If there is a term that can best describe the current climate in the Eurozone, it is “complacency”. Markets are rising, bond yields are at an all-time low, growth estimates have improved and the European Union has triumphantly declared the end of the crisis, thanks to its “decisive action”.
There is no denying that the European Union is in recovery mode, and that is a positive. Business confidence is rising, and manufacturing indices are in expansion. However, the pace of said expansion has moderated in the past months, and challenges remain.
The biggest problem for the Eurozone is demographic. The population is ageing rapidly, and in several countries that issue is compounded by a shrinking number of inhabitants. Average age in the largest Eurozone countries ranges between 44 and 47. At the same time, the United Nations estimates that the European Union population will have peaked and start shrinking in less than two decades. Less people and older, too.
Ageing presents many challenges. The cost of healthcare and pensions rise, while tax revenues decrease as consumption and investment slow down. This demographic challenge creates a fiscal and productivity challenge that can only be reversed by attracting high added-value investment and incentivizing high productivity sectors. The European Union is doing the opposite: it mostly subsidizes low productivity and taxes the productive, penalizing foreign technology giants and increases the tax wedge on small and medium enterprises.
The strong euro
This takes us to the second risk. The euro has strengthened against all its main trading currencies, despite a massive expansionary monetary policy that has taken the European Central Bank’s balance sheet to 35% of the Eurozone GDP. Eurozone countries mainly export to each other, with 75% of exports made within the single currency boundaries. This means that financial repression measures might help to artificially boost internal demand through credit expansion, but it immediately creates an inconvenient side-effect by strengthening the euro. As such, non-EU28 export growth has stalled since the European Central Bank started its enormous asset purchase programme.
A strong euro is not a problem for consumers or high-added-value companies. Consumers benefit from low inflation, and their savings are predominantly in deposits, so a strong euro helps families navigate a challenging environment thanks to contained prices and better purchasing power. High-added-value companies are exporting without a problem, as demand for quality and advanced products is soaring, and these companies do not need the artificial subsidy of devaluation to increase sales.
A strong euro is a problem for the European Central Bank’s plan to inflate its way out of debt. Inflation expectations have been cut dramatically in the past month, and this obliterates the idea that price increases will help deflate the debt of deficit-spending countries.
The strong currency is a relevant problem for low-added-value and productivity sectors. The main trading partners of the Eurozone are the US and China, which account for nearly 50% of the group’s exports. A strengthening single currency diminishes the possibilities of selling more abroad, when competitiveness is not driven by technology or innovation, but costs. As the Eurozone has focused its efforts in supporting these weak-to-average competitiveness sectors though low rates, devaluation and subsidies, it is a challenge for them to grow when the euro becomes a “safe haven” currency. Additionally, investors are realizing that a strong euro erases the earnings growth estimates of the large European stock market indices, making stocks more expensive in the process.
The third risk is financial. The Bank for International Settlements warns that the percentage of zombie companies has soared to 9% of the total of large quoted non-financial entities. Zombie companies are those unable to cover financial expenses with operating profits. At the same time, non-performing loans in Eurozone banks have reached a three-year high of more than €1 trillion, 5.1% of total loans.
What these figures tell us is that ultra-low rates and massive liquidity have not made the financial and corporate system stronger, but weaker. European governments have “saved” nearly €1 trillion in financial costs due to the European Central Bank’s extreme loose monetary policy, but the vast majority of them remain in deficit and continue to delay essential reforms to strengthen their fiscal position. In fact, there are political calls all around Europe to spend more and forget the wrongly called austerity, which was in reality just a very moderate budget adjustment.
There is an even more concerning conclusion. Neither deficit-spending countries nor weak companies would be able to absorb a mere 1% increase in rates, and the financial system would suffer more liquidity and solvency episodes than the ones we have seen in the past years.
The European Central Bank cannot fix structural problems, and it seems that countries and companies have forgotten that unconventional monetary policies are there to buy time to strengthen the system and undertake reforms and restructuring, not to grow accustomed to massive liquidity and low rates as a given. Complacency is the last thing that European governments and companies should fall into.
This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is Chief Economist at Tressis SV and author of Life In The Financial Markets, The Energy World Is Flat and the most recent Escape from the Central Bank Trap. This piece does not necessarily reflect the opinion of Hedgeye.