Six years after the financial crisis, the Eurozone continues to face major challenges in restoring economic growth. Our investment thesis has been that the structural problems facing the European Union are real impediments to sustained economic growth and until they are addressed, sustained growth is elusive. While that does not mean that there are not investment opportunities in Europe, it does mean that as one of three major capital markets in the world, investors need to be careful. For 2016 we expect lower oil prices and quantitative easing will help support GDP growth. In spite of the improvement in our near term outlook, we expect economic growth will still be limited to 1.5% on average through 2018.
While the Eurozone grew by 0.92% in 2014, it faces numerous structural problems. These structural problems are evidenced in sustained high unemployment, excess capacity, stagnant wages, slow private credit expansion, declining manufacturing output, low levels of capital investment, increased defense spending and the uncertainty of Russian foreign policy. The result is that member countries are still struggling to comply with the original terms of the Maastricht Treaty and running budget deficits in an attempt to stimulate growth within their countries. While Germany is consistently the strongest economy, the other major countries including France and Italy continue to struggle to produce traction.
Like other developed countries, Europe has benefited from low interest rates over the past several years; and, with easy access to the capital markets, Europe has been able to borrow at low rates to meet its funding needs. Over the past six years, the majority of European countries individually have had to tap the debt markets in order to plug their budget deficits. Since the Financial Crisis, member countries in the Eurozone have borrowed over €2.375 trillion. This means that €2.375 trillion of expenses has been funded through the issuance of additional debt. The result is a growing debt burden rooted in a broken monetary union with very little potential for near term growth.
The low interest rate environment has been fueled by the European Central Bank’s €1.1 trillion quantitative easing program which it initiated earlier this year and recently announced it will extend into 2017. As Europe has struggled with weak corporate investment, one of the primary objectives of the asset purchase program has been to stimulate investment with the hope of spurring growth. However, Europe is challenged with differences in each country’s distinct culture barriers, sovereign debt, bank regulator, taxing authority and economy. Yet, the euro is the common currency across the Eurozone. Business risk and entrepreneurism has proven difficult for countries rooted in socialism and fascism. We expect economic growth will continue to be challenged across the Eurozone as private credit expansion, job growth and capital investment remain slow through 2016.
Europe’s Debt Problem
We consider the fiscal position and economic growth prospects of the Eurozone to be very weak. Of the nineteen countries utilizing the euro currency, only three have managed to produce a budget surplus in the past three years. From 2009 to 2013, the countries in the Eurozone added €2.375 trillion in debt. An analysis of each country’s budget position over the past five years reveals that most countries generated a budget deficit, with the largest deficits being consistently generated by France, Spain and Italy. We do not expect that to change in the 2015-2016 budget years.
The cultural differences between the countries creates difficulties in implementing timely policies to effectively implement change within the European Union. Strong unions in France, Spain and Italy have made labor reforms difficult to implement. At the same time, the banks have been forced to strengthen their capital position to comply with Basel III standards and new Federal Reserve guidelines resulting in weak private credit expansion. As a result, job creation, fixed investment and business formation has been slow.
While the fighting over stimulus versus forced austerity measures has subsided this year, many countries in Europe rely on public debt to fund their budget deficits. Over the long term, we do not believe the cultures of many of the European countries that rely on government sponsored social programs for citizens (including Italy, Spain and France) will change in a manner that allows for a more robust business and consumer sector. As each year passes and the deficits turn into additional debt, the financial burden on Europe grows. Ultimately, the growing debt burden will result in further credit deterioration and ratings downgrades.
Even with additional quantitative easing, we expect the Eurozone will incur over €400 billion in additional cumulative debt over the next two years.
Access to Capital Markets
The large majority of European countries are experiencing historically low interest rates similar to the United States. Several countries including Austria, Finland, Italy and Germany have negative yields out to the seven year part of the yield curve. In our view, this is not a long-term healthy dynamic for capital markets since the borrower is effectively paying the country to make the loan. In addition, it provides an unusual incentive for the country to continue to fund its cumulative deficits through the public debt markets and not address the underlying problems in their economy.
Continued access to the capital markets is critical for Europe to fund its projected budget deficits over the next two years. The ability for each country to access the credit markets has helped to push the growing debt problem into the future. Every year a country operates under a deficit, it must fund it by incurring more debt. As the debt grows, it will ultimately put pressure on the country’s credit rating. Theoretically, lower credit ratings result in higher borrowing costs; however, that has not necessarily been the case in Europe.
