Senior Macro sector analyst Matt Hedrick presented a European economic update conference call for our institutional clients. Hedrick discussed the current climate and headwinds impeding growth; how current European Central Bank (ECB) policies affect the markets; the continuing disparity of policy choices, and of economic inputs – and especially outcomes – across the Eurozone; and risks and opportunities at the Eurozone’s periphery.
Europe Who???
Henry Kissinger famously said – or maybe didn’t say, according to people who claim to know – “Who do I call if I want to call Europe?”
The comment referred to the disorganized entity known as “Europe.” Decades later, the EU has 27 members, while the currency club – “union” would be too strong a word – known as the Eurozone has 17 members with a common currency, a single central bank… and seventeen different economic policies. That’s not seventeen different economic policies – it’s 17 different nations, each of which is internally arguing over what their economic policy should be, to say nothing of what happens when all seventeen sit down together at the same table.
The Eurozone history indicates there will not be any startling changes that will all of a sudden harmonize policy across the membership. That would require a common willingness to make sacrifices, and the monetary “union,” as it insists on calling itself, remains beset by multi-lingual finger-pointing where the rich nations (read: Germany) blame economic weakness on the profligate habits of poorer nations; meanwhile the poor nations blame the rich (again, Germany) for being stingy.
The Eurozone policy debate remains a major stumbling block to making any economic progress. The inability of the members to reach consensus continues to drag on, all the moreso when many members feel badly handled by their more flush fellows.
One negative outcome of this logjam has been an inability to effectively confront inflation – or deflation – both of which periodically threaten to break through ECB target levels.
And in general, economic policy is sclerotic. Like a wounded limb, the Eurozone will only heal when healthy fresh blood pumps freely through the affected parts, and under the present political stalemate, that is simply not happening. The “periphery” – the weaker economies more likely to need bailouts – can not heal before the core economies, principally Germany. Eurozone output has declined for 6 consecutive quarters, and the ECB and the IMF have both revised their outlook downward. Hedrick says these new forecasts may not be pessimistic enough and he expects Eurozone GDP to remain weak for a protracted period.
Unemployment should “remain staggeringly high,” with the very real risk of a “lost generation.” The easy jobs in construction and unskilled manual labor (remember the “Polish plumber”?) vanished with the evaporation of easy credit and the real estate implosion. Administrative jobs have been drastically reduced through austerity, and cross-border labor migration suffers from quotas, and linguistic barriers and cultural difference that can pose real problems. Germany, for example, has a longstanding cultural tradition of robust training in the trades. Workers from other countries who were not raised in this environment don’t do well in the apprenticeship system that has been so successful in Germany. The disdain for skilled manual labor felt by youths from other cultures has proven to be a stumbling block to employment immigration.
We hasten to point out that large numbers of unemployed young people also becomes a recipe for major social unrest in the longer term. The discontent that sparked such movements as the Arab Spring, Spain’s “Indignados” (credited as the impetus for Occupy Wall Street) – and that is now bubbling over in Istanbul – can easily provide the spark for a generation sullen over the failures of their elders.
Hedrick says high debt levels and deficits will persist, and the lack of availability of credit will hamper small and mid-sized business growth for a very long time to come. Since most new jobs are created by start-up small and mid-sized businesses, the employment and business formation end of this dreary cycle looks set to continue.
“Super” Mario?
Eurozone central banker Mario Draghi has had a certain degree of success “jawboning” the markets. One might say that, compared to his US counterpart Ben Bernanke, his record is astounding.
Like Bernanke, Draghi has increased the flow of cash into his system. And like the US, the increased liquidity has not translated into massive new lending. But Draghi remains with an ace up his sleeve, in the form of a massive quantitative easing program called the “Outright Monetary Transactions” bond-buying program (OMT). Just this week Draghi called the OMT “the most successful monetary policy measure” of recent times. Last week he boasted that the OMT has made the Eurozone “a more stable and resilient place” by removing “unwarranted fears of a systemic collapse” of the monetary union.
The truly impressive bit about the OMT is that it has never been used. In fact, this week a German is hearing arguments on whether the OMT would violate the German constitution. We expect the approval to be forthcoming – probably in September or October. But the mere fact of Draghi announcing the OMT in September 2012 was enough to pop European markets – bond yields retreated, and most European equity markets rose, with the effect that the “fear trade” no longer dominates.
There remains some way to go before stability returns to the Euro area. Central bankers have not been helpful, saying little or nothing to give a sense of direction to the markets. Rate manipulation is of limited effect – risk spreads on European CDS are down, but there’s not enough oomph in a negative return on consumer savings accounts to drive to a full recovery.
In the absence of anything resembling policy agreement across the Eurozone, Draghi looks to retain his ability to lift the markets by occasionally referring to the – as yet untried – OMT.
Tighten das Belten
In “The Great Dictator,” Charlie Chaplin mocked (among other things) notions of Austerity, particularly as it relates to a Greater Cause. With the bloom fading from the Great Cause that was European unity, austerity is becoming less popular with ruling politicians. European Commission president Barroso recently said austerity policies have reached their limits of both social and political acceptance. Translation: if we push one more inch, they’ll vote us out.
This may lead to more moderate policies – the German finance minister is already muttering that France and Spain may be granted “certain flexibility” in meeting deficit targets.
