A Reluctant Europe Looks at Prosperity

The mood among investors in Europe is generally positive in spite of mixed cyclical and secular factors influencing the economies and the markets there. The cyclical forces are dominated by a better business tone across the continent. The secular factors are the spread of populism as a result of governments not providing opportunity for the people, and terrorism, which can erupt almost everywhere and cannot be controlled. The secular factors will eventually affect spending and investment, but so far the data are coming in better than expected, and Europe should have real growth of 1.7% this year. Even the United Kingdom, with Brexit looming, should have real growth of 1.2%.

In June, I traveled to five cities in Europe over a two-week period and talked to investors and policy makers about economic and political conditions and the outlook for the intermediate term. A number of views have changed over the past year. Concern about a breakup of the European Union has clearly subsided. Countries on the continent believe they are benefiting economically from their membership in the union, and even many in the U.K. realize Britain made a mistake by choosing to leave. Immigration and nationalism were the key issues. Most observers believe the degree of European integration will not progress much beyond the current level, which is based on open borders, free trade and a common currency. There will never be a political union, which was Jean Monnet’s original conception, but the European project, as it is sometimes called, is likely to endure for at least several more years and perhaps indefinitely.

In contrast to a year ago, there is little fear that Greece will drag everyone else down. The country has negotiated a deal with creditors, and its economy appears to have stabilized. Italy, another country with a struggling economy, is expected to grow at 1% this year. Probably the biggest surprise is Spain, which I didn’t visit, but which has recovered nicely from its economic distress several years ago and is expected to grow at 2.3% this year.

Similar to the situation in the United States, European financial markets have benefited from the increase in the balance sheet of the European Central Bank. My view is that central bank liquidity has been a key factor in the performance of the equity and bond markets in developed countries over the past eight years. Now that is changing: the Federal Reserve has already tightened twice with more increases likely, in my opinion, before year-end. The European Central Bank is talking about being less accommodative but has not taken definitive action yet. So far, Japan is still easing.

A shift away from monetary expansion for the world’s major economies is likely to affect future returns, and everywhere I went investors were having difficulty finding attractive opportunities in what they perceive as a continuing low-interest-rate environment. They generally believe the public markets for equities are fully priced; inflation will rise, but not significantly; interest rates will remain low; and earnings will expand at a modest rate. Austerity is no longer considered a favorable policy alternative.

What they fear is geopolitical dislocation that upsets this unexciting but positive outlook. Possible upsetting events would be North Korea developing an intercontinental ballistic missile that could reach California, Russia invading the Baltic States, terrorist acts becoming more frequent in Europe and the United States, or Iran escalating tensions in the Middle East by supporting anti-Sunni groups. Investors are suspicious of private equity and real estate because they believe EBITDA prices for the former are high and cap rates for the latter are low. There is overbuilding as well, and they wonder who will buy these assets when they are ready for sale.

Europeans don’t know what to make of Donald Trump. There was general agreement that his decisions to withdraw from the Paris climate accords as well as his unwillingness to wholeheartedly back the obligations of Article Five of the NATO agreement have diminished America’s leadership status in the world. The biggest problem Europe seems to have with Donald Trump is his unpredictability. They are used to dealing with mercurial people, but they feel that they don’t know where Trump really stands on many issues important to them. As a result, their confidence in the American policy framework has been reduced. As on my trip to Asia last month, I was asked everywhere whether Donald Trump would be impeached and I told them it wouldn’t happen. Several investors made the point that Trump’s “America First” policy had brought the countries of Europe closer together.

Europe has always been self-absorbed and latently nationalistic and it took for granted that the United States would play a leadership role in dealing with major geopolitical confrontations. Now, Europe can no longer count on that. There is also more talk in Europe about China’s growing influence in the world. China’s “One Belt One Road” initiative, which has it reaching out beyond its borders to increase its trade, investment and influence, is being widely discussed by investors. As I wrote in my last essay about Asia, there is a widespread belief that China will become the largest economy in the world sometime in the 2030s. At that point, it will expect to play a major role in world affairs. Exactly what that means for the United States and investors everywhere is hard to determine at this time.

At the beginning of this year I thought the dollar would be strong against the euro and the yen, but that has not been the experience so far. The reason may be that the inability of the administration to get its pro-growth agenda implemented has reduced the likelihood of tax reform, extensive dismantling of regulation and infrastructure spending happening this year. I still believe we will have some of this legislation passed by the end of the year or in early 2018. That will be an imperative for the Republicans. They cannot go into the 2018 Congressional election without something substantive having been accomplished or their loss of seats in the House of Representatives will be significant.