European consumers have been deleveraging for some time now and governments cannot compensate for that, because they are implementing austerity in order to get public finances back in order. The ECB could in theory come to the rescue, but doubts are lingering about the effectiveness of monetary policy. How will this play out and what are the consequences for European stocks, interest rates and EUR/US dollar?
Governments to make up for private sector weakness?
In the period from 1980 to 2007, there was a great deal of borrowing in Europe, creating bubbles in the property and stock markets, that have since burst, prompting consumers to attempt to reduce their debts. Additionally, as the population ages, a shrinking workforce has to maintain a growing number of people not working and repay old debts. Moreover, from the age of 55, people save more.
Most governments are unable to compensate for deleveraging in the private sector. In many countries, this is generating a negative spiral. With low or often negative growth, public expenditure on social support is rising and tax revenues are falling. Despite austerity measures and tax hikes, budget deficits are falling too slowly, leading to new rounds of austerity measures, further weakening the economy.
To make matters worse, investors are not convinced that some of the weaker countries will be able to fulfil their financial obligations. Investors then start demanding increasingly higher risk premiums, in the form of higher interest rates, inhibiting the economy further and public finances continue deteriorating.
Markets fixated on Draghi
All eyes are therefore on the ECB. Can it suppress interest rates in the weak countries and get consumers in all the countries borrowing again? Unfortunately, the ECB can only implement a single policy. The approach is, therefore, the same for both weak and strong countries. Devaluation is no longer possible and quantitative easing would generate far too loose a policy for the strong countries, resulting in rising inflation. Germany will not accept such a policy.
The ECB is obliged to follow a monetary policy that is too tight for the weak countries. That is generating an unfortunate situation where the weak countries can only improve their competitive position by cutting wages and prices, causing additional bank losses and further falling asset prices.
Inflation hampering competitiveness
The entire European economy is therefore currently in a recession. The ECB is attempting to suppress interest rates as far as possible and get banks lending again, but the latest figures point to stagnating credit activity. An even looser monetary policy would therefore be welcome. Interventions by the ECB will probably not enable interest rates in the weak countries to be lowered to a level at which their economies will really be stimulated. It will only prevent a slowdown. Besides, the ECB has its hands tied, as all over Europe attempts are being made to increase tax revenues by hiking excise and consumer taxes. That keeps inflation high.
One might expect this effect to be overshadowed by high unemployment. After all, it puts downward pressure on wages and prices. In Europe, however, a great deal has to happen before wages can fall. They are often even inflation-linked by agreement. On top of that, there are still a lot of people without work who are covered by social security laws and therefore still have money to spend. As a result, in a country such as Spain, where there is a recession and almost 26% unemployment, inflation is still around 3%. There is therefore no question of improving the competitive position in the near future.
To summarise, the European economies are struggling with a number of major problems about which little can be done. The entire European economy is in a recession, from which it will only be able to emerge slowly. That is hindering the weak countries in reducing their budget deficits and means there have to be even more austerity measures in the weak countries. Their populations are growing tired of austerity measures, though. At the same time, in the strong countries, resistance against continually providing the weak countries with more money is growing. In such a climate, it is becoming ever more difficult for Europe to form a fiscal and banking union.
Where to go from here?
While all eyes may be on the ECB now, the central bank would rather see politicians taking measures for structurally improving the economy, such as better education of the working population, improving the business climate, and creating the conditions for inventing and marketing new products and services.
Aside from the fact that such measures only take effect in the longer term – and often initially even inhibit the economy – they are generally also politically unfeasible. So help really has to come from the central banks. But interest rates are at almost 0% virtually everywhere and asset prices – stocks, in particular – have been considerably boosted. It is therefore far from certain that further monetary loosening will be of much assistance.
Nevertheless, we certainly cannot rule out the possibility of the ECB opening the liquidity taps even further. If the situation in Europe does not improve soon, the EMU and the euro will break up. That would have disastrous consequences for virtually all European countries. There is therefore enormous pressure on the ECB to save the EMU and the euro through monetary policy. A far lower euro rate is probably the only practical way of getting the weak countries to grow again to some extent. This can only be achieved by the ECB.
The situation is increasingly risky. The recession is deepening in the weak countries, credit activity is steadily shrinking, losses on old loans are mounting and unemployment (particularly among young people) is gigantic. Furthermore, the strong EMU countries are now also being visibly hit by the euro crisis and resistance among the population – in the weak countries to the conditions that have been set, and in the strong countries to extending further financial aid – will grow rather than weaken, as a result.
Therefore, ECR expects the ECB to ultimately loosen the monetary policy much further. Monetary stimuli are still the only possibility for reversing the negative spiral, because the European government leaders have committed themselves to reducing budget deficits and the private sector wants to keep deleveraging. But many fear that further monetary loosening is no longer achieving a great deal and proves to have more and more drawbacks. An increasing disconnect is growing between the higher stock prices and the real economy, for example. Eventually, that bubble will burst and stock prices will tumble, despite the looser monetary policy.
This creates a picture where we foresee tensions mounting substantially. Against a backdrop of weakening growth worldwide and growing skepticism regarding the effectiveness of further monetary stimuli, we expect a risk-off phase; a phase in which stock prices drop, ten-year German and US government bond yields slide towards their all-time lows and EUR/US dollar falls.