Eurozone in motion

This is the main text for my latest Fund Strategy cover story that examines the state of the eurozone. The original layout in the magazine, including accompanying graphs, can be found here.

Many have made such claims before but this time around there is significant evidence that the eurozone is finally recovering from its slump. In the second quarter of the year the eurozone returned 0.3% GDP growth in aggregate after six consecutive quarters of contraction. It may not signal the end of the region’s problems but, for some at least, it could be the beginning of the end.

The Organisation for Economic Cooperation and Development, a rich country think tank, expects the growth to continue. Earlier this month it forecasted a 1.1% expansion for 2014.

In addition, talk of eurozone bailouts has been relatively subdued since the Cyprus deal was announced in March. This may be partly the result of the German election campaign (see box) but the region has certainly managed to stave off any crises in recent months.

Under such circumstances it should not be a surprise that many fund managers are upbeat about the Europe’s prospects. Confidence about Europe hit a nine-year high in August according to the regular Bank of America Merrill Lynch survey of European fund managers. Earnings confidence is back to pre-crisis levels and a net 17% of managers were overweight eurozone equities.

It does not follow that even the optimists naively expect a trouble-free path in the future. The International Monetary Fund recently noted that for the eurozone: “reversing financial fragmentation and unlocking credit supply through repairing banks’ balance sheets and advancing on a credible banking union remains crucial” (IMF Update on Global Prospects and Policy Challenges, September 5-6).

It is also clear that unemployment remains high and that while some countries have returned to growth (including Germany France and Finland) others remain in a technical recession (including Italy, Spain and the Netherlands).

Greece is reliably expected to need a third bailout some time in the second half of 2014. A report by the Bundesbank, the German central bank, along these lines was leaked to Der Spiegel, a leading German weekly newsmagazine.

This article will examine the debate about the eurozone’s prospects in more detail. First, it will look more closely at the recent figures for economic growth. Headline data can give a misleading impression of the underlying picture. Then it will examine the debate about the banking system banking union. Finally, it will examine the ongoing debate about the structural weaknesses of the eurozone. In conclusion it will look more closely at the investment prospects for the region.

Eurozone growth

Although a return to economic growth in the eurozone is in itself welcome news it does not necessarily reflect a durable improvement. It could just be a blip or it could mask underlying problems or discrepancies.

Hetal Mehta, a European economist at Legal & General Investment Management, by her own account has a view that is “broadly in line with consensus”. She sees some elements of a cyclical improvement and some of structural change.

On the cyclical side she says part of the apparent recovery is “being driven by inventories”. After several quarters of stagnation it is hardly surprising that some restocking is under way.

In relation to the structural side she points to improvements in Spain’s trade balance and the easing of austerity in some countries as positive. Mehta is “tentatively optimistic but still quite cautious about how things pan out next year”.

Others point to an uptick in car sales as a special factor in turning the growth figures positive. Apart from a new round of Spain’s “cash for clunkers” Pive (Programa de Incentivos al Vehículo Eficiente) scheme there is no obvious reason this should be the case. It seems simply to indicate replacement spending after a protracted period of low sales.

The labour market also appears extremely weak with unemployment running in aggregate at a higher level than the US or Japan (see graph). However, Mehta notes that despite this remaining a problem the rate at which jobs are being shed has slowed significantly. For this reason she says “consumer spending should start edging upwards now”.

At the same time debt levels remain high. Charles Dumas, the chairman of Lombard Street Research, an economic consultancy, says “the debt story has not improved at all over the last four or five years”. Private sector has not been brought control and public sector debt has increased a little.

As would be expected there are substantial national differences within the overall pattern of economic growth. While Germany grew by 0.7% and France by 0.5% in the second quarter the Spanish economy shrunk by 0.1% and Italy by 0.2%. Even the Dutch economy, which is often seen as akin to Germany, fell by 0.2%. Having said that even those countries that suffered a contraction still lost less than previously.

It should also be noted that even the optimists are often cautious on prospects for economic growth. Even though they foresee a recovery they typically do not envisage a return to above trend growth on the immediate horizon. The differences in relation to the prospects for growth over the short-term medium term are not perhaps as great as they first appear.

The banking system

It is widely accepted, even among the relative optimists, that the banking system is one of the region’s key weak spots. Looking at the recent history of the region it is not hard to see why.

As a union of 17 member states it should not be surprised that the banking system is fragmented with 6,000 banks across the region. Over time it might be hoped that true single market in financial services will develop but in origin the banks are overwhelmingly national.

In the run-up to the emergence of the Greek crisis this started to change with a huge increase in regional lending. Cross-border, euro-denominated liabilities of eurozone banks surged from about €2trn with the advent of the eurozone in 1999 to about €10trn in 2008, according to the Bank for International Settlements, the central bankers’ central bank.

However, with the advent of the crisis this trend went into reverse. Foreign banks were no longer keen to invest in what had been a booming southern periphery.

In addition, the banks have been left with a huge legacy of bad debt. The challenge facing many is how to rebuild their balance sheets and recapitalise. Banks in the southern periphery suffer from a particularly acute problem of non-performing loans (see bar chart).

Under such circumstances it should not be surprising that banking union was adopted last year as a central component of eurozone integration. The hope is that the banking system can be made less fragmented and regulation can become more pan-European. If these goals are achieved they will constitute significant steps towards solving the region’s structural problems.

