Europe's Window: Will Policymakers Seize This Final Opportunity?
Despite the gloom which continued to pervade economic forecasts and prognostications in 2016, the global economy appears set to enter 2017 in an emerging synchronous cyclical upturn that could well surprise to the upside. The US economy has now, arguably, reached full employment and with wage growth likely to accelerate further in 2017, supporting continued real income growth, the outlook for consumer spending in the world's largest economy remains positive.
Further to this, the downturn in capital spending and associated inventory liquidation between 2015 and 2016, (driven by the twin shocks of a large relative appreciation in the US Dollar and the collapse in energy prices) appears to have come to an end. Already, US-focused energy companies are set to ramp up capital investment for the first time on a y/y basis since 2013.
Couple this dynamic with the prospect of a large positive fiscal impulse (lower taxes, higher spending) from the new Republican-led administration, it is difficult (barring an unfortunate policy mistake say on trade policy), to make the case for a weakening in US growth in 2017.
With the Federal Reserve likely to remain cautious in terms of the pace of further tightening, a stronger US economy should also impart an important "demand-side" impulse to the rest of the global economy including Europe (VGK). In Europe itself, monetary policy appears set to remain extraordinarily accommodative in 2017, which in turn should also lend further support to the recovery in domestic demand.
With credit conditions in most of Europe having returned to the same levels of "looseness" prevailing prior to the global financial crisis, there is no reason not to expect a further recovery in the demand for credit and by extension, acceleration in credit growth. The crisis in the Italian banking system appears to be entering its final stage and will likely see some kind of resolution in 2017. In the final analysis, as discussed here, the Italian banking crisis remains manageable and should not pose a broader or systemic risk.
In Germany, the unemployment rate has reached its lowest levels in nearly three decades, and wages are finally starting to accelerate.
More importantly, the German property market continues to see further price gains, with average residential property prices finally moving higher on a sustained basis after two decades of stagnation. Rising property prices play an important role in expanding the capacity for further leverage, by increasing the value of available collateral to underpin further borrowing.
Finally, the economic imbalances that became a feature of the partially "artificial" economic boom experienced by the European periphery prior to the financial crisis in 2008 appears largely absent at present. The fundamental structural flaw in the design of the single currency was the assumption that a single interest rate and/or exchange rate would "fit" all member nations at all times.
The lack of a flexible currency and the associated adjustment mechanism meant that member countries were able to sustain economic imbalances, such as large current account or fiscal deficits, far longer than what would have been the case if each member country had maintained its own national currency. The "poster child" for this was Spain, whereas the chart below shows the current account deficit as a % of GDP reached nearly 10% of GDP in 2007 and 2008.
Spain's current account balance remained in a persistent deficit from 1988 to 2013, but it was only in the 2000s that it started to widen more significantly. This period not coincidentally, coincided with Spain joining the single currency. In the past, devaluation in the Spanish peso and higher interest rates would have prevented the current account deficit from blowing out as much as it did - particularly after 2005. With the single currency, Spain no longer faced such an immediate and more benign adjustment, at least while risk appetite in financial markets remained elevated.
Following the financial crisis, market participants became overly risk averse (something which has persisted to the present day), and started focusing more on prospective risks and financial fault lines, as opposed to purely focusing on potential return. Seemingly overnight, the financial markets went from the positive narrative of a single currency negating any exchange rate risk, to realizing that in return, member countries had also given up their ability to "print" their own currency. This, in turn, suggested that a member country could indeed actually default on its sovereign debts. The rest is history of course, and we do not need to dwell on the series of events that constituted the infamous "Euro Crisis" again.
But where is Europe today and more specifically, what is the prospect for the single currency remaining intact? The long period of underemployment and stagnation in many member countries have inevitably led to rising populist and "anti-euro" sentiment. This still represents a significant risk to the long-term survival of the euro currency and possibly the entire project of European integration.
However, if we focus solely on the issue of economic imbalances, the situation in Europe appears much improved. Again returning to the chart on Spain's current account balance, we can now see that Spain is in fact running a current account surplus for the first time since the early 1980s. In fact, Europe as a whole is now running a fairly large current account surplus (larger than China or Japan).
Although the overall surplus is mainly due to the very large current account surplus attributable to Germany, as the charts below also show, across Europe, most member nations are now running current account surpluses including Ireland and Italy. The one exception remains France, where the country continues to run a current account deficit.
What does this mean? It implies that in large part, the euro (NYSEARCA:FXE) as a currency is probably "fairly valued" at present exchange rates, and that the European economy in large part, can be defined as being in equilibrium or closer to equilibrium than at any time since the launch of the single currency in 1999.
