Apart from a Great Depression, there’s only one rational way out of Europe’s crisis – QE. That’ll be good news for stocks, says James Ferguson.
A Radio 4 presenter on Monday completed his coverage of this weekend’s German elections by interviewing matrons coming out of the Frankfurt opera (I’m guessing they were matrons by the venue). What do you think of Angela Merkel? he asked. “We’re not really fans, but what is the alternative?” What about the eurozone? “We love the euro! Why don’t you British join too? That would be great for us.” (Because we’d be another rational buffer against the spendthrifts to the south.) And what about eurobonds – government debt issued and backed by the eurozone as a whole? “No way! Terrible idea, we’re all against eurobonds.”
And there it was in a nutshell. The Germans love the idea of the European experiment – but only if they don’t have to pay for it. I love the idea of a Ferrari on pretty much the same basis. The difference is that I haven’t already taken delivery of a Ferrari on hire purchase. Eurosceptic MP John Redwood likens the euro experiment to sharing a bank account with your neighbours. In Germany’s case, they see themselves as the one with the nine-to-five job and their southern neighbours as the ones who go off to buy cider in their pyjamas when the shops open at 10am.
Wisely and predictably, Merkel played down the euro situation in the run-up to the elections. This strategy was aided by the economic outlook improving somewhat (from recession to something closer to zero growth). But there’s much unfinished business. Slovenia needs a bail-out to recapitalise its banks, Greece needs another bail-out (its third) and the noises coming out of Spain remain dire.
Next in line appears to be Italy. Last week, says the Financial Times, LCH Clearnet, the clearing house for inter-bank transactions, would no longer guarantee to stand behind Italian bank repo transactions. Instead, lenders will only receive the sale value of any collateral. To cut a long story short, that’ll make funding for Italian banks more expensive and push them closer to the brink (or at least to the European Central Bank to ask for cheaper funding).
And this ongoing mess is why euro observers have always known that it was important to create a hiatus in the euro meltdown until the German elections were out of the way. Any solutions that can be found to hold Europe together are going to cost someone a lot of money. That ‘someone’ is the German taxpayer.
The price of the eurozone
German enthusiasm for a united Europe goes back a long way and, as the Frankfurt matrons confirmed on Monday, is still very much alive and kicking. But where Germans seem to have a national blind spot is over the need for fiscal transfers within any currency union. These transfers have to come from the area or country running the current account surplus, and be paid to those running the deficits.
For example, in the US, it is just a given that New York and Connecticut fund Alabama and Mississippi. Closer to home, Westminster council, with its annual budget of around £200m, raises nearly £2bn in rates alone. This goes into a national pot and is redistributed to councils across the country. In other words, higher restaurant prices in London directly fund local services in Blackburn and Durham. Similarly, areas within Europe need rebalancing.
While Europe as a whole runs a pretty balanced budget – its finances are arguably in better shape than Britain’s, or even America’s – there need to be transfers between wealthier countries such as Germany, and poorer ones such as Greece. Merkel sees that, but her electorate are going to take longer to convince, so she needed to get over the electoral hump before the fiscal tidy-up could begin.
If they want to keep the European dream alive, Germans have to be taught that the reason they are able to run such large surpluses (they export more abroad than they import from abroad) is effectively because the euro is undervalued relative to the strength of their economy. It’s undervalued because the weaker peripheral countries drag it down. Without them, the German mark would be strong like the Swiss franc, and as a result, German goods would be priced out of many more markets.
In other words, a lot of the money that Germans make they make specifically because of the ‘help’ they get from other countries in keeping the value of their currency down. In return, they must hand some of this money back to pay for this backdoor aid. The trouble is, as the Frankfurt matrons loudly illustrated, they just don’t see it this way.
That is why no one was keen to point it out ahead of the election. Because, like it or not, a vote for any party that wants to stay in the eurozone is effectively a vote for higher taxes – perhaps much higher – all in aid of foreign beneficiaries who are still largely seen as lazy and indolent.
