Gravity is a curious phenomenon. If an apple drops off a tree it will fall at a velocity of roughly 10 metres a second. Drop the same apple from a high bridge, however, and the speed of its descent will accelerate by an additional 10 metres a second, every second, until it hits the ground.
The ultimate velocity of the fall depends not on the mass of the fruit but on the height from which it is released. A water melon will fall no faster than an apple but it will undoubtedly make a bigger mess when it lands.
The same can be said of financial markets. The higher asset prices climb above fundamentals, the more rapid will be their downfall when the gravity of rational thought prevails. The present market bounce will end in a fleshy mess.
Investors have taken solace from coordinated policy action and signs that recovery is at hand. But in their extrapolation of the marginal change they are misreading the pips. As Bank of England governor Mervyn King pointed out: "It’s the level, stupid!"
Even by the end of next year, should consensus expectations be fulfilled, real GDP in Europe will still be four percentage points below its first-quarter 2008 peak. Industrial output is down by one-fifth and capacity utilization is below 70%.
The artificial stimulus that prevented recession becoming a depression will have to be unwound. As the aftermath of the cash for clunkers car purchase programmes in the US and Germany will show, final demand doesn’t have a leg to stand on once you take away the crutches.
Policy interest rates can’t go any lower and at some point will start to go higher. The European Central Bank does not have much quantitative easing to withdraw (in contrast to the US Federal Reserve and the Bank of England) but its obsessive price-stability mandate will force a speedier normalization of monetary policy than in the US when the time comes.
European banks are only halfway through their likely losses. So despite the contraction of Libor spreads, the system’s willingness – or ability – to extend credit to the private sector will remain severely impaired.
Large companies with soft order books might not want to borrow at the moment. But smaller enterprises depend on bank lending to survive. Without it, the German Mittelstand and its equivalents will struggle to keep workers in jobs once government-subsidized short-time working schemes expire.
The other great obstacle to recovery is the looming fiscal squeeze. Debts and deficits will have to be brought under control right across Europe. With the exception of Finland, not one country will meet the requirements of the EMU’s Stability and Growth Pact next year.
| OECD budget deficit forecasts |
| As a percentage of GDP |
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| Source: Datastream |
The Germans in June voted for a constitutionally binding change to their public finance regime. This will require that, from 2016, the federal government runs an annual budget deficit no greater than 0.35% of GDP over the cycle – compared with next year’s expected out-turn of 6.7% of GDP – and from 2020 the states of the German federation will be permitted no structural deficits whatsoever. Ironically, this might prove to be a bullish story for European financial assets in the longer term. A smaller state sector would free up resources for all. But tensions will arise before the investment case is clear. Germany’s unwavering insistence on fiscal (as well as monetary) rectitude is going to call into question the willingness of other countries in the euro area to follow suit.
Berlin is effectively saying "shape up or ship out". Government bond yields over Germany will widen sharply for those countries that resist the call.
One of the reasons the bulls say the equity market rally is sustainable is that companies have been aggressive in cutting costs. This might be true in the US but it is not the case in much of the euro area. In contrast to the US, where unit labour costs fell 2.7% in the first six months of the year, they have soared in core Europe.
Eurostat reports that labour costs rose 4% year on year in the second quarter of 2008 even as nominal GDP shrank by 3.8%. The peak-to-trough drawdown in eurozone corporate profits has been much more severe than in the US. And even taking into account consensus expectations for a 2010 earnings rebound, the reality remains that listed-sector profits will be 20% to 50% below end-2007 levels by the end of next year.
Melon frappé, anyone?
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com