Beached | European Markets

European markets are being left high and dry by the rush to fund America's stronger economy, says Michael Wilson. Well, that’s the way it sometimes looks. How long before the tide turns again?

Hands up if you’ve heard enough about Europe for now? Okay, okay, you can put them down again. I’m going to try and talk about something that isn’t Brexit this time.

I promise...

I mean, what would be the point? By the time you read this, depending on who you choose to believe, we’ll either be heading proudly out toward the sunlit uplands, flying free with £39 billion of unpaid euro-divorce bills jingling in our back pockets - or else we’ll be returning gratefully to the bosom of the European establishment, having scared ourselves silly during a 30-month flirtation with the cold, empty darkness outside. It might be one, it might be the other. Then again, it might be something else. I’m sure I wouldn’t know.

So, just for once, I’ll try not to bully you into looking at it in any particular way. Shall I mention, though, that over the last year my Legal & General European Index fund has outperformed the Footsie, the All-Share, the Nikkei, the bullion index and the Brent oil price? Not so bad, perhaps, for a part of the world that’s not been getting a good press?

Over the last year my Legal & General European Index fund has outperformed the Footsie, the All-Share, the Nikkei, the bullion index and the Brent oil price? Not so bad, perhaps, for a part of the world that’s not been getting a good press

EUROPE SAYS IT HAS OTHER FISH TO FRY

In short, I’m going to leave you for the moment with my personal view that Europe’s market situation isn’t actually as tough as it looks, even though its economy is growing at only about half the rate of America’s. It’ll be back eventually. It’s just that we don’t know exactly when.

In the meantime, though, I’ll step back into my anti- Brexit character for long enough tell you that Brussels has got much more on its plate than dealing with a stroppy departing Britain that’s wasted the last two and a half years of its life by initiating a Brexit programme without undertaking any Brexit planning, never mind any attempt to establish a common platform on which its own politicians could agree.

No, the Europeans have a host of other issues to think about - any of which could normally be expected to put some sort of question mark under a stock market at the best of times. Such as the rise of xenophobic nationalism; the slowing rates of growth in many of the major European economies; the growing doubts about whether China will prove to be the friend it claims to be; the still awful state of joblessness in many areas; the tricky problem of defending the weakening euro at a time when the US dollar has been hoovering up the whole world’s liquidity; and, oh yes, the 45th President of the United States.

And all of this, moreover, at a time when the two great political bulwarks of the European Union are losing some of their vice-like hold over the stroppier peripheries of the Union. Germany’s Chancellor Angela Merkel is set to step down in 2021 after 21 solid years at the helm of the EU’s primary economic powerhouse. Her French counterpart, the impressive liberal Emmanuel Macron, has been around for barely two years but is already threatening to go the same way as the country’s last golden hope, the centrerightist Nicholas Sarkozy.

Which is to say, Macron’s reforming impetus has been blunted and stifled by the same stroppy proletariat demanding the same impossible things: short working weeks, early retirement, a generous state, and rock bottom taxes. It doesn’t stack up, but who’s going to tell them?

Meanwhile, the European populists who take their cue from Donald Trump have been consolidating their positions – from Hungary’s prime minister Viktor Orban, whose overt racism has been ruffling feathers in Strasbourg, to Matteo Salvini, the far-right Italian deputy prime minister who says he wants to create an anti-foreigner alliance with Poland. While also demanding that Italy’s government must ignore the economic foundations of the euro and spend, spend, spend until those boring Germans get tired of their insistence on a shared fiscal responsibility.

ABSENT FRIENDS

But the most commonly quoted reason for Europe’s disquiet is, of course, the current occupant of the White House, who has actively set out to distance America from the internationalist stance which the United States has adopted since the end of the Second World War.

Donald Trump’s many rants about Europe’s terrible state are often as funny as they are annoying. (Did you know that Birmingham is an all-Islamic zone where the British police don’t dare go? That Finland sweeps its forest floors daily with brooms to prevent fires?? That Paris’s gilet jaune protesters have been loudly shouting “We want Trump”, in English? No, nor did we). But beneath the deliberate lies and the obfuscations is the undeniable fact that Trump’s supporters believe every word that he says.