The improved external position of these same member countries along with the accommodative stance of the European Central Bank (ECB) should be sufficient in the context of a synchronous global upturn, to underpin renewed confidence in European financial assets including across the periphery.
However, despite the rebalancing that has taken place, sovereign debt levels and unemployment remain high in several member countries. This will continue to pose long-term risks to the European economy and the sustainability of the single currency looking out to the next decade. High sovereign debt levels and the negative demographic profile of most European economies (shrinking and ageing working age populations), mean that these countries will be vulnerable again in the future, should the global economy face a renewed economic slowdown or negative economic growth shock.
With unemployment rates still high in several member countries, the risk of populist or anti-euro politicians or parties taking power will remain a central risk for investors in the region. Even if the elections scheduled to take place in France, Germany and Italy in 2017, do not lead to a change in the status quo, a political "discontinuity" in the future cannot be ruled out.
As such, it is imperative that European policymakers seize the "window" of opportunity that may be provided by the recent hard-earned external rebalancing and more benign global economic backdrop, to implement more serious reforms in the structure of the European Union and the single currency bloc in order to ensure that the currency bloc can endure and survive the next downturn, when it arrives.
What does this all mean for investors? It means that over the shorter term or looking out over the next one to two years, taking a positive (and still largely contrarian) position with regard to European financial assets and even possibly the Euro itself, may be profitable and rewarding for the first time in more than a decade. This more positive narrative could be reinforced should the general elections in France lead to the election of a reformist and centre-right government, as opposed to the current socialist incumbents or even more alarming, the election of the nationalist National Front party (led by Marine Le Pen).
In Germany the threat of a populist party taking power remains low, and in fact there is a high probability that the still popular Angela Merkel will be re-elected. The most serious risk of a populist anti-euro party taking power in 2017 will be in Italy (likely to hold a general election by the third quarter of 2017), where the "5-Star" party remains popular, with sustained support in various opinion polls of between 20% and 30%. Holding a referendum on whether Italy should stay or remain in the single currency, is a key pillar of its current policy platform.
However, even in Italy, it will still be difficult for the 5-Star party to win a majority and govern on its own while former Prime Minister Renzi remains popular, despite the defeat of his constitutional reform proposals in the recent referendum. If Europe can get past these three important elections without any real shift in the political landscape towards more extremist elements, then the recovery in the European economy and re-rating in European financial assets could gain even further and significant traction. In fact, European equities and in particular European financials may prove to be one of the top performing asset classes and sectors for 2017.
What are the reforms that Europe requires in order to be more sustainable in the long term?
In the final part of this article we provide some basic suggestions and opinions on the type of important reforms European policymakers need to consider, if the currency bloc is going to survive the next global downturn or economic shock. In our view there are three "pillars" of reforms that European policymakers need to embrace, including a structural framework for preventing persistent intra-bloc economic imbalances from developing and ensuring that financial markets come to believe that sovereign debt levels (for all member nations) are sustainable.
Finally, European policymakers (both at the Federal and National level) will need to be far more proactive in embracing micro reform measures aimed at boosting Europe's long-term growth potential. It is only through faster real growth that unemployment rates can be further reduced, while also ensuring that sovereign debt levels remain sustainable. In the final analysis, faster real growth and declining unemployment are also the only real long-term cure for the populist sentiments sweeping through the continent.
1) Preventing renewed and persistent external imbalances from developing.
As we detailed earlier, a key reason for the European crisis was the fact that external imbalances (current account deficits) were allowed to develop and persist. Without the natural adjusting mechanism that a flexible currency brings or the ability to set different interest rates, the only real adjustment available is via more activist fiscal policy or macroprudential regulation.
To be sure, there are other more painful ways of achieving an external rebalancing in the face of a fixed-exchange rate regime, such as internal devaluation. An internal devaluation is the process of improving the real exchange rate by reducing domestic nominal prices and nominal wages. However, prices and in particular wages, are not comparably flexible to a traded currency and these adjustments take much longer and often involve a period of high unemployment. It is the resulting surplus of labour that inevitably pushes down domestic wages, but very often this process is accompanied by a protracted recession or depression. The external rebalancing that Europe has achieved over the last five years has arguably been mainly due to internal devaluation, particularly in countries such as Spain and Greece.
