June?s European Parliament elections confirmed two things. First, public discontent is so high that the EU?s new constitution will be rejected. This will leave the EU without the institutional framework to make vital economic decisions. Second, the elections showed that incumbent European governments (especially those that supported the US invasion of Iraq) will soon be thrown out. There is deep, widespread, seething resentment about government policies and posturing.
Europe?s political thrust will now be focused more on building itself and its allies into a counterweight to US primacy. A leaderless multipolar world seething with power rivalries is a breeding ground for beggar-my-neighbour economic policies and protectionism by populist governments. That will not be a good world for investors.
Some of these poor conditions for investment are obvious: lower growth, higher inflation and slimmer profit margins. Second-round investment consequences include government sponsorship of inefficient national champions, the survival of weak national corporations and sectors and restrictions on capital flows.
In the EU, the European Central Bank will have to cope with continuing big budget deficits and lack of economic reform. This will keep inflation high and growth low. The ECB will prioritize inflation control with higher real interest rates. Politicians will attack it but it will almost certainly retain its independence.
The latest indicators suggest some revival in Europe?s economies, especially from foreign trade. But this will only be sustainable if it broadens out to the domestic consumer. The chances of that look slim. Germany, for example, is continuing to slash jobs.
And eurozone inflation remains sticky. Even a 40% appreciation of the euro against the dollar has done little to lower prices. This suggests poor productivity growth is responsible for keeping core CPI inflation up.
And eurozone households haven?t made the best use of their wealth to boost income. In the US, house price growth enables property owners to withdraw equity and spend the proceeds. And they also benefit from any stock market rally, holding nearly 25% of their assets in equities. In Germany, house prices still suffer from overcapacity and households have only 10% of their assets in equities.
Germany?s revival is now vulnerable to an export slowdown, especially in capital goods. China accounted for 35% of German export growth in 2003. That demand is set to slow.
But this does not mean that there will be no growth in Europe or even no economic reform. The key reason for this is globalization. EU corporations are nearly 50% US dollar businesses and US corporations do 35% of their overseas business in Europe. So the need to compete drives bottom-up reform (and overseas investment) at the corporate level.
As Europe?s population ages and economic dynamism lessens, the continent will live more by spending balance sheet wealth rather than income, so reducing savings rates. Ageing will also push public saving rates down and deficits up. The process will be particularly emphatic in economies like Japan and the eurozone where massive unfunded government pension liabilities will necessitate cuts in benefits, forcing the aged to mobilize their assets.
Ironically, while the long-term impact of ageing is to lower growth, the short-term impact is to increase it as those in retirement save less and spend more. Also, retirement cuts corporate labour costs as high-paid older workers leave. And falling levels of saving might raise the cost of capital to the detriment of wasters of capital (principally governments) but to the advantage of the sales revenues of productive users (successful corporations).
This means that in order to get savings to equal investments, the price of capital must rise or, more unlikely, investment has to fall. Central banks are a part of this process. If they become politicized, they will be expected to print money to fund public deficits and fuel growth. If they don?t, they will play a part in shifting the price of capital upwards.
The ECB might lead the pack among central bank players in capital repricing. But it must eventually happen everywhere, because if central banks don?t act prudently, markets will. Last will be the Federal Reserve, because, given the US?s massive stock of household debt and related inflated asset prices, it cannot afford to be otherwise than tardy.
What does this suggest for European financial assets? European equities will follow any new rally in the US. And the euro is likely to be a beneficiary of any tough ECB policy.
European bonds might suffer from structurally (relatively) high inflation, big budget deficits and declining household savings rates. But they will also benefit from a tough, realistic central bank, at least for a while. So they look attractive relative to a poor single-digit return outlook for global bonds.