And that in turn means that whenever Trump brands Europe an enemy of the American people, they tend to believe him. When his unilateral tariffs on imports of European steel raise the domestic prices of US steel - and hence the US prices of refrigerators – the rust belts are happy to agree with him that the accursed Europeans, ungrateful for their salvation on D-Day, deserve everything bad that will come to them.

We could, of course, giggle and wait for the madness to pass. But that wouldn’t help the German auto industry, which is suffering hideously from Trump tariffs at a time when its Eurozone volumes are already down because of the switch away from diesel cars. It wouldn’t help European government bonds, which have been tanking because their ultra-low yields can’t compare with the fruity 3.0% (and upwards) that dollar bonds can currently offer.

SOUR GRAPES?

It wouldn’t help Europe’s stock markets, which have witnessed a disproprtionate outflow of foreign funds over the last year because of the magnetic effect that Trump’s $1.6 trillion tax giveaways are exerting on the Wall Street mood. And it does no good at present to remind Americans that splurging $1.6 trillion of new money during a strong economic phase is the exact opposite of what that other American, John Maynard Keynes, said we should do. (Fiscal stimulus was strictly for lean points in the cycle, he insisted.)

More to the point, it isn’t just sour grapes for Europeans to point out that Trump’s economic ‘boom’ is all demand-side

(“go out and buy another TV”) rather than supply-side (“build a factory that makes better TVs.”) That’s the way that US GDP has been calculated for many decades, and although it looks strange to us, it’s the way people are used to seeing it.

Surely this feast of empty fiscal calories can’t last, can it, the Europeans ask? Surely there’ll come a point where the strong dollar and the surging trade deficit tip over and invert themselves? (Perhaps suddenly?) And when the relative virtues of a traditionally based, non-interventionist and fundamentally sane management philosophy in Europe start to show their true colours?

UPSIDES, DOWNSIDES

Well, indeed. That day will come eventually, as I say, which is why I’m holding onto my eurostocks. But, for the time being, we might as well accept that when a Japanese or Chinese investor decides where in the world to invest his cash, he’s likely to go with the current favourite.

Let’s also accept the fact that Trump’s anti-European tariffs and other worries have hurt Europe’s trade prospects in tangible ways. And that basic metal-bashing industries such as Germany’s all-important car manufacturing trade have caught it especially badly. (The Dax lost 18% last year, compared with 12%-ish losses in the stock markets of Britain, France, Canada, Japan, Spain and the Netherlands. All this, of course, on top of the euro’s 5.5% slide against the mighty dollar and the pound’s 8.1% decline.)

Let’s cheer ourselves with the thought that Europe’s financial services are in world-beating form, with masses of emergency cover. That its medical and scientific research is unrivalled. And that European listed companies tend to be only the very largest, whereas in America size is less important. And let’s add that European companies tend to be more wary of bank debt, which in theory ought to make them more solid.

Or that a self-isolating America, if that’s the way it continues to go, will necessarily increase the economic self-reliance of the 400 million West Europeans who inhabit this continent.

And that, at the end of the day, the European Union is the world’s largest trading bloc. (Well, it is now that last July’s free trade zone with Japan has come into effect.) These are important points that Wall Street tends to overlook. How about you?

CYCLICAL AS A PARROT

All the same, though, Europe’s economy is not in a particularly happy cyclical position. Its business cycle, like that of America, is probably nearing its peak after a ten year bull run, and the most obvious way forward points to down. Its economic growth doesn’t match America’s (officially stated) results. And European worries about relationships with Turkey (which takes the Middle East migrants), Russia (which supplies a lot of its gas) and the oil producing world (on which it almost totally depends) are always on policymakers’ minds.

And we haven’t even mentioned China yet. The EU’s second largest external trading partner (after the US) has taken a knock from worries about its own headlong internal growth which have sapped confidence in Chinadependent industries throughout the European bloc. All of which underlies the IMF’s uncomfortable feeling (graphic on this page) that 2019 is unlikely to bring any immediate likelihood of stronger trade.

SOME COMPARISONS

Does it sound as though I’m obsessed with what the external forces in China and the US are doing to European financial markets, rather than focusing on the internal strengths and weaknesses of the European economy? If so, I apologise. It isn’t all Mr Trump’s fault, no matter how tempting that conclusion might be.