Attempting to re-balance any future external imbalances that may arise will simply not prove politically feasible in the long run. It should also be understood that under the existing monetary system (where credit acts as the medium of exchange), debt burdens are fixed in nominal terms, while an internal devaluation also implies a devaluation in the future nominal cash flows that will be generated, and therefore, an increase in the real debt burden, often to unsustainable levels.
As such, if the single currency is to survive into the next decade, relying solely on internal devaluation as a solution to resolving future imbalances, can never be an option. Very often, external imbalances can develop in tandem with a fiscal imbalance. Countries running large current account surpluses often exhibit insufficient domestic demand or excluding the contribution of the trade surplus, growing at a pace well below potential.
As such, a more proactive fiscal policy targeting fiscal balances that counter a member country's current account balance could be very effective in preventing more severe and sustained external imbalances from developing. Other measures, such as macroprudential measures, could also be effective. Such measures could include raising capital requirements for banks in member nations where credit growth is deemed to be growing too fast (and the current account deficit is also large) or even changing the risk-weighting attached to the financial assets of that member nation.
However, given the imperative for faster real growth in Europe, the main emphasis should be in targeting the correct fiscal balances and stimulating the overall economy. Macroprudential measures cannot by themselves engineer faster growth and can serve mainly as prudent "risk management" tools.
Therefore, we would argue that it is important that in setting fiscal deficit targets (and we emphasize primary fiscal targets before taking into account interest payments) that a country's external position needs to be taken into account. Member countries that are running large current account surpluses should be targeting an equal and offsetting primary fiscal deficit, while member countries running a current account deficit should be targeting a primary fiscal surplus.
This is simplistic and some exceptions should apply. For instance, countries that still have high unemployment rates but also continue to run a current account deficit could perhaps target a balanced primary fiscal balance rather than a surplus. Also, the primary fiscal deficit to be targeted by country's running a current account surplus need not be (in terms of a % of GDP) exactly equal to the current account surplus.
One possible innovative way to structure such a mechanism is via the formation of a central European Debt Agency (EDA). The EDA could issue debt into the capital markets on an annual basis equal to the total current account surplus of the entire economic bloc (19 member currency bloc). At present this amounts to roughly 4% of GDP or EUR 400bn. The EDA could then forward (via interest-free and perpetual loans) to the various member nations running individual current account surpluses, pro-rata (based on the % contribution of that member nation to the bloc's overall current account surplus) a portion of the proceeds of the issued debt.
These member nations would then use the proceeds to run a more expansionary fiscal stance. The advantage of such a scheme is that the increased debt is "mutualised" so that the individual member country running the current account surplus benefits, or is rewarded in some way for perhaps having instituted the necessary structural reforms that have enabled that member nation to improve its competitiveness and produce the current account surplus in the first place. The interest due on the bonds issued annually by the EDA would be paid by all member countries, pro-rata based on the relative size of their GDP.
Such a scheme at the margin punishes member nations running persistent current account deficits, but ensuring that such "punishment" is small and not debilitating. Importantly, it will ensure that countries running a large current account surplus are appropriately stimulating domestic demand in their economies, creating the necessary demand-side impulse to growth, not just for their own economy but importantly, providing stimulus to the rest of the economic bloc.
The unwillingness by the German government to run a more expansionary fiscal policy, despite its relatively lower sovereign debt level and importantly very low interest rates on its issued sovereign debt, is a major fault line in the longer-term prospects for the European economic bloc at present. Indeed, one can argue that the German current account surplus and lack of offsetting domestic demand stimulus present a major risk for the entire global economy.
The large German and now evolving European current account surplus makes the global economy increasingly dependent on sustained growth in the US. This makes the current cyclical upturn in global growth narrow, fragile and prone to renewed weakness in the event the US economy slows or suffers a negative growth shock (such as the imposition of trade barriers)
If German and European policymakers do not take advantage of the more benign global economic backdrop at present in order to accelerate economic growth, it may become a pivotal factor leading to the collapse in the single currency in the next decade, as well as providing the impetus for another global financial crisis and recession, similar to 2008/09.
2) Restoring debt sustainability WITHOUT encouraging moral hazard
The European debt crisis was essentially brought to an end by the commitment of the ECB to act as a final and unlimited backstop. In other words, if the sovereign bond yields of any member nation start to rise to levels that would threaten that nation with bankruptcy, the ECB would stand ready to buy an unlimited amount of that country's debt, in effect capping that country's sovereign bond yields.
The ability of a central bank to act as lender of last resort and by implication, the ability to buy unlimited quantities of sovereign debt is an important pillar that ensures that sovereign bonds issued in local currency, throughout the world, remain "risk-free." However, in a currency bloc, extending such a "safety net" to the individual sovereign debt of disparate and still largely political independent member nations is a recipe for introducing substantial moral hazard. Very simply, individual member countries get to have their cake and eat it.
