European Affairs

Spellman 1On many fronts, Europe’s economy is strengthening as consumers become more confident, investment inflows accelerate, unemployment falls, and sovereign debt costs decline for the EU’s most troubled member-countries.
Since spring, a week doesn’t pass without yet another positive sign of Europe’s rebound.  Domestic demand is the strongest since the global financial crisis (2007-2009).  French joblessness stands at the lowest level in five years.  Investors demonstrated strong interest in Greece’s first international bond offering since 2014.  Italy’s growth rate has been revised upward.  Manufacturing gains are occurring throughout the EU, especially in Germany.  Housing prices are rising.  Moody’s, a global bond-rating agency, and others have been raising their forecasts upward.  In August, a eurozone economic confidence index hit its highest level since the start of the global financial crisis in July 2007.  Ireland and Spain are emerging as Europe’s fastest growing economies in 2017.    
“Robust survey indicators in euro area countries suggest that growth should accelerate through the rest of the year, while the consumer confidence indicator at a 16-year high bodes well for the consumer-driven recovery,” said Madhavi Bokil, Moody’s vice president, in his August 30 report.[1]    
“Eurozone growth has been the clearest exclamation point so far during 2017, and the upturn is becoming increasingly broad-based in sectoral and geographic terms,” said a just-released report by the Nordic financial services group SEB. [2]  “Central banks are encountering diminished deflation and recession risks.  Rising capacity utilization is leading to larger capital spending, and good international economic conditions are boosting exports.  So far this year, the region has grown faster than both the UK and the US….”
Domestic Demand Builds and Labor Market Strengthens as Low Inflation Holds
Source:  OECD. “Euro Area - Economic forecast summary.” June 2017.
These and other headlines seemed improbable 18 months ago as the European Central Bank took unprecedented steps to expand money supply through negative interest rates and more than €2-trillion euros ($2.4 trillion) in purchases of sovereign bonds and other debt.  "All the signs now point to a strengthening and broadening recovery in the euro area," ECB President Mario Draghi said in June.  At Jackson Hole, Wyoming last Friday (August 25), he signaled that the “quantitative easing” exit will be slow (for now, “a significant degree of monetary accommodation” is still warranted), citing concerns that inflation has yet to hit the two-percent target and unemployment remains stubbornly high, which is preventing wage gains.[3]   His remarks affirmed the commitment the ECB made last December to extend the “net asset purchases … at a monthly pace of €60 billion [from April] until the end of December 2017, or beyond, if necessary.[4]”   
How and when the ECB will wind down its unprecedented stimulus initiatives is the central question for investors.  Can the ECB strike the right balance between tightening money supply (averting an asset price bubble and runaway inflation) and strengthening the expansion underway?  More clues about the program’s fate in 2018 may come after the ECB’s Governing Council meeting next week (September 7) with Draghi having pledged to hold talks about 2018 “this fall. [5]”  
Overall growth in the EU is forecast to exceed 2.0 percent for the remainder of this year and, likely, next year, too, according to one of the more bullish analyses, that from Goldman Sachs.  That’s 50 basis points higher than the 1.5 percent the investment bank had announced in January.  In reporting that EU growth accelerated to 0.6 percent for the latest quarter, compared to the same period last year, Eurostat projected a 2.1-percent annualized increase in GDP through 2017.  That pace would be the fastest since the second quarter of 2011.[6]   Only the U.K. saw a slowdown in the first half of this year, growth slipping to 0.3 percent in the second quarter, the slowest six-month pace since 2011, according to PwC.[7]   Economists attribute this deceleration largely to the fallout – uncertainty as the withdrawal’s scope and timing stand at an impasse – from Brexit.[8] 
More robust growth will likely elude the EU, as it has the United States, over at least the next year or two.  That is the consensus of economists, but the reasons for the laggard post-crisis recovery are disparate if not conflicting.  From technology’s impact on the labor market to the aging population (and the attendant decline in labor participation and consumption) to rising socio-economic inequality to the severity of the global financial crisis to the “chicken and egg” issue of whether supply or demand dynamics are at fault – there are fierce debates over the lethargy and how policymakers should respond.[9] 
Real GDP in the Euro Area, January 2013 – December 2018 (Forecast)
Source:  ifo Institute.  ifo Economic Forecast for 2017/2018: Germany’s Economy Is Strong and Stable   June 20, 2017.
Drivers of growth include political stability, QE, confidence and exports
What is driving growth throughout Europe?  Is it strong enough, and sustainable, to lower unemployment and push wages higher?  
