Core European growth is picking up. Late last year, I said growth disappointments would make the “Emu on time” outlook seem less probable by early 1997. Consumer spending would disappoint because of Maastricht masochism and the fiscal squeeze, and because of job losses and labour market deregulation.
Now the market believes that European monetary union (Emu) is in doubt because of dreadful growth, in both core and peripheral Europe. But the market is about to be proven wrong. I now expect fast growth in core Europe by end-1997. The reason is cheap money. And exchange rates have fallen, adding to easy monetary policy, particularly for core Europe.
What’s the evidence that all this is working through to demand and not just pushing on a monetary string? First, exports are recovering strongly in Germany and France. So is business confidence. The consumer is still feeling bad, but no worse than last year. French consumption of manufactured consumer goods is on the rise, as are German orders and output. And we are starting to see a turnround in capital expenditure in both France and Germany. The inventory cycle will help because stocks are down to normal levels in both countries.
Economic strength, rather than weakness, in the core will change perceptions radically. Contrary to the current pessimism, growth will help Emu get done on time. German short-term interest rates will rise. But they will top out at the end of next year below the average of previous business cycles. Why? First, because of record high unemployment and low wage growth. Second, the Emu-inspired public spending squeeze. And third, global competition. These are all reasons to believe that price pressures will get less out of hand than in the past.
But a shift in perception towards higher interest rates in core Europe changes all. The Deutschmark will re-emerge as a strong currency, particularly as dynamic exports are part of the recovery process. Interest-rate convergence will occur in Europe no longer because interest rates will fall in Italy, Spain or Portugal, but because German short-term rates will rise.
And renewed growth in Europe will change market perceptions of the future strength of the euro (with big negative implications for the dollar and the ancient policy of its benign neglect). But it will hurt Italy’s chances of being in the first wave of Emu as the country’s virtuous budget arithmetic is only sustainable in a low interest-rate environment and is relatively insensitive to higher growth. In contrast, faster growth and higher interest rates will help Spain get into Emu as its debt to GDP ratio is only a little higher than Germany’s.
Currently investors are massively long the fixed-income markets of Italy, Portugal, Spain and Sweden. They assume that convergence towards monetary union in 1999 means only one thing lower interest rates in all European countries, and stable or lower interest rates in the core of Europe.
But if German rates rise, perceptions on how convergence would happen would push up bond yields in countries likely to be excluded (or to opt out) from the first wave of Emu. That means Italy and Sweden. Indeed, their yield spreads over German Bunds are likely to be higher in a rising interest rate environment than in a low, stable rate situation.
Rising interest rates (together with their short-duration bond markets and heavy dependence on foreign bond ownership) would substantially worsen the budget arithmetic of these countries. That’s why I would stay out of bond markets in Sweden, Italy, Ireland and even Spain.
What happens to Europe’s currencies in this faster-growth environment? Reviving growth and rising German and French short-term interest rates will strengthen the Deutschmark and French franc against all other European currencies through narrowing interest-rate differentials.
The Deutschmark and franc should also benefit from other factors: market anticipation of a strong euro as a credible alternative to the yen and dollar; a possible breakthrough on tax reform in Germany (likely in April); plus Helmut Kohl’s decision to run again for chancellor on an “Emu on time” platform.
Sterling will weaken as the Deutschmark strengthens. And Switzerland, as a small cog rubbing against the big German and French economies, will spin as its big neighbours start to rotate. The market will anticipate that Swiss monetary policy will reverse, so the Swiss franc will start to rise faster than the Deutschmark. The Deutschmark and French franc should also strengthen against the dollar and the Swedish krona.
Equity markets are the last chapter in the Emu-convergence process. A single market with a single currency and a fiscal chastity belt will force European corporations to run for shareholder wealth and compete in dynamic markets. Therefore, European equities deserve to be re-rated.
And more growth in core Europe improves profit perspectives for cyclicals in Germany and France (but not autos). But it makes exposure to the interest rate-sensitive markets of Italy and Spain downright dangerous.
David Roche is president of Independent Strategy, a London-based research firm.
