The end of the beginning

An investor’s view of the eurozone crisis

We need more Europe. We don’t only need monetary union, we also need a so-called fiscal union. And most of all we need a political union – which means we need to gradually cede powers to Europe and give Europe control.

Chancellor Merkel’s quote at a press conference with David Cameron, 7th June 2012. She added for good measure “We cannot just stop [the process] because one or other doesn’t want to join in yet.”

Now is the moment of truth. Well at least over the next few weeks! Forget the Greek elections on June 17th. While doubtless the Commission would prefer Greece to knuckle down and accept austerity, rather than take the gamble and from an EU perspective, set an unfortunate precedent of a Greek withdrawal, markets would do well to remember Merkel’s words.

However suboptimal the Eurozone, regardless of the economic divergence caused by this currency union, and the subsequent loss of competitiveness of the periphery, ‘more Europe not less’ is the answer from the people who matter, the European Commission and the German hierarchy. Bamboozled, bankrupt and broken, the weak Southern neighbours will accept this milk as a short term palliative to their considerable woes. Long term may be a very different story.

The elite, who no doubt for honourable reasons in the 1950’s, wanted to banish war from the continent for ever, through this ‘ever closer union’ have met their moment of truth. They say there will be no U turn. They say let’s finish the job. We would not bet against that attempt, ill-conceived, or not.

While the fat lady has not yet sung, and their plans may still be derailed, we have argued that their political will towards a Federal Europe, remains undiminished. While ‘the project’ has very little active support, outside the elites, it is also fair to say, outside the UK and a few other northern European countries, the populations have been somewhat supine in their acquiescence. They have trusted their political betters to lead them. Although ‘the peasants’ have revolted, a bit in France, and elsewhere, in truth these revolts remain well below boiling point. Further, we would somewhat controversially suggest deep rooted psychological scars are liable to result in this European process accelerating, short term.

While the forthcoming European football championships will doubtless underline that national loyalties remain supreme, it is possible to construct a thesis where many of the people of European nations actually see European Government as an enhancement to their nationhood.

Our brief analysis is that Germany arguably still sees a burden of guilt and perhaps a lack of trust in itself, hence its willingness to support a perception of the greater good. Many Southern European states were either military or fascist dictatorships in our lifetimes and could be considered to have weak governance. Perhaps they too don’t trust themselves? East European nations remain wary of Russia and perhaps look for a shield too?

The principal exceptions are certainly Britain which is not in the Eurozone, Scandinavia which has shown some concern at the process, and France. France remains the enigma. A proud, ancient nation with a very strong culture, its elite has arguably seen Europe as a method of enhancing ‘la Gloire de France.’ Coupled with concern at a more powerful neighbour who has flexed its muscle three times in the French direction in a hundred years, their elite concluded, in our view, that it is better to have Germany in the tent than outside.

France does however have a robust political tradition, with the far left and right consistently polling strongly (they scored around one third of the popular vote in the recent 1st round of the French Presidential elections). France short term looks wedded to the project. Longer term, we must wait and see.

While the above comments are clearly a massive simplification of reality, we do believe they possess more than a grain of truth. The problem is that if populations convince themselves that more Europe is their national salvation and if, in time, ‘Europe’ is manifestly in charge and it does not work as expected, then we have a problem. To date, more Europe, certainly in the terms of the divergence of the Single Currency, cannot have been considered a triumph.

This creates a major problem for investors. Short term ‘a resolution’ will clearly be positive, but longer term we have our doubts. That said, bad systems can and do survive for very long periods of time. Ask the peasant farmers of Maoist China or, closer to home, the proletariat in the good old USSR. Predicting timelines of disaster is an imprecise art and while it is hard to believe Europe can return to any real, meaningful growth any time soon, unusual and distorting monetary practices can impact markets for long periods.

The primary reason we have been equity market bulls since January 2009 (indeed the only reason) and we accept that that positivity has, of late, been tested to the limit, has been our belief that, when push comes to shove, Western Governments would effectively print money.

