What started out as cracks in the edifice is starting to reach the foundations. While the European Union is highly unlikely to fail altogether, the post-war consensus for ever-deeper integration might have peaked. Meanwhile, stress points seem to multiply faster than the EU is able to solve them. For the markets, the stress points are emerging in three critical areas.
Economically, the outlook is grim. Unemployment just hit a record high. Industrial production continues to contract. Purchasing manager surveys remain weak. Retail sales are sluggish. And sentiment is uneven at best. When the financial crisis first hit, policymakers responded with fiscal stimulus. When that failed to turn things around, they tried austerity. Now the pendulum is starting to swing back the other way. Meanwhile, the divide between north and south is getting blurry: Greece and Spain are still struggling but now France and the UK have been getting weaker. Even Germany is beginning to sputter. There are a few bright spots, such as low inflation and a trade surplus, but they are getting hard to find.
Politically, the governing elites are embattled. France had a presidential election last year and the winner is already less popular than his predecessor. Italy had parliamentary elections earlier this year but has yet to form a government. Germany will have elections later this year; right now the chancellor is leading the polls but her coalition partners are not. The UK will vote in two years and the future for its current coalition is not bright. Historically, the leading parties across Europe had a shared vision of a united continent; where they have differed was in how united it should be and the best way to go about it. As the elites lose their edge from Finland to Greece and from France to Germany, smaller parties are rising in prominence with more radical agendas. And those agendas are going mainstream. The UKâ€™s government has promised a referendum on whether to leave the EU altogether. Such talk has always been on the political fringes; the difference now is that it is respectable.
Internationally, the third critical area, the European Union is now punching well below its weight. Even with its current ills, Europe is a leading global market with a highly educated and dynamic population. But in international affairs the EU is losing influence. The euro was intended to be a global reserve currency, but lately China has had better traction with its yuan. Carbon trading was to be Europeâ€™s signature policy contribution to curb global greenhouse emissions, but that initiative now lies in tatters. Vestigial over-representation in international bodies like the United Nations Security Council and the International Monetary Fund is not only anachronistic, it risks bringing those institutions into irrelevance as well. It is probably not a coincidence that trade talks at the World Trade Organization are paralyzed while regional trade agreements are blossoming across the globe.
Europeâ€™s markets have been doing reasonably well despite the headwinds, with some caveats. Borrowing costs for most of the continent remain low, partly thanks to the ECBâ€™s bond purchases. Credit default swaps show little risk of sovereign default, in part because regulators recently banned speculators from trading CDS. Equities have been rallying, even if they lag the US and Japan. The euro itself has strengthened against its trade partners, although that might be a reflection of relatively restrained policy at the ECB. The Fedâ€™s quantitative easing policies have been far more aggressive all along. And the yenâ€™s recent plunge shows what can happen to a currency when a central bank abruptly shifts policy. The ECB is expected to cut rates a modest twenty-five basis points at their next meeting. If EU policymakers change course to take bolder action and adopt their own version of Japanâ€™s Abenomics, the â€śDraghi Tradeâ€ť might see stronger stocks and weaker bonds combined with a sharp drop in the euro.
The bottom line is that for over fifty years the European Union had the luxury of evolving in an environment of relative prosperity, with strong elites, and a sense of common purpose and destiny as new institutions were created and its membership expanded. The results are now being stress tested. If Europe is able to negotiate its way through these stresses, as eventually seems likely, it will undoubtedly be stronger with a renewed sense of unity. If. As Roman emperors found centuries ago, an empire is built in pieces but must be held together as one.
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Warren Hatch, PhD, CFA
Chief Investment Strategist
McAlinden Research - a division of Catalpa Capital Advisors, LLC.