EUROPE - After a week of market panic met fears that the debt crisis of peripheral Europe might be spreading to Italy, Europe's third-largest economy, Legal & General Investment Management has warned that investors are underestimating the strength of Northern Europe's economies and their ability to pull the euro-zone out of its current mess.
James Carrick, an economist at the UK-based asset manager speaking at a briefing in London today, made no bones about the straits in which big economies like Italy and Spain find themselves.
While Spain went into the financial crisis with an apparently healthy budget, its surplus turned out to be illusory and unsustainable - built upon a real estate bubble.
Wage increases have been outstripping productivity gains since the mid-1990s. The last improvement in competitiveness Spain enjoyed came as a result of its devaluation in 1992, as the ERM broke down - a solution no longer available. As such, it had to respond to the crisis with a severe cut in government spending.
"This has hurt the economy and labour markets," said Carrick.
Unemployment has been rising since 2008 and shows no sign of slowing, while real estate markets also show no sign of stabilising, which has constrained consumer spending after the short-term fillip of the post-crisis car-replacement scheme.
Among corporations, the proportion of profits being paid in interest is still higher today than it was at the height of the dotcom bust, even after a period of deleveraging and recovering revenues.
"Spanish companies have to keep a lid on costs to pay their coupons, so they are not ready to go out and expand," said Carrick.
It is no surprise, therefore, to find Spanish banks hanging on to their capital - credit conditions, in the form of loan application rejection rates, show no sign of improvement.
Italy's competitiveness gains of the early 1990s have also been squandered since the mid-1990s - unlike those of France, for example. Moreover, Italy, though its budget balance was less severely negative than that of France, has by far the highest debt-to-GDP ratio of any European country, at 120%. This is the reason why it responded to the crisis by tightening fiscal policy, said Carrick.
"Italy was petrified that it might become the 'I' in 'PIGS', rather than Ireland," he said. "The fear was that the market would punish it sooner or later - and we have seen that this week. Austerity plans have been brought forward and that is going to hurt the economy."
Like Spain, Italian employment levels are in freefall, consumption has been muted, and although its companies are not spending as much of their profits on interest repayments, the levels remain higher than they were during the dotcom bust. Italy's banks, like Spain's, are not expanding their lending.
But Carrick draws the contrast with Germany. It maintained a budget surplus in 2005-08, which enabled it to expand its spending to meet the crisis. Government spending is still increasing in Germany, and tax cuts are also on the way.
While its competitiveness suffered during the early 1990s as the Deutschmark appreciated following reunification, for the past 15 years productivity gains have been outstripping wage growth.
"This is now enabling Germany to compete with Asian production and for Asian demand," said Carrick.
Unemployment barely moved during the crisis and now stands at its lowest level since reunification, and that has resulted in a strong rebound - "a mini-boom", in Carrick's words - in consumer spending. Meanwhile, the proportion of profits companies pay in interest has fallen back to the levels of the boom years of 2005.
"If German companies wanted to invest and expand now, they could gear up to do so and pay their low costs out of profits easily," said Carrick. "And that's precisely what we think is happening today."
And German banks are eager to lend to these industrial poster-children: loan rejection rates hardly lifted during the financial crisis and are well on their way back to 2006-07 levels. The story is similar in France, where rejection levels rose quite sharply during the crisis, but are now falling just as sharply again as banks recognise that corporate indebtedness is settling around its historical average.
"Our view is therefore that it's not all bad news in the euro area," said Carrick. "And in particular, we would point out that the euro-zone is not one country that is 'muddling through', which seems to be the consensus."
While L&GIM's forecast for euro-zone GDP growth in 2012 is close to the consensus of 1.75%, its forecasts for Germany and France are far more optimistic and those for Spain and Italy much more pessimistic - but Carrick observes that Greece, Ireland, Portugal, Spain and Italy combined make up 36% of the euro-zone's economy and are easily outweighed by those economies that face a much sunnier outlook.
"Markets are in danger of missing the good news about Germany, France, the Netherlands, Scandinavia, Austria, Slovenia and the rest," said Carrick. "We need to differentiate, and when we do, we think Europe as a whole will be OK."
Asked about the danger of peripheral liabilities materialising as the contingent liabilities of economies like Germany's, Carrick observed that the credit improvements in Germany and France suggested their banking systems - usually identified as one of the vectors of contagion from the periphery - were in better shape than many feared.
"Having said that, credit conditions can worsen quickly, and we are monitoring that very closely, as that would be an indication that the picture is changing," he said.
And while he conceded that there was "no easy way out" for economies like Spain's and Italy's - given the difficulty of cutting spending for growth without the ability to devalue - he felt that the political elite would do "everything it could" to keep these countries in the euro-zone.
"To do otherwise would be to admit to a huge mistake," he said.
The result, he speculated, would be losses for lenders, a recapitalisation of the banking sector by the ECB and a subsequent fall in the value of the euro.
Commenting on the spike in Italy's bond yield to more than 6% this week, Carrick noted that, unlike many other peripheral economies, Italy could rely on solid domestic demand for its bonds.
"The yields rallied pretty quickly back down to 5.5%," he said. "So while speculators can cause short-term volatility, it's not so easy to see that overcoming the demand that there is from domestic buyers."