A more stable political environment is often suggested by analysts as one key factor, following elections in the Netherlands and France, in which euroskeptic candidates’ campaigns for economic nationalism failed.  Angela Merkel’s ruling Christian Democratic Union in Germany is polling close to the party’s 2013 election result (when it had just missed capturing the majority vote) a few weeks before voting on September 24.  This fall will see local or parliamentary elections in Austria, Portugal, the Czech Republic, and Denmark plus the Catalan independence referendum, but few see major downside risks from these polls in forcing a breakup of the euro.
The ECB’s “QE” program undoubtedly helped, though there’s wide debate about the extent and duration of the jump-start’s impact, and whether the bank has created an addiction for “free money,” money that can be borrowed at little or no cost, that will be difficult to end.  QE, “notably Longer-term Refinancing Operations (LTROs), Targeted LTROs and the Securities Market Program decreased the yield spreads” of sovereign debt.  In other words, the programs lowered the cost of government borrowing.[10]    That has helped member-countries to pursue weakly expansionary fiscal policies.  Beyond that, researchers generally believe it is too early to judge the impact on macro-economic conditions.  Some concur that long-term bond yields were lowered, at least temporarily when the initiatives were first announced, and particularly for debt in countries with high interest rates.[11]  
These political and economist trends bolstered consumer and business confidence to the highest levels since July 2007.  One indicator from the European Commission shows the decisive strengthening of confidence.  In Germany, the manufacturing, construction, and wholesale sectors are the most optimistic in years (as the charts below illustrate).[12]   
EU Business Climate Indicator, August 2016 – July 2017
Consumer Confidence in Europe (OECD members) Stronger than OECD (total), March 2014 – July 2017
Source:  OECD. Consumer Confidence Index. .
German Business Situation and Expectations by Sector, January 2013 – August 2017
Exports from Europe have strengthened, triggered partly by the euro’s fall in value last year (€1.00 =$1.04 in late December), but the climb to $1.19 is raising concerns that it may curtail export sales in the months ahead.
Export Levels (Constant Prices, Rebased, 2008=1000)
Source:  Silvia Amaro, “The European periphery is back from the brink. Where should you invest?”  CNBC, August 30, 2017.
Employment recovery, investment revival, productivity gains are key to momentum ahead
With growth solid but slow, can it support employment growth from record lows?  Two economists, Refet Gürkaynak and Philippe Weil, are optimistic that it can, and see the employment gains so far as unprecedented compared to past recoveries in Europe.  “Although Eurozone GDP is recovering slowly, it is remarkable that employment is being created at a rapid clip that surpasses both the current rate of growth in GDP and the rate of employment creation in previous expansions,” they write.  “This means that the steep employment losses from the double-dip recessions are being reversed at long last. However, the counterpart to the outpacing of GDP growth by employment growth is that productivity is so far sagging during this recovery.” 
Eurozone Employment (in Persons), Comparison of Recoveries
Source: Refet Gürkaynak and Philippe Weil, “Eurozone economic recovery: Humming along just fine.”, August 24, 2017.   
Reviving investment is another factor that must be revived, as Jacques Bughin and Jan Mischke of McKinsey Global Institute argue.  “Investment has since crept back to 2007 levels in absolute terms, as a share of GDP it remains at its lowest level in more than 20 years, at just 19.5 percent,” they write.  “Without a return to stronger investment, especially (but not only) corporate investment, Europe will continue to lack a motor for sustainable economic growth.  If overall investment levels were to return to their pre-crisis proportion of GDP by 2020, we estimate that European GDP could expand by an additional €1 trillion in 2030, or adding 5.7% to baseline GDP.[13]”  
After Emmanuel Macron’s victory in France’s elections in May, investors have accelerated their purchases of European equities, raising inflows through mid-July to more than $26bn, according to a financial data provider EPFR.[14]   But there hasn’t been a similar escalation in capital investments, those used to modernize and/or expand production of goods and services.
Investor Flows into European Stock Funds Accelerate
Source:  Eric Platt and Joe Rennison, “Investors turn from US to European stocks.”  Financial Times, July 20, 2017.
What is attracting investors is the low valuation of European stocks, as measured by the price-to-earnings ratio, compared to U.S. equities, a difference of roughly 55 percent according to one analysis.
Schiller P/E Ratio Suggests Europe Is 55% Cheaper Than the US
Source:  Olivier Garret, “4 Reasons European Stocks Will Make A Big Comeback This Year.”  Forbes, August 21, 2017. .
Ahead, Key Questions
In the months ahead, eurozone growth will be buffeted by many factors.  Will the rise in the euro curtail export growth and slice off a percentage of GDP growth that would have materialized if the euro remained lower?  Will the slide in unemployment continue at current pace, breaking the typical trend of past recoveries?  Will sovereign debt remain priced at current low rates as investors gain confidence in European governments’ abilities to control spending and stimulate their national economies?  Will investment in Europe ramp up to bolster productivity, competitiveness, and job growth?   The answers that unfold to these questions will give clearer indications of the breadth and duration of the recovery underway.

