becoming older. That said, the rate of population growth has been gradually slowing in recent decades from 8 per 1000 inhabitants per year in the 1960s to 3.2 per 1000 per year in the period of 1.  A turning point came in the early 1990s, when net migration became the main driver of population growth and has since far outpaced natural change in the population.

In context, Germany has the oldest population in Europe, with a median age of Nationals at 44.5, whereas the Total Foreigners, which made up 11.6% of the population in 2009, averaged median age of 34.3 years (a consistent spread across most major western European countries). Below we provide a table of average median ages of nationals and foreigners across Europe. Noteworthy is that citizens of Italy (43.9), Luxembourg (43.0) and Greece (42.6) follow Germany for the oldest nationals on the continent.  

The Push and Pull of Europe’s Borders and Demographics - a1

Further the report shows that Germany has the oldest population aged 65 and older (20.7%), and the country’s aging is set to “proceed at a sustained pace until 2040 and then to almost halt in the 2040s and the 2050s.” As we show in the chart below based on the growth rate projections from the report (and here we focus on the main western European economies, plus Denmark given the write-up above)—it’s clear that short of the UK, all major western European economies will experience negative population growth by 2060.

The Push and Pull of Europe’s Borders and Demographics - a2

Turning to Germany’s increasing dependence on foreign labor as the population ages, the magazine Spiegel Online published an interesting article with Polish migration expert Krystyna Iglicka, who expects between 500K and 1 MM people to leave Poland for Germany in the next two years as a result of the lifted restriction. Citing demographers’ estimate that Germany needs 300,000 extra workers every year if the country is to maintain growth at 2 to 3%, Iglicka believes that given the geographical proximity of the two countries, Poles are more likely to work in Germany than they were in Ireland or Britain, where hordes moved in 2004 when Poland joined the EU.

And given the often cited fear that cheap labor from the East will steal jobs and push down wages, Iglicka said, “experiences with immigrants in Britain and Ireland have shown that this is absolutely not the case. Poles often take on the dirty, difficult jobs that Germans don't want to do themselves. In addition, Poles and other Eastern Europeans can assimilate much more easily than other ethnic groups. After all, they come from a Christian background, do not form ethnic enclaves and generate far less fear than immigrants from, say, Africa or Bangladesh.”

Hedgeye’s Take: With Germany’s aging population, more porous borders and lenient work and residency permits will help Germany maintain its competitive edge and drive growth. As the Demography Report states, immigrants will increasingly take a larger share of European populations, with estimates suggesting that in 2008 12.7% of the EU residents aged 15-74 were foreign-born or had at least one foreign-born parent, while in 2060 this group may more than double and exceed 25% of the population.

Spain’s Pains

As is well documented, the “Spanish Nightmare” is Spain’s slow transition from a decade-long boom to bust as a result of the leverage cycle finding her dark side. In particular, Spain's housing industry, which fueled much of the country's prosperity in the late 1990s to mid 2000s, has been turned on its head and prices continue to depreciate. As it relates to unemployment, many of the unskilled construction workers that fed the boom are now out on the street (or have returned home), with companies across all industries cutting jobs as the government struggles to issue austerity to cut a budget deficit of 9.3% of GDP.

This week saw unemployment demonstrations across the country ahead of regional and municipal elections this Sunday. Forecasts suggest PM Jose Zapatero and his Socialist Party are bracing for a crushing defeat. In any case, the discontent in Spain is commensurate with the highest unemployment rate in the industrialized world, at 21.2%, and frankly we’re a bit surprised the protests took this long!

As the two charts below present, not only is Spanish unemployment a full 10% higher than the EU average, but when we look at unemployment of individuals less than 25 years of age, the data is even more staggering. (And a similar argument could be made for Spain’s peripheral peers). While the data could be massaged in any number of ways, it’s fairly obvious that Spain faces a long tail of unemployment, and the probability of a lost ‘generation’ of youth is a very real threat that will weigh on the country’s social net for decades to come.   