We believe countries are postponing the inevitable reconciliation between excessive spending and fiscal prudence into the future. Simply put, their economies cannot grow fast enough and produce increased tax revenues to rationalize the debt being incurred. As long as countries can access the capital markets and continue to borrow, the debt burden will continue to grow as the country incurs deficits.
The battle waged earlier this year was over whether to force increased austerity measures or allow countries some relief from the Maastricht Treaty and, as a result, budget deficits to increase temporarily beyond the 3% of GDP. Austerity measures lost (for now) and countries lead by France and Italy have submitted budgets for 2016 with healthy projected deficits.
The European Central Bank
The European Central Bank (ECB), under Mario Draghi’s leadership, has made asset purchase program a key initiative for 2015. The initial €1.1 trillion quantitative easing program was well received at the beginning of this year as the euro dropped to $1.05 against the US dollar and stocks prices rose. Inflation across the Eurozone has been subdued and the initial stimulus served to boost the rate of inflation earlier in the year. The program is designed to purchase asset-backed securities and covered bonds in an attempt to add liquidity to the financial system while driving the yields on these assets lower. The initial response to the ECB’s stimulus was extremely positive, however economic growth has slowed and inflation declined below target levels.
Last week, Draghi announced a six month extension to the current €60 billion per month bond buying program. This is an attempt to provide further stimulus to its moribund economy and increase the rate of inflation. Inflation registered 0.1% in August, job growth is slow, and corporate investment has stagnated. In addition, the ECB announced that it cut the deposit rate to -0.3%, further into negative territory. This means that European banks must pay more for the ECB to hold their money and provides an unusual incentive for the banks to lend.
Structurally, the ECB is not like other central banks which represent one sovereign country. The ECB is more like a cooperative that manages the monetary policy for the Eurozone members. In addition, while the ECB does have supervisory responsibility over the 300 largest banks in the Eurozone, it does not have prudential regulatory authority. Each country still has their own bank regulator which creates a system riddled with conflicts and differing agendas.
Because of the design of the ECB and the European Banking system, we believe that the ECB’s program will ultimately fall short of its intended stimulus impact. The problem in the Eurozone’s economy is not a lack of liquidity in its financial system; it is a lack of demand. Along with the extension, the ECB announced that it will also buy the debt of local governments. We expect that this will help provide banks with additional liquidity relief. However, monetary policy only buys time for fiscal policy to work. Monetary stimulus alone will not help the Eurozone toward a path of sustainable growth. In the absence of fiscal policies that will stimulate capital investment, job growth and business formation, the stimulus will only provide temporary relief.
Europe’s banking system traditionally is more leveraged than the major banks in the United States and relies on wholesale funding for its deposit base. Much of this financing comes through the U.S. money market system which invests in the commercial paper and certificates of deposit of the European banks. As the domestic money market system moves to adopt to a new regulatory environment in 2016 which will require the use of higher quality investments for prime money market funds, we expect there may be marginal pressure on funding for several European banks as they find it more difficult to place their certificates of deposit.
The Eurozone has continued to struggle to achieve sustained economic growth following the financial crisis. Much of this past year was spent fighting over whether austerity measures should be imposed on member countries not exercising fiscal discipline or to allow additional stimulus measures in an attempt to spur growth. Once the Eurozone moved past the distraction of Greece, a path toward additional stimulus was paved. There has been significant progress made over the past three years to stabilize the Eurozone economy and capital markets. The 2012 bailouts of Cyprus and Spain brought stability to the European banking sector. We believe that we are at a point where the European banking system is stronger and better capitalized but economic growth across the Eurozone is slowing again.
The cultural differences between countries are an important aspect of the European landscape. Job growth, business formation and productivity of countries like Germany, Netherlands and Luxembourg are consistently stronger than many of the other countries. Furthermore, the form of government also plays a significant role in the potential economic growth of the Eurozone. It appears to us that fascist and socialist governments are having a harder time creating jobs in the private sector compared to more democratic governments.
Ultimately, we do not believe that “growing their way out of the problem” by attempting to stimulate growth through monetary initiatives will work over the long term. Further, we do not believe there is a vision to achieve any meaningful fiscal reform necessary to achieve sustained economic growth throughout the Eurozone. In the absence of meaningful growth, the next likely step will be a series of downgrades starting with Italy and France. Any escalating conflict with Russia will be expensive and distract further from the European Union’s fiscal problems. Immigration will continue to be a problem for the southern countries and put pressure on its social program costs. Ultimately, we expect the dithering in Europe to continue.
Gregory J. Hahn, CFA
Chief Investment Officer