However, competing national interests remain a barrier to achieving such a union. To be fully implemented it would be necessary to accept fiscal transfers between member states. For example, Germany would need to be willing to bail out Greek or Italian banks. Fiscal integration would be necessary to achieve such a union in its most ambitious form.

Banking Union includes several elements. The first is a Single Supervisory Mechanism, due to be introduced in autumn 2014, under which the region’s banks will have a common regulatory framework. The vast majority of banks will be under the direct supervision of their national regulators but the ECB will supervise 130 institutions, accounting for the vast majority of assets, directly. Ultimate responsibility for all bank regulation will also reside with the eurozone’s central bank.

Before the ECB takes on this responsibility it will conduct a balance sheet assessment (BSA) of the largest institutions by February 2014. This will in turn be followed by stress tests – essentially the use of computer models to determine how well banks are likely to weather adverse economic conditions – in May.

A study by Deutsche Bank has described the BSA as possibly a “major market moving event.” (EU Banking Union: Right idea, poor execution, September 4 2013). This is because it sets the ECB up for a potential conflict with member states. If capital shortfalls revealed by the BSA are not addressed the ECB will not assume its new supervisory responsibilities.

Another key plank of banking union is the Single Resolution Mechanism. This is meant to provide a framework for dealing with banks that get into trouble.

However, progress on the SRM has stalled as it will inevitably involve cross-border assistance to rescue troubled institutions. This has raised fears in Germany that it might end up picking up a substantial tab when other countries’ banks experience difficulties. This probably helps explain why Wolfgang Schäuble, the German finance minister, has added the caveat that European treaty change would be necessary for the SRM to be enacted.

As it stands the Deutsche Bank study has reservations about how the new system will work. It says “there is a strong probability that the institutional arrangements that will be put into place will end up as a halfway house and, hence, fall short of forming the consistent, effective framework required to attain the objectives of Banking Union”.

Structural challenges

The debate about banking union points to the structural challenges still facing the eurozone. In particular there is the difficulty of tying together national economies with widely varying levels of competitiveness.

Such a set-up inevitably creates tensions. For instance, the optimum interest rates and fiscal policy can vary considerably from country to country. Yet the eurozone essentially imposes a one-size-fits all policy across the region.

In a national state such imbalances can be resolved through fiscal transfers. If necessary, resources can be transferred from one area to another. Within the eurozone such transfers are more difficult to achieve as nation states retain significant control over their budgets.

Such tensions can pull the region in two competing directions. For europhiles the region should move towards full integration. In contrast, eurosceptics argue that the eurozone should be broken up or else it will face chronic imbalances and instability.

Charles Dumas of Lombard Street Research is firmly on the eurosceptic side. In his view “The structural problem in Europe is the euro”.

In contrast, Gareth Colesmith, a fixed income fund manager at Insight Investment, argues that some kind of compromise can be found. “We are of the view that while there are clear issues within the eurozone sensible policy will ultimately prevail,” he says. In his view the eurozone is likely to end up as “an orderly union of nation states”.

This kind of compromise seems to be the direction in which the region is heading for the time being. A recent study by Piotr Buras, an expert at the European Council on Foreign Relations, a think tank, argued that a “silent revolution” is taking place (The EU’s Silent Revolution). In his view the supranational dream of a European federation is giving way to a more pragmatic approach. An intergovernmental network is emerging which involves incremental reform rather than treaty change.

Whether such a compromise can resolve the underlying tensions within the region remains to be seen.

Investment prospects

In the eurozone as elsewhere there is no straightforward relationship between economics and investment prospects. Although economics certainly has a bearing many other factors come into play. It is also important to remember that many companies, particularly large ones, earn much of their earnings from overseas.

Stephen Macklow-Smith, a fund manager and Europe strategist at JP Morgan Asset Management, is upbeat about the region’s investment prospects at least partly on this basis. Whatever the economic growth numbers he notes that companies are doing well. “Company balance sheets are extremely healthy,” he says. “They get healthier and healthier as they are very cash flow generative.”

One reason for this optimism is the international reach of European companies: “Corporate Europe is incredibly diversified outside Europe. About 50% of revenues not generated in Europe,” he says.

In practical terms this means that eurozone firms can benefit from developments outside the region. “Someone in an emerging market who is going down to his BMW dealership is not going to stop doing that because he is worried about the euro,” he says.

Given the results of the BofA ML fund manager survey it is clear that such optimism constitutes the majority view at present. But it is not universally held.

Neil Dwane, chief investment officer for European equities at Allianz Global Investors, is more sceptical. Not only is economic growth still weak but, in his experience, companies are lacking confidence: “In a lot of our equity company meetings we are not seeing anything that would leave you and I to conclude that the CEO [chief executive officer] and the CFO [chief financial officer] are any more confident of what happens next in their businesses than they were a year ago when Europe really was on the rack.”

It is also possible that emerging economies will suffer a prolonged slowdown. If that transpires the worst scenario for eurozone companies would be weak demand in the emerging world combined with economic lethargy at home.

The eurozone appears to be at a watershed. Although the optimists do not foresee rapid economic recovery they see steady growth and buoyant corporate prospects. In contrast, the pessimists are wary of the region’s economy and in some cases see structural impediments to growth. The debate has yet to be resolved.