Europe Outlook: Behind the gloom
Pessimism abounds about Europe’s prospects but is it justified?
- There is considerable pessimism about the prospects for Europe
- Whether such a gloomy outlook is justified is an important question for investors
- Many attribute the negativity to the rise of populism
- Populist parties have filled a vacuum created by the decline of social institutions such as trade unions
“There is a wave of pessimism regarding the future.”
This statement on Europe’s prospects does not come from a populist political leader or a bearish fund manager. On the contrary, it was made by someone who many consider as at the pinnacle of the European Union’s financial elite.
Mário Centeno, the finance minister of Portugal and president of the Eurogroup of euro-zone finance ministers, was giving a lecture at the London Business School. His point, of course, was to challenge the pessimism rather than endorse it. “Once again we will disappoint the scaremongers. While some, including in this country, continue to expect the collapse of the euro every other year, the single currency has made its survival from the crisis to a point of no return.”
Like many in the financial markets, he blamed “a tremendous accumulation of political uncertainties” for Europe’s recent slowdown. His conclusion was that “only political resolve will fix it”.
Naturally, it would not do to take Centeno’s arguments at face value. It may turn out that he is right but such claims demand investigation. For one thing, he has a vested interest in talking down any problems.
The markets are showing signs of concern. For example, in both March and April the most crowded trade in the monthly Bank of America Merrill Lynch fund manager survey was to short European equities.
Then there are extraordinarily low euro-zone government bond yields. At the time of writing, the Bund was in negative territory. Such low yields are taken to signal a deflationary environment.
On top of that are the more fundamental criticisms of the euro-zone economy. Ashoka Mody, a Princeton economics professor and author of Eurotragedy, is a critic. He rejects the orthodox view that a single market demands a single currency, as well as arguing that Germany, the region’s economic powerhouse, is losing its competitive edge to Asia. Some of the developments he points to – such as Greek bonds currently trading at yields less than US Treasuries – are certainly thought-provoking.
Such discussions are, of course, of huge importance to asset owners. If the pessimism is justified, then it probably makes sense to be wary of investing in the region. On the other hand, if it is overdone, then there are probably good returns to be made from taking a contrarian stance. This article will focus on populism, while the box will look at the economy.
The source of negativity
The spectre of populism is the most common reason for negativity about Europe’s prospects. This is in contrast to the economy, which is generally seen as broadly healthy. For many, the actions – or perhaps even the existence – of populist parties can be destabilising. This was a particular concern in the run-up to last month’s European parliamentary elections.
Nicola Mai, a sovereign credit analyst at PIMCO, argues that the negative effect of populist parties is likely to be limited, at least at EU level. For one thing, they are not a homogenous bloc. Some are identified as far left and others as far right. “A lot of these populist parties are quite divided,” he says. There is no unified populist movement across Europe and, despite significant support, they tend to be outnumbered by the mainstream.
Mai also points to the system of institutional checks and balances in the EU which constrain the European parliament. “The EU political system works in such a way that there are a lot of inter-governmental controls,” he says. Parliament is only one of four key institutions in the EU. The other three – the European Council, the Council of the European Union and the European Commission – help to constrain its power.
Prof Sebastian Dullien director of the Macroeconomic Policy Institute (IMK) in Berlin, sees populists as a more direct threat to economic stability. In his view, populist parties do not even need to implement policy to have an economically destabilising effect.
“The most relevant is a combination of political risk and financial market risk,” he says. “The most dangerous scenario in my eyes is that in one country either a party comes close to gaining power which has promised a euro in/out referendum before, or someone in government promises a euro in/out referendum.”
In Dullien’s view, such a scenario would lead to an outflow of bank deposits from the country concerned. With the advent of cheap internet-based cash transfers, this could have a greater effect than the Greek crisis of a decade ago. Money could rapidly exit Italy, for example, and find its way into Germany. This would drain liquidity from the Italian banking system, while creating a dilemma for the Bundesbank in terms of how to react.
Whatever the short-term prognosis for populism, the longer-term outlook poses fundamental questions. This naturally raises the question of what is driving populism. That will give some indication of whether it is likely to be a transient phenomenon or a lasting one.
Elga Bartsch, the head of economic and markets research at the BlackRock Investment Institute, argues that two key drivers are at work. The first relates to social inequality. “Economic outcomes are not inclusive enough to make the very large majority of citizens feel good about their lives,” she says.