There are reasons why European companies don’t command the same profit multiples as their transatlantic counterparts, and they’re not all about Wall Street insanity.

The Eurozone’s economic growth will be lucky to equal last year’s puny 2.1% during 2019, the economists tell us. The 2.8% rate that was still around during final-quarter 2017 had fallen to 1.6% in third-quarter 2018, and quarterly growth had halved to 0.2%. Whereas in America, by comparison, the 2.9% growth rate during 2018 seems set to hold broadly steady during 2019.

US unemployment is running at a wafer-thin 3.7%, and falling; in the Euro zone it’s 8.1%, with Greece and Spain scoring 18.6% and 14.8% respectively. (Germany has just 3.1%, but France has 8.9%, more than twice the British level.)

And yet, as the International Monetary Fund reported last October, there is much to commend the European economic scene, if only for its ability to keep on going.

The IMF’s current 2019 forecast of 1.9% GDP growth (rising to 2.0% in emerging Europe) looks a lot less vulnerable to extreme volatility than the US, where around half of analysts say they are currently expecting not just

a downturn but a recession. (This year, next year? None of them seem willing to commit themselves, for some mysterious reason.)

LIFE, QUANTITATIVE SQUEEZING, AND THE ANSWER TO EVERYTHING

But if we’re really looking for an Answer to Life, the Universe and Everything - in the true spirit of Douglas Adam’s 42 (you’ll either understand that reference or you won’t……) - we could probably do worse than turn our gaze to the phenomenon of quantitative easing, which has dominated the last decade but which is now in its terminal stages. (Well, unless you count Trump’s tax cuts, which amount to the same thing by different means.) Europe has done QE relatively well, and has known when to call the game off; America, perhaps, less well.

There’s no denying that QE has delivered an enormous and much-needed boost to global developed-market economies in the ten years since the 2008 global crisis – mainly by allowing central banks around the world to issue vast quantities of new and unfunded debt, with which to buy back existing obligations and generally to put liquidity back to the pockets of banks, employers and investors.

But a cyclically strong period is the time to be taking your foot off the throttle, which is why the European Central bank first decided in 2016 to rein it in. December 2018 marked the formal end of QE issues in Europe, with the ECB having pumped €2.6 trillion ($3 trillion) of new liquidity into the European economy.

Whereas the Federal Reserve, er, hasn’t. Well, not yet, in the sense of reducing the central bank’s overall balance sheet, anyway. Technically, QE is indeed in the past (since 2014); in practice, however, Trump’s “calorie-free” tax breaks, which generate no intrinsic GDP growth, have revived the dilution of value, and more such vote-grabbers may well follow from the White House in the coming year. It’s QE by another name. Call it QE3, or maybe QE4?

INTEREST RATES AND CURRENCIES

But one intractable worry still remains for European economies. Namely, that Europe’s interest rates and bond yields are now so low that many have dipped into negative territory in inflation-adjusted terms. And that simply hasn’t been the case in America, where a ten year government bond will get you 2.75%, against 0.21% for an equivalent Euro zone bond. (Ouch.) Or 1.2% for a UK bond with a significantly inferior outlook. You can see why international investors prefer to back the greenback?

There’s another drawback which doesn’t get much attention. Donald Trump may be currently livid at the Federal Reserve’s Jay Powell for raising US interest rates, but it does mean that the US retains one advantage which Europe doesn’t have – it can always opt to stimulate growth by cutting the bank rate.

That’s because the Fed is running a 2.75% base rate, whereas Britain offers just 0.75%. And the euro zone – wait for it – comes in at a big fat zero. Which means that, if the European economy were to weaken for any reason, the European Central Bank – unlike the Fed would have no obvious fiscal means of encouraging growth. That’s an issue which the economists are well aware of.

So, to repeat the question, if you were a Japanese looking for a place to park your investment cash, which would you find more attractive?

Well, as an EU fan (and a languages graduate, and an ex-Berliner), I’m hanging in there while I wait for better and more optimistic times. Which must surely arrive one day?

For that matter, who knows, maybe I’ll even forward-book my car ferry to Normandy for the summer holiday season? But otherwise, my money is staying in my sceptical wallet until I can see the way forward a little more clearly. There is more to this situation than Trump – much more….