As a Strategy team we are sceptical that such a policy creates real wealth, rather than merely distorting asset prices and delaying the inevitable adjustments. It surely has not helped real growth. Like it, or not, monetary policy in the UK and US has been extraordinarily loose. Germany has, to a degree, held out, correctly in our judgement, against Eurobonds and a pooling of liabilities. It has promoted southern austerity. Ultimately, we remain of the view, Greece or no Greece, that Germany supported by the EU institutions, US, China and even the UK, will indeed commit to some kind of fiscal union. Certainly we believe it unwise to ignore Ms Merkel’s stated comments. If correct, this should, in the short term, be highly supportive for markets which are, in our view, discounting very negative news. Markets have discounted European recession, in our opinion, hence the maintenance of even temporary monetary order in Europe would surely be positive?

There may not be direct Eurobonds issued, but doubtless a political and legal sleight-of-hand will be found. While we believe such a Union will continue to be very far from optimal, given the divergent nature of the European economies, differing political and cultural traditions and differing stages in competitiveness and economic development, if the political will exists, in the medium term, at least, it can hold. Such a move can only succeed with a very significant creation of money. This remains our primary call and while we reiterate our view that this does not provide real growth, real assets, like equities, are likely to be the best protectors of wealth in these unprecedented times.

The implications of a move to effectively a Federal Europe are profound indeed. The outcome in the long term is very hard to predict as it is dependent on some many new and untested variables. Short term markets have been ruled by fear; fear of collapse, banking contagion, confidence and very poor growth. If the EU can cobble together a sufficient monetary creation firewall, markets will rally. We believe the EU will move down this route, but this is essentially a political call, not an economic one. The LTRO deal in late 2011 is a prime example of how markets may respond to further stimulus.

Remember that the FTSE100 trades at a discount in excess of 40% of its long term average and trading on a consensus based PER of 9.7x for 2012 is less than 10% above the post Lehman low. Further, a 4.3% yield is reasonable compensation when the 10 year UK benchmark gilt yield a mere 1.7%. Further, balance sheets remain strong and corporate profitability, despite a highly uncertain macro-economic backdrop, elevated. Very bad news is priced in, in our judgement.

However such a monetary creation, in whatever legal form they felt is most expedient does not solve the fundamental problems that the Eurozone has created. Unemployment, fiscal deficits and economic contraction in ‘the South,’ are at dangerous levels. The Euro has created these imbalances, removing the safety valve of devaluation. There was a reason that when one used to visit Rome that there was over one thousand lira to the pound, that reason was to stay competitive as these nations constantly devalued. That option is no longer available so long as they remain in this currency union.

There are however two ways they can regain that competitiveness. One is to cut wages (and living standards) so far that they become attractive again and can grow from a much lower base, or they can culturally change, toss away a thousand years of tradition and adopt a Teutonic efficiency.

Looking at the first method, to some degree it is happening now with unprecedented Southern unemployment, depopulation and a rebasing of new private sector wages. Unfortunately such enforced deflation further undermines tax receipts, widens deficits and risks social cohesion. Outside massive transfer payments across the Union, it is hard to see this ending happily on a medium term view.

Further, at a time when resentment is rising in a country as stable as the UK with transfer payments, or alleged payments, between north and south, Scotland and England, what hope is there for long term meaningful transfers amongst linguistically and culturally distinct nations? The transfers involved would need to be huge and near permanent. Will that be acceptable to the good people of Rhine Westphalia?

Our second suggestion of adopting Teutonic efficiency can be dismissed. Culture is not so easily malleable in our view.

These are fascinating and unprecedented times. What the Eurozone attempts to do have implications far beyond it’s borders. If Europe federalises, what will be the British response? Will the UK seek to realign towards its historic partners in American and the fast growing commonwealth countries or will it be drawn further into the EU? What are the implications for migration flows of European policy choices and London’s position as de facto global financial capital? How will the Euro’s travails impact UK monetary policy? These are essentially political questions, but the implications will reach far and wide, with long and uncertain timelines.

Our conclusion is stark. Too much political blood has been spilt building this European home for the elite to abandon the estate. Germany will accept substantial short term transfers and monetary creation in exchange for a much tighter political control at the European level. The democratic deficit will become ever more apparent as voters still remain attached to national politicians who will be increasingly impotent. Longer term, this is a toxic mix indeed. Short term, markets will sigh with relief, rally hard and worry about the sand this European house has been built on tomorrow.