Trouble in the Eurozone

Author: Bill Witherell, Post Date: September 9, 2008

The 10th anniversary of the January 1, 1999 launching of the euro is approaching.  However, the celebrations are likely to be tempered by the sluggish performance of the 15 European economies that have adopted the euro as their common currency (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain) and other countries with currencies pegged to the euro.  The prospects for the Eurozone economies have clearly worsened following an unexpectedly strong first quarter.

The euro-skeptics that predicted that the largely political decision to launch the euro would founder in the absence of the economic conditions thought necessary for a common currency area have been proven wrong at least thus far.  On the other hand, it is not evident that the euro has made a significant contribution to the region’s growth or international competitive position. The Bank for International Settlements (BIS) reports that the euro’s role in the foreign exchange market is pretty close to just the sum of its parts (the former national currencies of the Eurozone members).  The same can be said of the euro’s share of official reserves.

Our focus in this note is on the region’s economic performance.  When a country adopts the euro as its currency, it must cede control over the nation’s monetary policy to the European Central Bank (ECB).  Thus the ECB calls the tune for all of the 15 Eurozone economies – from Germany to Malta – and it can not differentiate among these economies. One size of monetary policy must fit all, regardless of the situation in the national economy.  A further constraint on policy flexibility is the fact that the ECB has only one policy objective in its mandate – to maintain price stability, which they interpret to mean inflation rates below but close to 2% over the medium term.  This does not mean the ECB must ignore economic growth or employment conditions, but combating inflation must be its over-riding priority.

Earlier this year the Eurozone economies were registering healthy growth and economic policymakers were proclaiming that Europe would escape much of the crisis in credit markets and the slowdown underway in the US.  The ECB’s single-minded focus at that time on the inflationary threat from surging global prices for oil and other commodities looked appropriate. 

As the credit crisis spread to Europe and European banks encountered funding problems, the ECB moved promptly to provide extra liquidity but did not reduce their policy interest rates. Indeed, in July, following a quarter in which the German economy actually declined and many economic indicators were heading south, the ECB increased ECB interest rates by 25 basis points, citing risks to price stability.  In their latest, September 4, press statement, the ECB left rates unchanged.  They recognized the "weakening of real GDP growth" but still emphasized "continuing upside risks to price stability."  It appears that ECB interest rates will remain on hold at their current relatively high level for the next several quarters, despite the weak economy.

The ECB does have more reason to be concerned about persistent inflation than do the US monetary authorities.  The Eurozone’s markets – particularly the labor markets – are considerably less flexible than is the case in the US. This means that inflation, once it takes hold, is considerably more "sticky" than in the US.  While the global prices for oil and other commodities have backed off from their recent highs, underlying inflation in Europe continues to rise and is likely to remain well above the ECB’s "comfort level" for some time.  Higher wage inflation and slower productivity growth will combine to boost unit labor cost by some 3 percent this year.  The deteriorating inflation picture will prevent the ECB from moving to a more pro-growth policy stance unless a serious recession should appear to be likely.  A more likely outcome appears to be an extended period of essentially flat economic activity for the Eurozone.

The implications of this economic scenario for Eurozone stocks are not promising. In addition, investors have to consider the implications of the Russian invasion of Georgia and subsequent deterioration in Europe’s relations with its large neighbor to the east. These events have underlined the region’s dangerously high dependence on Russia for its energy needs. International and domestic investors have retreated from Eurozone equity markets and from the euro. The MSCI index for the Eurozone’s equities markets is down 27.3 % year-to-date (Aug. 8); and the MSCI indices for Germany and for France are down 27% and 24%, respectively.  In contrast, the MSCI index for the US stock markets is down only half as much, 13.5 %.  This is a reversal of Europe’s relative outperformance last year, when Eurozone’s equities rose by 18.7%, Germany’s by 32.5%, and France’s by 10.9%, while the US index rose by only 4.1%.

Despite the declines in Eurozone equity prices, we do not yet find European valuations attractive, relative to those in North America or Asia. The prospects for earnings in Europe’s sluggish economy with rising cost pressures are not bright. The weakening of the Euro, if sustained as we expect, will eventually help Europe’s exports, which have suffered under the recently high value for this currency. The immediate effect of a lower euro/US dollar rate, however, is to reduce earnings translated into US dollars, which is the relevant measure for US dollar-based investors.  We expect the latter effect will be dominant during most of the remainder of this year. In view of these prospects, we have scaled back the weight of Eurozone ETFs in our international and global portfolios.

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