Some of the perks paid to public-sector workers in countries such as Ireland, Spain and Greece, and that are still coming to light, frankly shock parsimonious and industrious private-sector workers in the core. Now that the election is past, and the bad news can be broken, what we’re likely to see from now on is many more shocks, but of an increasingly financial nature and on an ever more mind-boggling scale.
After all, every politician knows that, if an unpleasant job needs to be done, it’s best to get it out of the way as soon as possible after the election. That way you have as much time as possible to try and put things right again ahead of the next election. So whereas we always knew there’d be a dearth of bad news ahead of the German elections, it is a slam-dunk that there will be more than our fair share of cripplingly large bail-outs and losses over the first year after the election.
It’s all about the banks
At the heart of the story, of course, all along, have been the banks. Banks lent too much compared to their capital – and they were particularly bad on this score if they subscribed to what was known as the Basel II regime. US banks never signed up for Basel II, and as a consequence, they were never allowed to get as leveraged as European banks.
It’s ironic, given that America is where the crisis first erupted, and given that US banks have weathered such enormous losses – but on paper, they never looked as vulnerable as their peers in Europe. That is why large US banks have been able to realise such enormous losses (over 15% of their entire loan books in some cases) and yet (mostly) still survive. As loan loss provisions now fall away and US banks are able to pass ever more aggressive stress tests, it is now fair to say that they are out of the woods. You can’t say the same for European banks.
Adjusting for the different accounting methodologies, European banks now appear to be only a bit more highly leveraged than those in America. But it’s taken almost five years of rebuilding their capital to get there. A recent study by consultancy Bain & Co of 88 of Europe’s largest banks found that capital had grown by 50% over the last five years. The problem is that, because banks began with so little capital (because they were so highly leveraged), they first had to build it back up.
So while US banks were able to get on with recognising, crystallising and writing off non-performing loans on their balance sheets – and so returning to health – European banks have been forced to focus on the preliminary stage. They’ve had to build up a capital buffer that is robust enough to absorb their losses before they can start writing those losses off. As a result, cumulative loan loss provisioning over the last five years at large European banks tends to average closer to 5%-6%, compared to the 13%-15% achieved at the major US banks.
So, European banks still have a long way to go in terms of fixing their balance sheets, compared to their peers in America.
Election over – here’s the bad news
With Merkel back securely at the helm in Germany (whichever form the eventual coalition takes) and banks now better capitalised, the next order of business is for the banks to purge their balance sheets of non-performing assets. Europe could do this the fast, but politically painful, way. This would involve bail-outs and taxpayer-funded capital injections into the banks, as well as bank failures and nationalisations. It’s like ripping the sticking plaster off all at once – the banks get fixed fast, but everyone will have tears in their eyes.
The slow option is much easier to get past taxpayers – thus far more politically palatable – and much less brutal in the short term. And five years into the process, it seems more likely that Europe’s banks will be encouraged to get on with the business of processing bad loans, but only at the pace that allows them to re-capitalise themselves at the same time out of retained earnings.
Whatever happens, bank lending in Europe, which has been pretty much flat for the last five years, is now likely to shrink, because banks will be directing their resources at rebuilding their balance sheets, rather than making new loans.
That’s a problem for the European economy as a whole. Eurozone M3 broad money supply (on an existing members basis), which was briefly growing at around 4% last October on the back of various European Central Bank measures, is now only growing at around 1.5%. If banks tidy up their balance sheets by writing off bad loans at a faster rate, bank lending won’t be flat – it’ll shrink.
In both America and Britain this process would have led to a nominal contraction in broad money supply – also known as deflation. Deflation would be great for bunds (German government bonds), but lousy for Europe’s economy.
