Investors should look beyond the politics


David Roche
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Europe is in better shape than a cursory examination of its politicians might suggest.

Europe is in a political mess. President Chirac and Chancellor Merkel seem determined to block any speed-up on reform of the Common Agricultural Policy before 2012 and stop further concessions in the Doha round of trade liberalization agreements. The prospects of meeting the targets of the Lisbon Agenda to make Europe a world competitor by 2010 look remote.

At the very least, further economic reform in taxation, market deregulation and labour flexibility seem ruled out until at least 2008, when it’s just possible there will be a new set of political leaders on the European stage.

No wonder the euro has dived against the dollar in 2005. It’s not surprising too that many investors dismiss European financial assets. However, I reckon that is a serious mistake.

First, things might not be quite as bad politically as they appear to be. Ironically, in France, the heirs apparent to Chirac, interior minister Nicholas Sarkozy and prime minister Dominique de Villepin have gained in popularity by talking tough over law and order. Indeed, the more reformist Sarkozy is now a clear leader in the public opinion polls for the presidency.

Moreover, the programme of Germany’s grand coalition does aim to rein in the excessive fiscal deficit, even if it postpones further reform.

But even more important, Europe’s economic prospects are a lot better than its politicians. Specifically, the eurozone economy grew by an annualized 2.4% last quarter. This growth has been led by a combination of external and domestic demand.

Low-cost locations

Foreign orders for German manufacturing capital goods grew at an annualized rate of 32% in the third quarter of 2005 – the fastest in more than five years. Exports have been struggling to fulfil that demand. Instead, companies are meeting it by moving manufacturing facilities to lower-cost locations in eastern Europe and east Asia.

German labour productivity growth now matches that of the US, and the trend is up. As a result, unit labour costs are flat, while those of the US are pumping along at about 2% year on year. With producer prices (even excluding energy) rising, German corporate profit margins are moving up just when US profit margins might have reached a peak.

German industry is beginning to motor, and that has filtered through into rising business confidence. The IFO manufacturing business survey is at its highest level for five years. Against the backdrop of a depreciating euro, exports are rising fast and German businesses have even been tempted to accelerate real domestic investment in plant and machinery.

Split of Germany’s national income
Source: Datastream
In France, consumption has recovered from the downturn in the summer. Buoyant property prices and rising real wage growth have maintained consumer purchasing power. And consumers are taking advantage of a favourable environment to buy more goods on their plastic and to upgrade their homes.

Germany has made efforts to make its labour market more flexible. A whole industry of mini-jobs – tax and social security exempt positions that pay less than €400 a month – has developed. Around one in six of the workforce now hold such jobs. Job vacancies are booming. But as the eurozone downsizes its manufacturing workforce, new service sector jobs are accelerating. Service sector jobs in the big-four eurozone economies are growing at a rate on a par with the US.

In 2005, the euro depreciated 14% against the greenback. That was for two reasons. First, US economic growth has continued to outstrip European expansion. Second, with the Federal Reserve increasing interest rates and the European Central Bank sitting on its hands until December, the short-term interest rate differential of the US over the eurozone widened.


But 2006 will be a different story. Global liquidity is set to tighten as the US property bubble contracts and the ECB will continue to jack up interest rates. At the same time, the real GDP growth advantage that the US currently enjoys will narrow – indeed it already has. Consumer spending growth will slow sharply in the US, while the converse will happen in Europe, so the growth differential could disappear by the end of the year.

Europe’s big companies and financial institutions have been getting on with the job anyway. They have created sufficient momentum to take Europe’s economy forward, whatever the politicians do.

David Roche is president of Independent Strategy Ltd, a London-based research firm.