Europe: a safe haven for investors?

Published: Nov 2013

Lately, various economists and analysts have suggested that Europe is – or will become – a safe haven for investors. This is most probably premature: the Eurozone is still on shaky ground. Over the coming quarters, the Economic and Monetary Union (EMU) countries will have to navigate dangerous quagmires and patches of quicksand.

Along the way, these countries face many dangers that could throttle the fragile recovery in one fell swoop, for example, mainstream politicians who are afraid of reforms, anti-European populists, obstructive judiciary, central banks saddled with impossible tasks, floundering financial sectors, and conflicts between national and international interests. And all these issues are compounded through combination and overlap with the other issues.

The political landscape

Beginning with politics, it is clear that populist parties are on the rise and on the march. They make promises that appeal to voters who are disenchanted with the incumbent political elite. There is no denying the pull of populism. All the more so as knee-jerk reactions, such as resentment against immigrants and an aversion to Brussels, often go hand-in-hand with progressive goals, such as the protection of pensions and generous social welfare systems.

Chart 1: MSCI index versus US balance sheet
Chart 1: MSCI index versus US balance sheet

Source: Thomson Reuters Datastream/ECR

Many analysts and mainstream politicians fear that the populist movements will stand a good chance at the upcoming elections to the European Parliament. For example, Alternative für Deutschland (AfD) did not make the threshold (5%) during the recent national elections in Germany, but for the European elections the threshold has been lowered to 3%. Other small, populist, and anti-euro parties could also be voted in, while the larger parties (Front National, PVV) will probably sail through.

The Lisbon Treaty, which entered into force on 1st December 2009, has increased the power of the European Parliament and many Eurozone decisions and regulations require its approval. This means that following the May elections, the populists could be in a position to scupper any concerted effort to tackle the euro crisis.

The courts of justice

The judiciary also plays a part in encouraging a piecemeal approach to the euro crisis, particularly in Germany and Portugal.

The German Constitutional Court in Karlsruhe has clamped down on several attempts by the German government to give up sovereignty in favour of European institutions. For example, German judges have reviewed and imposed restrictions on the European Stability Mechanism (ESM) – aka the Eurozone bailout fund – and on the Outright Monetary Transaction (OMT) programme of the European Central Bank (ECB). In the past year, Portugal’s Constitutional Court has struck down various austerity measures, which is hampering the government’s attempts to lower its budget deficit.

This won’t be the last time that national judges rule on European initiatives that are intended to defuse the economic and political crisis. Each time, investors will have to nervously wait and see – especially when it involves the Karlsruhe court – if the judiciary will put obstacles in the way of further fiscal, economic, and political integration. So far, this interference has not been disastrous but who knows what the future will bring as more powers are transferred from the national to the EU level.

The role of the central banks

Meanwhile, central banks (including the ECB) seem to have become political ‘megapowers’ and the dominant drivers of the financial markets. To date they have managed to prevent a total collapse of the global economy through ultra-loose monetary policy and unconventional instruments such as quantitative easing (QE).

Chart 2: Spanish government bonds versus total bank assets
Chart 2: Spanish government bonds versus total bank assets

Source: Thomson Reuters Datastream/ECR

In 2012, ECB President Mario Draghi calmed the markets – and staved off chaos in the Eurozone – by stating that the ECB was fully committed to the euro. However, in reality Draghi – plus Federal Reserve Chairman Ben Bernanke in the US and Bank of Japan (BoJ) Governor Haruhiko Kuroda – can do little but buy the politicians time to address the structural problems that stymie sustainable economic growth.

At the same time, the politicians and the markets seem to expect miracles from central bankers, who are supposed to contain inflation, avert deflation, guarantee the stability of the financial system, and promote growth. Everyone knows that, sooner rather than later, central banks will have to taper their asset purchases. That will not be easy.

Last summer, Bernanke only had to hint at a more neutral monetary policy to trigger market unrest around the world, particularly in the emerging economies. Apparently, both politicians and investors have become so addicted to the monetary ‘drugs’ supplied by the ‘dealers’ behind the increased money supply that nobody can think of a roadmap that would allow the ECB, the Fed and the other central banks to retreat into the shadows as politicians take over the helm.

One reason is that many banks are still reeling from the after effects of the 2007 crisis. In some respects, the banks have grown more vulnerable compared to a few years ago. The Italian and Spanish banks have gorged on domestic government bonds. Across the Eurozone, the percentage of government securities on the bank balance sheets has increased from 4.0% (five years ago) to 5.4% at the time of writing.

In Italy and Spain, 10% and 9% of bank assets respectively consists of government debt. This increases the dangerous interconnection between the governments and the banks. On top of this, many banks are sitting on bad debts. According to a recent International Monetary Fund (IMF) report, Italian and Spanish banks could face €230 billion of losses on credit to businesses in the coming two years.

Waning appetite for a European banking union?

All the problems that plague the Eurozone – ever more popular populist parties, dissatisfied voters, legal impediments, an overly dominant ECB, and faltering banking systems – seem to converge in the debates about the banking union. Not so long ago, it appeared that everyone who was someone in European politics agreed that the only way to solve the euro crisis was monetary, banking, fiscal, economic and political integration.

The banking union was seen as a first essential step. On the agenda for next spring are stress tests and an Asset Quality Review (AQR) for European banks. At the end of 2014, the ECB should be regulating the 130 largest banks. However, the EMU states are already at loggerheads about this proposal, especially now the markets are no longer driving up interest rates to unsustainable levels and the pressure on the politicians has eased.

The fading appetite for the banking union is not an isolated development. Euro scepticism is on the rise across the Eurozone. People want to ‘claw back power’ from Brussels. In this respect, the UK goes farthest, with a referendum about EU membership re-emerging constantly. Even founding members and driving force of the EC, the Netherlands, has issued a report stating that Brussels should do less and national governments should do more.

The Eurozone faces challenging quarters and the euro is unlikely to stay at its current level. Or if it does, the Eurozone will again come under pressure from – or be mocked by – the markets. The political stability premium that has been calculated into the exchange rate of the euro of late (partly because of the US budget battle and the restive emerging markets) will likely slowly disappear. Plus, in a climate of rising Eurozone tensions, the politicians will put pressure on the ECB to ease its policy. This, too, will have a downward effect on the euro.

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