The access to cheaper interest rates and the availability of abundant capital inflows from abroad has eventually led to real estate bubbles in some countries (Spain and Ireland); to an excess of unproductive public spending in others, and to “easy lending” (corporate and retail lending) in other countries, which eventually have contributed significantly to the massive NPL (non-performing loan) problems in the Eurozone.
A number of countries who were no longer able to rely on their national fiscal and monetary policies after joining the euro, due to limited space in their budget and to the change of ownership of the monetary policy mandate from the local central bank to the European Central Bank (ECB), began to “use” the cheap real interest rates and their political influence in the attempt to boost consumption and economic growth through the national banking system.
The 2008 Crisis
Then, the financial crisis of 2008 abruptly sparked a systemic risk in the markets and caused a sudden and severe collapse in the financial markets, the freeze of the liquidity markets, and a severe slump in the real economy, thus ultimately accelerating the bursting of the asset bubbles in Europe, liquidity problems, credit crunch, and the fall in global demand and trade of products and services.
This dramatic and systemic event was almost the missing piece necessary to complete the process of divergence and imbalances that started in the Eurozone when the weaker economies failed to take advance of the stronger euro, cheaper interest rates and optimal market conditions to boost productivity enhancement policies in the early days of the euro and to close the gap with the more productive and competitive countries.
The real missing pieces that completed the crisis in Europe were the tough austerity measures, the dramatic fall in capital investments, and the persistent credit crunch which contributed in dragging the weaker economies into a prolonged recession.
Only when the ECB began to provide massive cheap liquidity when they introduced the QE program, and when they helped bail out ailing banks with the Troika (i.e. Spain, Ireland), or promised to protect countries from high spreads/high bond yields (speculation), and to avoid a potential exit scenario from the euro area with the famous “Whatever it takes” statement – offering the Outright Monetary Transactions (“OMT”), or creating with the European institutions the European Stability Mechanism (ESM) and the Single Resolution Mechanism (SRM), did these weaker economies start to recover.
The current scenario is much better. The economy is growing quite strongly in Europe: exports are increasing, and firms’ confidence levels are improving (PMI indicators). Yet analysts and investors should not forget that the ECB’s non-conventional monetary policies and cheap interest rates will not last forever.
Similarly, they should not forget that the massive liquidity offered by the ECB’s QE (sovereign and corporate bonds purchases) will not be available forever too. As it is today, the ECB’s nominal exchange rate has already risen to the highest level since December 2014, thus proving that the ECB’s QE effect on the exchange rate seems to be ending.
In fact, currently, the faster recovery of the Eurozone economy, and the uncertainty about Trump’s policies and the Brexit deal are strengthening the euro versus the US dollar and other currencies. Yet, a faster than expected monetary policy normalization by the US Federal Reserve, with rising interest rates and the unwinding of its huge Balance Sheet, might change the course of the US dollar trajectory versus other leading global currencies.
Nevertheless, Europe seems to remain on solid path to stronger recovery. A number of favorable economic conditions of the current economic cycle such as, lower crude oil prices and energy prices; improving manufacturing activities, the perception of greater political stability in Europe; the forward guidance of the ECB; and a gradual stabilization of the banking system in the region (except, in case of Black Swans), are contributing to increase confidence in the EU and Eurozone governance and to attract more foreign investments and capitals.
The financial crisis, the Great Recession, and the slow recovery have created a number of investment opportunities in Europe in specific sectors and countries due to a number of undervalued equities (alpha and beta opportunities). Thus, it looks like Europe is heading for a very exciting future scenario, unless trade wars, international geopolitical tensions, and unexpected internal and external shocks undermine the current favorable political climate.
European countries with high public debt and moderate GDP growth have to progress in their structural reforms programs, innovation and modernization of their economies (labor market, PA sector, internal competition, welfare systems, retirement plan systems, digital transformation, and so on) and should increase their levels of productivity and competitiveness, while also progressively reducing public debt and maintaining higher level of investments on innovation, education, R&D, and infrastructures, thanks also to support of the EU investment plans.
Things now seem to be much better than before, and there are good reasons to cheer about the recent positive development in Europe, yet investors should remain aware of a number of potential externalities that might affect the economic region such as: Donald Trump’s protectionist policies and potential tensions in the trade agreements, and the impact on the European economy of market deregulations and liberalizations in the U.S.; Other key relevant emerging factors to consider include: the “Brexit” and “Grexit” scenarios; asset bubbles (low interest rates for long, abundant liquidity, and credit-led growth), China’s corporate debt and shadow banking, and the emerging markets rising debt and rising concerns about bond market liquidity; tensions in the Middle East (Saudi Arabia, Qatar, Syria, Iraq, Iran), the complex issue of North Korea; Venezuela, Brazil, terrorism, cyber-attacks and bitcoin, and the potential ‘taper tantrum’ of central banks that might lead to dramatic sell-off in markets. Last but not least, also the risk of a potential correction in the US stock market. It is almost ten years since the US had a strong correction in the financial markets, and according to many analysts and commentators, many valuations in the market are already a bit stretched to say the least. Furthermore, the massive recourse to passive investment strategies and the heavy use of highly leveraged ETF’s intraday trading activities is likely to amplify potential risk in case of a sell-off and strong correction. The inflation rate in the U.S. is still below target, the yield curve is flattening, and the Federal Reserve seem to be fearlessly committed to progress with its policy normalization process and the unwinding of its huge balance sheet. Yet, one should probably also remember that probably by the beginning of next year the majority of its board members and the chairwoman of the Federal Reserve will probably retire or pursue a new career (Mauldin, 2017).
There are many good reasons to be cheerful about the future of Europe and about the new political cohesion and economic integration in the region, but analysts and investors should also remain watchful about how the future scenarios will actually unfold since the reform process can be quite long and challenging and, most of all, since meanwhile, a number of externalities in the global macro-environment might, directly or indirectly, somehow affect the inspiring vision and project that President Macron and Chancellor Merkel are bravely planning to undertake to “make the EU great again.”