21st November 2013
By Seven IM’s Ben Kumar
Europe – love it or hate it, here in the UK, we can’t escape it. In the past, we’ve invaded Europe, defended Europe from invasion, been invaded by Europeans, been invading with Europeans, stopped Europeans invading one another, helped Europeans invade one another…The continent is constantly lurking in our peripheral vision, sitting there just across a narrow strip of sea: our largest trading partner, and source of most contention; our holiday destination and site of our bloodiest battlefields; our closest ally and age-old enemy.
From an investment perspective the British view of Europe is just as mixed as the historical one expressed above (albeit with less invading), however we currently seem to be at something of an inflection point in the opinion of the UK investor. Just two years ago, sentiment was clearly weighted towards a collapse of the Eurozone as a currency union – some financial press headlines from then: “The terrible consequences of a Eurozone collapse”, “Why a breakup of the Eurozone is likely”, “Brace for Eurozone breakup”. Around this time, with Greece on the edge of ruin, a £250,000 prize was offered to the economist who could develop the best exit strategy from the Eurozone – today, no one is seriously talking about Greece leaving. The benchmark European equity index is now 50% higher than it was in September 2011, and with such a dramatic shift in outlook, it is worth looking at what has changed since then. The European Central Bank has also just cut its main interest rate partly to reduce the strength of the Euro after its recent strong run in currency markets.
The signs were already there in 2011; governments of troubled countries were already enacting reform policies to try and rein in budget deficits and rapid debt growth. Greece slashed government spending, pushed through labour reforms and started taking tax collection seriously. Portugal and Ireland took the same approach. Spain forced its banks to move the bad debt on their balance sheets to the state-supported “bad bank” SAREB. When these policies were announced, growth was already slumping and they seemed likely to make a bad situation worse. However the populations of these countries (and a number of others) have, after some understandable initial protests, knuckled down, made changes to their lifestyles and committed to a more sensible longer-term approach. The motivation for taking the short-term pain is the understanding that being a part of a larger whole is a thoroughly good thing. 24 months later, the “short term” is nearly over, and growth is sporadically returning. Ireland, Portugal and Spain have all seen an end to recessions, with Italy and Greece also moving firmly towards positive GDP growth.
The peripheral reforms could not have been undertaken without the support of the other side of the Eurozone coin – continued growth in the Core, in particular from Germany. After ten years as the “sick man” of Europe in the early part of this century as the costs of re-unification took their toll, German economic strength since the financial crisis has been sufficient to allow sustained weakness in the other countries, whether due to debt or austerity. There has been some criticism of German export policies recently – with the US Treasury singling out German exports as weighing down the world. However the German ability to continue creating goods that are in demand by the rest of the world continues to give implicit strength to the Euro project – an economic safety net that enables policymakers to behave strategically for the long term. And perhaps we should ask why Germany should be castigated for producing goods everyone else wants but can’t seem to make as well for themselves?
A 50% rise in a developed country equity market in two years is dramatic, and many investment managers missed out on some, or all, of the rally, due to a lack of understanding of the real driver behind the continued survival of the Eurozone. The Euro is not an “experiment” from which “lessons can be learnt”. It is not a trial run before the real thing, not a snappy idea conceived in 1999 and then rushed in before the new millennium. The integration of Europe is a decades-old project, with further decades (or even centuries) still to go and the eventual creation of a united Europe will not be through luck, but rather through a consistent effort over many generations by politicians from numerous countries. The Eurozone passed the point of no return some time ago, and while the journey may not be smooth or short, arrival at the final destination is not in doubt.