In her view, this effect is compounded by social media. “It allows protest parties to reach people who had previously become disengaged from the political discourse,” she says. Such people can be more easily activated to vote for protest parties.
A key part of the solution is to promote social mobility, which should include encouraging the education system to provide opportunities for all. “As long as people broadly have the perception that they are part of a fair race to economic success they are more willing to tolerate what some might see as temporary inequalities.”
Europe’s economic challenges
Although much attention is focused on Europe’s politics it would be a mistake to ignore its economic outlook. There are concerns about its structural weakness that should be examined.
Elga Bartsch of the BlackRock Research Institute makes the point that there is no simple relationship between the financial markets and the economy. For example, the recent negative perception of European equities can be explained in relation to investment factors. Europe is best characterised as a value market and that factor typically does best at the start of a recovery. So European equities would not be expected to do well in the late stages of the economic cycle.
“Not everything you see happening in the European stockmarket is directly down to the fundamentals of the underlying economy,” she says.
The same is true of bonds. “The ECB’s asset purchase programme has squeezed the free float of bonds really hard,” says Bartsch. As a result, yields are significantly lower than they would be otherwise. Low official interest rates and Europe’s strong fiscal position have also played a role in pushing down yields.
Nevertheless, she accepts that there are serious potential challenges in relation to Europe’s long-term competitiveness. For example, if Germany wants to maintain its competitive position as an industrial powerhouse it needs to invest more in its infrastructure.
Prof Sebastian Dullien, director of the Macroeconomic Policy Institute, takes a similar view. In his view Germany’s position is reasonable in the short term but it should not become complacent. “Germany has a problem of lack of investment in infrastructure and higher education, in modern technologies basically.”
Of course, although Germany is at the core of the euro-zone economy it is not its totality. One of the key criticisms is that the region’s half-way house institutional structure is unstable. It has moved away from being a region of distinct national economies (so annoying populist parties) but it is still some distance from being a fully integrated economic region (so galling federalists).
Dullien accepts that this set-up creates problems. “We are not yet at a new stable point and it is open to what happens politically whether we move to a new equilibrium or whether we move backwards.” However, many are confident that the euro-zone is moving towards a more integrated arrangement.
A concern for Nicola Mai, an analyst at PIMCO is Europe’s vulnerability to trade conflicts. “Europe is a very export-oriented economy. Germany first and foremost. The current environment of tariff wars and protectionism hurts the European economy significantly because it is so open.”
It is too easy to become preoccupied with the spectre of populism, but it is far from the only development to watch in Europe.
Prof Robin Best, an expert in political representation at Binghamton University in New York State, points to broader factors driving populism. She accepts that inequality and economic precarity have played a role, but identifies additional forces.
Indeed, Best had an article on political fragmentation published in 2013 in Government and Opposition, a comparative politics journal, which anticipated much of the subsequent discussion of populism. Three years before the Brexit referendum and Donald Trump’s election, many of the key trends were already apparent.
As discussed in IPE two years ago (‘Shifting to a new politics’, June 2017) the populist parties have filled a gap left by the decline of traditional right and left organisations. “We’ve seen the mainstream parties of both the left and the right slowly losing votes over time,” Best says. “And their votes are being redistributed to either new parties or parties that were once small and increasing in size.”
She argues that one reason many populist parties have done well is the existence of “very savvy political entrepreneurs”. Such leaders have taken control of radical parties and shaped the debate in many countries.
On top of that there are structural shifts such as the decline of both traditional labour and religious institutions. On the left, there were traditionally “strong linkages between voters and labour unions and political parties”. So the decline of unions has weakened the mainstream left as a political force.
It is also easy to forget that religious institutions helped provide a basis for conservative and Christian Democratic parties in Europe. The shift to secularism in Europe has weakened such movements.
“The social coherence of western European societies has been breaking down,” she says. “It’s becoming increasingly individualised and less institutional. So you don’t have those social bonds that are linking voters to parties. And it’s making voting alignments much more fluid.”
In Best’s view it is possible that the existing mainstream parties could retain their positions but that scenario is far from certain. The future will depend on how the mainstream parties play their hands and how voters respond.
On balance, it looks unlikely that the challenge of populism will disappear soon. It is a feature with which all of those involved in political life will have to contend. It is also likely to have a significant impact on the future of Europe’s economies and markets