The Push and Pull of Europe’s Borders and Demographics - a3

The Push and Pull of Europe’s Borders and Demographics - a4

To understand the context of the influx of workers to Spain we turn to the European Commission’s 2010 Demography Report, the Institute for the Study of Labor (IZA), and a 2009 IMF report on Spain. The charts below from the IMF clearly show the demographic ingredients that fueled the relationship between population growth and house prices and construction. Interestingly, Spain was second only to Ireland in average annual population growth, however immigrant growth in Spain on an aggregate basis far exceeded Ireland over the period. IZA notes that between 1 the foreign-born share in the working age population increased from 2 to 16%. In absolute terms, the foreign-born population increased from barely half a million to 5 million over the course of the decade, while the total (working-age) population increased from 26.7 to 31.3 million, implying that immigration was responsible for 98% of total population growth during the period. Based on IZA projections, this influx helped construct roughly 2 million new housing units!

The Push and Pull of Europe’s Borders and Demographics - a5

However, when the bubble burst in 2007, the overall decrease in the flow of immigrants to Spain was substantial. The Demography Report shows that the foreign population declined -31% from 2008 to 2009 and was mainly due to the reduced inflow of non-EU immigrants (down 35%) and fewer immigrants from the other EU-27 member states (down 25%).

While immigrants may continue their exodus from Spain, which may lessen unemployment rates and reduce the tax on the social state, Spain’s housing market is still far from the right track.

Two stories out this month caught our eye:

Firstly, Bloomberg reported that about 50,000 owners of beachside properties in Spain have lost rights to their homes after Spain’s coastal law was amended and applied retroactively to increased restrictions on coastal developments passed in 1988. According to PNALC, a group representing owners affected by the coastal law, as many as 500,000 could eventually be affected by the law. And even should homeowners win the right to keep their home, the law stipulates that owners of the homes in question can apply to extend their stay in the property for as much as 60 years, though they can’t sell it or pass it on to children, which clearly leaves the owner in a perilous state indeed.

While the law attempts to correct extensive cases of developers building on unclassified lands without appropriate permits, often for cash or other incentives, the pain is levied squarely on home owner who were often led to believe that they had proper documentation. According to a report by the savings bank Cajamar, Spain built 675,000 homes a year from 1997 to 2006, more than France, Germany  and the U.K. combined. Further, the development ministry estimates that British nationals account for about 31% of all foreign-owned homes in Spain.

Hedgeye’s Take: The implications of this law are naturally huge for the housing market. What foreign national is going to want to buy a home (and a significant amount want a coastal one) given the uncertainly if the home belongs to you?  And according to RR de Acuan & Asociados, a Madrid-based research company, the country has a surplus of more than 1 million empty homes, both new and existing—that’s a supply headwind that will have an impact for the years ahead!


Secondly, the FT reported this week that Banco Santander, BBVA and Caja Madrid, Spain’s three largest banks by assets, along with the cajas of La Caixa, CAM and Bancaja are offering “mortgages for repossessed residential properties with loan to value ratios of up to 100%, for up to 40 years.”  [According to the Bank of Spain, high loan to value mortgages, those above 80%, comprised 11.9% of all house loans in 2010, and were similar to levels in 2008.]

Hedgeye’s Take: The willingness of banks to essentially provide the entire loan for repossessed properties at such long maturities reflects how much pressure these institutions are under to remove direct exposure to homes on their balance sheets.

While the consolidation of banking sector over the last 18 months in Spain is a positive development, it’s clear there will continue to be pain ahead for the banking sector as unsold homes weigh on the economy at large. Spain printed a Q1 GDP number of +0.3% Q/Q or +0.8% Y/Y. We think this could be its best quarter of 2011. With the trifecta of rising unemployment, continual strain from the housing market, and a shaky government that must prove to the market that it can cut its fiscal deficit, we’re bearish on Spain’s outlook. And it too may be next in line for a European lifeline.


As the face of Europe changes, we’ll be changing along with it. Given persistent sovereign debt contagion across Europe, we continue to like Germany as a defensive name with a healthy growth profile for this year. While we’ve indicated that German fundamentals are slowing marginally, the DAX maintains its momentum above its intermediate term TREND line of support at 7100.

Have a great weekend,

Matthew Hedrick