They can run largely autonomous (unless they are under a bailout program) fiscal policy, while secure in the knowledge that the interest rates they will have to pay will be tied to the average rate for the entire economic bloc. This reintroduces the same kind of moral hazard that pervaded the European economy prior to the financial crisis. Some have argued the case for full debt mutualisation accompanied with greater fiscal integration or a transfer union. This may be a noble objective over the very long-term, but realistically is simply not politically achievable or even desirable at present.
So what would be a good compromise? Like in the United States, federal debt or debt issued by the central federal government should be "risk-free" while debt issued by individual states or member nations should not. However, without the level (or current desire) for political integration on the scale we have in the US, how would something similar be achieved in Europe?
One scheme that has been mentioned on several occasions is to allow member nations to issue two kinds of debt, or perhaps something like "Blue" federal bonds that the ECB would be allowed to buy in unlimited quantities (therefore making these bonds risk-free) and Red bonds, that the ECB would not be allowed to buy. Member nations would be allowed to issue Blue bonds up to an amount equivalent to 60% of their GDP (the original Maastricht convergence criteria) and if they need to issue debt above that level, they would be required to issue "Red bonds."
A member nation that issues substantial amounts of debt above 60% and therefore Red bonds, would be forced to pay a much higher rate of interest on the red bonds compared to the blue bonds. Of course, implementing such a measure "ex-post" would be challenging, given that the existing debt level for several member nations is already very high. For example, Italy's sovereign debt level stands at 130% of GDP, and even if it could issue Blue bonds initially, given the existing duration profile of its outstanding debt, it would not take long before it was issuing red bonds. The market would quickly move to price these red bonds at much higher interest rates, fearing a default in a few years.
As such, the second pillar of any kind of reform aimed at debt sustainability should be aimed at a once off "re-set" that lowers individual member nation's debt levels. One avenue that could be explored is for the ECB to exchange the sovereign debt of individual member nations it has purchased via its Quantitative Easing (QE) programme, up to an amount equivalent to 30% of that member nation's GDP for debt issued by the EDA in a debt swap.
In something akin to the reform instituted by Alexander Hamilton following the founding of the American Republic, a large portion of existing individual member countries' debt would be turned into central federal debt. Again, if we take Italy as the most relevant example, it would immediately reduce that country's debt level to a more sustainable 100% of GDP. In this case and assuming the introduction of the "two-tiered" Blue federal and Red state debt scheme and assuming further that Italy's average duration profile on its remaining outstanding debt was say 7 years, it would give Italy about 4 years "breathing space" to enact structural reforms and improve its competitiveness, before it would have to start issuing Red bonds, at much higher and possibly prohibitively higher interest rates. But, much can be achieved in four years, given the necessary political will.
The interest on this central or federally issued debt could be paid by the introduction of a Federal European tax of some kind. Possibly one kind of tax which would also work in a countercyclical manner, and help to counterbalance the divergence in economic cycles within the currency bloc and between individual member nations, would be a "payroll tax" adjusted for the level of unemployment in an individual member nation on a scaling basis.
Countries with an unemployment rate below 6% would pay say a 3% payroll tax to be paid by the employer not the employee. Between an unemployment rate of say 6% and 10%, the payroll tax could decline to 2% and between 10% and 20% this could be 1%. Above 20%, the payroll tax could be temporarily suspended.
3) Europe needs to embrace immigration and improve its competitiveness
Ultimately, however, as we have argued, Europe's problems will not be truly solved until it is able to generate faster and sustainable real growth rates. Europe's population is ageing and its available pool of labour is likely to shrink over the next decade - a powerful headwind for economic growth. As such, it is imperative that Europe embrace more, and not less immigration. However, an increase in immigration needs to be accompanied by training and integration programs in order to ensure that immigrants have the necessary skills to add value to the economy and are able to integrate effectively into European society.
Apart from the longer-term demographic headwinds Europe faces, improving the competitiveness and flexibility of member nations is imperative. As the table below shows, simply on one key measure, labour flexibility - Europe ranks well below other large developed countries such as the US and UK. In fact, Italy ranks 128 out of 140 countries in terms of labour flexibility, with an average score equal to South Africa, a country routinely criticized for its inflexible labour laws in the face of an official unemployment rate of 27%.
Source : World Economic Forum, Global Competitiveness Report
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FXE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.