Europe: Can’t Win for LosingApril 1, 2014
Europe was on the verge of recovery, but the problems in Ukraine may snatch defeat from the jaws of victory. Economic up-cycles are a function of rising investment, and investment is a function of confidence, which in turn depends on profits. Europe appeared to be turning the corner in 2014, as growth from exports had put the wind in their sails – but Russia is now a major headwind. Money is being pulled out of Russia rapidly as firms worry about sanctions and the possible loss of access to funds – from decisions made by either side. No one can know if conflict will escalate, so caution is the easy path. Uncertainty reduces confidence and investment, and now there are calls for recession in Russia – and maybe for those close by. Unfortunately, Russia has been a significant part of the European recovery as they spent the funds generated from selling gas to the West. Nations as far away as Spain have tapped into Russia’s earlier strong growth in order to increase exports. As these trades slow down, those that have become dependent on them may be found to be swimming naked – with too much leverage exposing them to a sharp squeeze on profits just as they started to rise.
We focus on Germany in particular, because they are the locomotive at the core of Europe. In our view, the Euro Area remains two years behind the US and in many ways will face challenges similar to what we have just muddled through. The Great Recession didn’t hit as hard in Europe, where the banks were protected by governments, until the sovereign debt crisis in Greece in 2010. Even then, German industrialists hardly cared, as the impact of even steep losses in sales to so small a market didn’t affect their bottom line. However, two years later when Italy and Spain fell into the quagmire, German businesses yelled loudly and their defenders – Angela Merkel, the Bundesbank and the ECB – quickly shifted toward easier policy. Today, we see the Bundesbank again doing the bidding of Germany’s industrial leaders, calling for easier policy as deflation threatens. Deflation that is being generated by the double whammy of Japanese devaluation and the loss of growth to the East. Abenomics has reduced the value of the yen by 25 percent against the dollar, but it has fallen 40 percent against the Euro. Germany and Japan have far more head to head competition that the US and either trade partner – so the swing in euro-yen has a meaningful impact. Indeed, in 2011 when the Tsunami hit, it was the fact that Germany benefited from Japan’s inability to produce that muted Europe’s will to aggressively resolve the imbalances in the Euro Area. They hoped, like all debtors in trouble, to grow their way out of it. Now, back at the pointy end of the stick, German is again ready to capitulate more on needed, but painful, reforms. With sales to Russia collapsing and new financial obligations to bail out Ukraine adding additional burdens on not yet strong shoulders – the sooner the better for stimulus. Europe is now dealing with the same problem the US had in 2010 and 2012 – when the recovery was just underway, and then Europe faltered creating new headwinds. Those headwinds led to QE2 and QE3. We expect Europe’s recovery will continue, but with more of a muddle through rather than the takeoff which many had anticipated.
The preceding was originally a commentary for McVean Trading and Investments, LLC and has been reposted here with permission of the author.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.