The solution employed in the Anglo Saxon economies – who learned from the ghastly US experience in the Great Depression – was quantitative easing (QE – printing money to buy government debt). QE is currently against the law in Germany – which is just one of the reasons why the German election was a hurdle that just had to be crossed before the true bank clean-up could begin. The other hurdle was that banks had to get their capital buffers up to a level where they were robust enough to withstand the bad loan recognition process.
The good news for investors
These two hurdles have now been overcome. So, while all looks calm for now, that’s because the starting gun has yet to go off. The good news for investors is that QE is stock market-friendly. And it seems likely that Europe will eventually be forced into doing QE as well. Whereas bunds will do well if tidying up bank balance sheets leads to an outright shrinkage of the money supply, that would also lead to a depression in Europe.
If you consider the amount of pain that some of these countries have already gone through, it’s hard to believe that the eurozone could survive a further Great Depression-style slump without one or more countries taking the exit route.
If Europe’s leaders want to avoid that – and all the evidence so far suggests that they do – then the only rational policy response is to re-write German law and start the printing presses rolling. From that moment on, if the US experience is anything to go by, bunds will fall back and stocks will take up the running. Because QE stimulates nominal GDP but is blocked from reaching the household sector and small and mid-sized businesses by the banks (who won’t lend, because they are fixing their balance sheets remember), the benefits flow disproportionately to the financial markets (stocks, prime properties, rich people) and abroad.
This latter point suggests that the euro as a currency stands to lose value once QE kicks in. QE has been equivalent to 15%-25% of GDP in the Anglo Saxon economies and if it turned out to be of similar magnitude in Europe, the euro could weaken substantially – just look at what’s happened to the yen this year. Since Japan embarked on Western-style QE, it has slid from $1 buying just ¥77 last August, to the dollar now buying close to ¥100. However, anyone buying Japanese stocks has been more than compensated for any currency losses by the sheer scale of the market gains.
In short, QE in the eurozone would be great for European stocks, but disastrous for bunds and the euro. And now that European banks have built up their capital buffers (so they can start writing off bad debts), and the German election is passed (so Merkel no longer needs to soft-soap the voters), the bad news can be broken to the German public, about the need for QE as an inevitable consequence of ongoing eurozone membership and the need to fix the banks.
What to buy now
If QE is launched in the eurozone, one impact will be to weaken the euro. In turn, that’s likely to lead to higher inflation, and the countries most affected will be those that already have the strongest economies (because in effect, monetary policy will be too loose for them).
There are already signs that the German public is concerned about inflation, with property finally becoming a more popular investment after years of stagnant prices. MoneyWeek’s Matthew Partridge looked at a number of ways to play the market last month – probably the easiest for UK-based investors is to buy the Aim-listed Taliesin Property Fund (Aim: TPF), which invests in Berlin property in particular.
Of course, as we know from experience, property booms tend to lead to consumer spending booms, which will boost economic growth and many firms profits, so if you‘re just looking for a more general play on the German market, you could go for an exchange-traded fund such as the Lyxor ETF DAX (Paris: DAX), which tracks the DAX. While there is currency risk, especially as we expect the euro to fall if QE is launched, we’d also expect stock market gains to outweigh currency drag, as seen in Japan.
QE will also buoy stocks in the hardest-hit parts of Europe. We tipped several troubled ‘periphery’ markets in summer 2012, and they’ve done very well since then. However, they still look cheap on a cyclically-adjusted price/earnings basis (the Cape looks at values on a ten-year basis, giving a better idea of how cheap a market is compared to history).
Italy still looks worth buying on a Cape of below eight (using figures from US investment manager Mebane Faber) – the iShares FTSE MIB (LSE: IMIB) is a simple way in. The Lyxor ETF FTSE Athex 20 (Paris: GRE), which tracks the Athens Stock Exchange, has also done well in the past year, but Greece remains very cheap on a Cape of below three.
• James Ferguson is a founding partner of the MacroStrategy Partnership LLP and regularly contributes to MoneyWeek.