The move against austerity is becoming a tailwind, as planners start prognosticating “a very gradual recovery,” “export growth caused by growing foreign demand,” and a willingness to promote government-bolstered private-sector investment.
Countries and Opportunities –
Germany and France… er… France and Germany… er… Germany and…
It is all too rarely acknowledged that, so far, the Common Market and its descendants – including the EC and the Eurozone – have accomplished their primary objective, which was to remove incentives for France and Germany to go to war with each other. With the ascent of French president Hollande the détente is nowhere near so close as during the days of “Merk-ozy.” Nonetheless, the two nations combine to represent half the Eurozone’s economic output, and their joint – or conflicting – interests should continue to dominate the sclerotic policy scene.
Germany…
We see this as a net positive for Germany, where we are bullish. German culture is work-oriented – French youths turn up their noses at the notion of becoming apprentices to German machine-shop operators, with the consequence that more Germans have jobs, while more Frenchmen continue to feel superior.
Germany’s export economy benefits from current weakness in the Euro, and it has one of the lowest unemployment rates in the Euro area.
Germany is a particularly bright spot, and one of the few countries where expectations are on the rise. It will remain the European “safe haven.” If, as we strongly anticipate, Merkel is re-elected this fall and if, as we strongly anticipate, the German court gives the go-ahead for the OMT, Germany should continue very much in the ascendant.
Investment idea: Long Germany through iShares Germany (EWG) and Short German government bonds through PowerShares DB German Bund Futures (BUNL)
… but France…
We are bearish on France where President Hollande appears decidedly “anti-business.” He currently enjoys a mere 24% approval rating – the country slid back into recession in the first quarter and only 5% of the French think things will improve. “Fifty million Frenchmen can’t be wrong,” they say. We agree with their dour outlook and would be short this economy. C’est la vie.
Investment idea: Short France through iShares France (EWQ)
Rule, Britannia
The first economy to impose austerity, we think the UK will be the first to emerge. Bullish elements – aside from an actual pick-up in growth in the first quarter – include new central banker Mark Carney, who has expressed his desire for greater transparency, and the pro-business stance of the Cameron government. Its distance from the Eurozone – both political and monetary – give it great flexibility, and its import-heavy economy stands to benefit as the prices of commodities continue to deteriorate.
Recent increases in retail sales figures and industrial production, together with a dip in the savings rate, signal greater bullishness – or should we say “John Bullishness”? – in the UK, and the housing market has turned up as well.
Investment idea: Long the UK through iShares United Kingdom (EWU).
Over the Edge: the “Periphery”
It can’t be nice being called “the Periphery.” Just ask Portugal, Spain and Italy.
Broad risks remain in these countries, one hold-up to the ECB launching new policy initiatives. These governments may prove incapable of honoring commitments to Brussels under the variety of austerity and bail-out packages they have taken on. Incurable mass unemployment may lead to severe social unrest – half of Italian youth are ready to leave the country to look for a better life. And sovereign bank risk is not out of the question – Spain’s bank system remains opaque even after significant high-profile corruption cases that even touched the prime minister.
At the other end of the periphery, Slovenia looks like a relatively stable newcomer – its risks appear self-contained, and if it does need assistance, it is likely to be small and highly manageable. Slovenia, in short, is not Cyprus.
Indeed, even Cyprus is no longer Cyprus. Hedrick says the risk of another Cyprus-style crisis is minimal. Cyprus has confirmed that, once they get in, no one wants to leave the Eurozone – and for all their complaining and chastising of weaker members, Germany can’t afford to have anyone flee the currency union.
On the negative side, these countries suffer from dreadful sentiment, crushing youth unemployment, and broad economic underperformance. Their governments range from unappealing, to unstable. Still, Hedgeye’s Macro readings have not yet flashed a definite Long or Short signal. Hedrick doesn’t rule out the possibility that negative trends in the Periphery could stabilize. If Germany recovers fast enough – and if France doesn’t lose more ground – there could be a positive contagion effect.
Investment ideas: For Spain, we would use the iShares Spain (EWP); for Italy, the iShares Italy (EWI). It’s too soon to call a Short or Long in these markets. We continue to monitor these economies to see which way the Macro cookie will crumble.
Conclusion: Portugal?
To everyone’s surprise – and to the relief of many – Portugal just successfully sold a 10-year government note issue. This, in a country that was for a time viewed as the basket case of the Eurozone.
Portugal still has government debt at around 122% of GDP – the third highest in Europe. Their bond issues are still costing them, though not so much as in the past. Coupons are in the 5%-6% range, which is a meaningful improvement. Hedrick says Portugal will want to join the OMT mechanism. While it is too early to make a decisive call, the government is showing real initiative, taking steps to cut government spending and still considering austerity measures.
We leave you with this analogy: in 1999 Portugal adopted a national strategy to fight drug addiction. Drug users were no longer treated criminally, but as clinically sick persons requiring a range of treatments. While it has by no means “cured” drug use, Portugal’s program is widely considered a viable alternative to the War on Drugs. The expansion of harm reduction efforts, coupled with aggressive after-care and social reintegration programs, have dramatically reduced the social impact of drug abuse, including HIV infection.
Like widespread drug addiction, the global financial malaise is not going to be “fixed” – not overnight, and maybe not ever. But there are surely more effective ways to contain the addicts and to limit the harm they do to society. After all, where there’s a will, there’s a way.
We are still waiting for Europe to show some willpower.
