Expect this grim reality as the ECB pulls the plug on cheap credit
‘The whispering campaign is already underway preparing Europe for the end to super-stimulus and the ECB already knows the consequences’
European equities have been one of the foremost financial tips this year and investors have not been disappointed. A rebounding economy, the more settled political picture, greater financial stability and a resurgent euro have been the hallmarks of success for European stocks in 2017. The key question now is future sustainability as European policymakers test the waters for tougher times ahead.
All good things eventually come to an end and the key worry for investors, now the European Central Bank is flagging an end to years of super-stimulus, is whether the fledging European recovery thrives under its own steam or withers and dies. Zero interest rates coupled with the ECB’s quantitative easing programme have clearly revitalised European consumer sentiment, business confidence, jobs and growth, but has it really paved the way for self-sustaining, economic renaissance for years to come?
The odds are probably not. Whatever the optimists may say, the euro zone is still a zombie economy. Artificially reflated by extraordinary policy measures, there are still too many “ghosts in the machine” for Europe to come out of years of grinding austerity, deep debt deflation, crushing balance sheet restructuring and dire financial crisis, unscathed and ready to enter into a bright new economic future.
As things stand right now, most signs are looking more upbeat than they have done for years. After two punishing recessions in 2008-2009 and 2011-2013, euro zone economic growth has slowly but surely ground its way up to 2.3 per cent in the last quarter with stronger consumer demand and export growth providing most of the leading edge for the recovery.
The euro zone jobless rate has fallen sharply to 9 per cent, with youth unemployment in the weaker economies showing signs of improvement too. Political risks seem to have abated after a bevy of key elections in the last few years have passed without any major upset. Meanwhile financial uncertainties have eased off quite sharply from the height of the European crisis in 2011-2013.
Investors have flooded back into Europe’s capital markets, stock markets have rallied, while the euro has almost assumed a safe haven bid to it with the US dollar down in the dumps on the so-called “Trump slump”. Parts of the German government bond curve remain submerged in negative yields, while euro zone peripheral bond spreads have narrowed considerably from crisis peak levels.
The key question is whether anything has fundamentally changed? Greece might have returned to the global debt markets in July with its first borrowings in three years after its close shave with default, but the nation is still saddled with a crippling government debt exposure at 180 per cent of GDP that will take future generations decades to overcome. Italy is not much better off with a debt load of 140 per cent.
In reality, Europe remains in a stand-off. It is fine while consumers, businesses, investors and markets enjoy the balm of zero interest rates and the ECB’s government debt buy-back under the quantitative easing programme. But take it away and the economic structure becomes a house of cards. Remove the balm and the economy and markets will suddenly start to feel the pain and confidence will collapse.
The whispering campaign is already underway preparing Europe for the end to super-stimulus and the ECB already knows the consequences. The consumer recovery has been floated on a river of cheap credit in the last few years, running close to a 7 per cent annual rate of expansion. Sharply higher borrowing costs could stop this dead.
The stronger euro could soon become a millstone around the recovery’s neck. The ECB cannot have their cake and eat it, talking tougher policy on the one hand, without ramping up the euro at the same time. ECB officials are already expressing concerns about the euro becoming “too strong” and the damage it might inflict on export-led recovery, but it is the unavoidable cost of normalising policy.
Investors may chose to ignore the writing on the wall, but it is plain to read. In the next few months, ECB deliberations on withdrawing stimulus will be critical to watch especially set against the backdrop of tighter money in the US, Canada, Japan and the UK.
The euro is unlikely to be an early bellwether to problems ahead, but rising credit default swap rates and widening peripheral government bond spreads over Germany should provide early warning signals. Investors need to be extremely wary.
David Brown is the chief executive of New View Economics