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Sunday 20 October 2019

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Europe: coming full circle

Written by Stuart Mitchell
March/April 2011

Stuart Mitchell explains how the German recovery could mean there’s light at the end of the tunnel for Europe’s economic stability

A good deal of attention has been paid to surging gov-ernment debt in developed economies, and rightly so. Govern-ment debt stands at 93% of GDP in the USA, 69% in Germany and 87% in France – levels which would have been unthinkable a decade ago.

Look again at the numbers. On the face of it they look not too different from each other. But they tell only a part of the story. It isn’t just governments which can run up debt. So too can households, andso too can the corporate sector. Add this indebtedness in, and a startling gap shows up. The core European economies of Germany and France now come in at 198% and 205% respectively; the corre-sponding figure for the USA is no less than 316%.

Many commentators have missed this much stronger financial position of the European core, allowing themselves to be diverted by talk of a possible break-up of the Euro, and above all the dramatic woes of its periphery. We think that Germany is at the beginning of what is likely to be a multi-year period of vibrant economic growth. Some of you may remember the persistent calls in the 1970s for Germany, then West Germany, to act as a ‘locomotive’
of growth, calls largely unheeded (perhaps because one of the voices was that of Jimmy Carter). This time, though, the train really is about to leave the Bahnhof.

This German economic revival is emerging as a result of the long period of sluggish growth which followed the reunification boom in the 1990s. While Germany struggled to de-leverage over this period, the edges of Europe boomed, low Euro interest rates revving up growth following the introduction of the common currency. The Irish economy more than doubled in size after 1995, while Germany expanded by a meagre 16%, well short of the 27% growth achieved by the EU economies as a whole. Levels of German investment at home fell to the lowest in Europe, and German capital was pushed out to the periphery, providing the fuel for Slovak property prices (to take one example) to rise by 80% from 1996, while German property gained a paltry 16%.

This is now, of course, all over. German banks, instead of financing property development in the south of Europe, will increasingly invest savings domestically. The funds are available for what may turn out to be one of the most vigorous growth periods seen in many years.

The corporate sector will have the appetite. At the same time as corporate Germany was de-lever-aging, it was also dramatically addressing its cost base. Between 1995 and 2009 German unit labour costs rose by only 8%. Ireland’s grew by 130%. In the many meetings we have held with German company managements we are again and again struck by the market share gains which many companies
have been making internationally. Volkswagen, for example, has over the last two years added two per-centage points to their global market share (to around 14 per cent), to take them close to being the world’s largest car maker.

Recovery is already taking hold. German unemployment barely rose over the recent crisis, and is now near a post-unification low, a sharp contrast with the experience of many other countries. The highly-regarded Ifo Institute’s Business Climate Index reached a two-decade high in January. Nor is this recovery confined to Germany. Other core-Europe economies are benefiting – French manufacturing industry sentiment, as measured by INSEE, is at a 10-year high. Statistics from Belgium paint a similar picture (even while Belgium has had to manage, since June 2010, without a government).

But what about the periphery?
Our assumption is that the Euro survives. Leaving the Euro is simply not an option for the peripheral economies as their various banking systems would inevitably collapse under the weight of falling govern-ment bond prices. Whatever combi-nation is needed of deep structural reform, and of austerity, will be applied. The austerity will be applied with as much force as the periphery can take. The task will be made easier (well, less hard) by the fact of revival taking place in the core economies.

But more important is the bit that doesn’t get the air time it might: the fact that we are at the start of the road towards an ‘ever-closer union’ in fiscal and credit terms. What we mean, in plain terms, is the accept-ance of responsibility for European economic stability by its economically stronger members. The lack of air time is driven by the lack of desire to tell German (and other) tax-payers that they have become this stability’s ultimate guarantors, but also by the lack of desire by those nominally in charge of the economic destiny of the periphery that their control has become just that – nominal. Nor is the cause of clarity helped by the habitual manner of European decision taking. It would not want to crow about it, but this is the triumph of the Bundesbank. That is the reality of the current situation.

The road ahead will not be straight: there may well be some debt restruc-turing, which will undoubtedly spook markets from time to time. The flow of fiscal aid may well be called something else, and its operation denied. But the engine of recovery is undeniably running.

In this light we find European stock markets curiously inexpensive. Trading on ten times prospective earnings, cheap even, especially compared with a US market on fourteen times earnings. And stranger still, given that the average European company generates a similar return on equity to its American counterparts.

And who knows – with Europe now starting, in however a muddled and muddling fashion, to face up to restructuring in response to the crisis, the Euro could even strengthen against the dollar.

Written by Stuart Mitchell, Founder and Investment Manager at SW Mitchell Capital



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