[1] Moody's, “Euro area to achieve above-potential growth over next two years as major economies accelerate.” Press release, August 30, 2017.

[2] SEB, “Nordic Outlook.” September 2017.

[3] Alessandro Speciale, “Draghi's Drama-Free Jackson Hole Message Reaffirms Slow QE Exit.” Bloomberg, ‎August‎ ‎25‎, ‎2017‎.

[4] ECB, “Monetary Policy Decisions.” December 8, 2016.  

[5] Paul Gordon, Chiara Albanese and Piotr Skolimowski, “Euro's Gain Makes for Eurozone Pain From Exporters to ECB.” Bloomberg, ‎August‎ ‎29‎, ‎2017‎.

[6] Mehreen Khan, “Eurozone economy grows at fastest pace since debt crisis.” Financial Times, August 1, 2017.

[7] PwC, “Global Economy Watch.” August 2017.

[8] See: J. Paul Horne, “Brexit Accelerates Business Exodus.” European Affairs, August 2017.

[9] See: European Central Bank, Investment and growth in advanced economies: selected takeaways from the ECB’s Sintra Forum.” August 23, 2017. The summary of this conference’s proceedings provides insights into the debate over the causes of the slow-growth trend.

[10] Antonio Afonso and Mina Kazemi, “Euro Area Sovereign Yields and the Power of QE.” ISEG Economics Department Working Paper No. WP 12/2017/DE/UECE. July 13, 2017. . Also: Harald Kinateder and Niklas Wagner, “Quantitative Easing and the Pricing of EMU Sovereign Debt.” March 2017. file:///C:/Users/JamesD/AppData/Local/Packages/Microsoft.MicrosoftEdge_8wekyb3d8bbwe/TempState/Downloads/me_sovereign_debt_2017.pdf. Franck Martin and Jiangxingyu Zhang, “Impact of QE on European sovereign bond market equilibrium." March 15, 2017. The paper makes the point that an ending of QE in 2018 would not adversely affect sovereign debt rates. “[T]he probable cessation of QE from 2018 would not, from this point of view, lead a violent rise in interest rates.” For a historical survey of “helicopter drops” to start economic growth, see:

[11] Florian Urbschat and Sebastian Watzka, “Quantitative Easing in the Euro Area: An Event Study Approach.” Munich Discussion Paper No. 2017-10.

[12] European Commission, “August 2017: Economic Sentiment continues to rise in the euro area, broadly stable in the EU.” August 30, 2018.

[13] Jacques Bughin and Jan Mischke, “Reviving investment in Europe: How to explain (and overcome) continuing business reticence.”, August 4, 2017.

[14] Eric Platt and Joe Rennison, “Investors turn from US to European stocks.” Financial Times, July 20, 2017.