The Cyclical Recovery in the EU

In his 1992 New York Times bestseller Head to Head, The Coming Economic Battle among Japan, Europe, and America, Lester Thurow, a respected American economist who was the Dean of the MIT Sloan School of Business at the time, attempted to predict which of these three economic blocks’ economies would dominate the 21st century. He chose Europe over the US and Japan. We are in the third decade of the 21st century and chances are he is not going to be right in his assessment. Also importantly, he totally missed the ascent of China, a country that has become a strong candidate for that prize. This is a very good example of why it is very difficult to make predictions, especially about the future.

The EU is beginning to resemble Brazil in the sense that it is the country of eternal missed promise and opportunity. Like Brazil, the EU offers stark regional differences in development and culture. Large swathes of the EU also suffer the cost of political corruption and weak civil society institutions. There are even some regions within the EU where, as is the case in Rio de Janeiro, we could argue there is a failed state, as the Government does not hold a monopoly on violence. Also like Brazil, the Eurozone subset of the EU is doing its best to debase its currency with a financial repression policy that is as ineffective as counterproductive. The EU is the centre of attention for the investment community again because the cyclical nature of its listed companies is fashionable just now and it has a large and growing Environmental industry centred on renewable energy utilities and equipment manufactures. We cannot bring ourselves to share in this bullishness built upon the illusion that one may recycle risk from growth to value and continue to make good investments. On the contrary, we will contend that most of these companies are low growth low return on investment businesses, and thus will not be great long-term investments. We contend as well that the current rerating will prove to be unwarranted in many cases, especially in the case of bank stocks, and that, as was the case in the previous dash for trash rally of 2013, many tourists will get a bloody nose and their wallets picked.

In addition to these macroeconomic and idiosyncratic risks, there is a looming political risk with critical elections in Germany and France taking place within six months from October. These two countries’ potential new leaders —at the very least Germany will have a new leader— will have the responsibility to shape the future of the EU. Voters in both of these countries may return candidates who are very different from Angela Merkel and Emmanuel Macron. Many people expect a Grand coalition in Germany, which we may safely assume, will be pro-integration with some important caveats as has been the case for decades. Conversely, the French electorate may open a can of worms because not all is swell in the hexagon.

Some people may have been surprised with Nicolas Sarkozy’s conviction on corruption charges, not us. It is neither the first time a former President of the French Republic is convicted of a felony, his fellow party member Jacques Chirac beat him to it, nor was Sarkozy’s conduct ever exemplary. Allegedly, he received illegal campaign donations form Liliane Bettencourt and Muammar Gaddafi. For all his dynamism and grinning, this French leader had a penchant for getting into trouble from the get go. Even before his inauguration, the press feigned to be shocked because he went on vacation on Vincent Bolloré’s yacht for a much-deserved vacation following an exhausting campaign.

Were you to think that we hold a grudge against him, you would be right. For Sarkozy, alone among global leaders, turned around the cause and effect of the Great Financial Crisis in detriment of our industry. He surprised most observers when he posited that the solution to the crisis was stricter regulation of hedge funds, not banks mind you, but hedge funds. This insight was his contribution to the first G20 meeting in Washington DC in November 2008. How did he come to such an extraordinary conclusion? One cannot be sure, but we dare venture a hypothesis. On the one hand, some of his backers, e.g. Vincent Bolloré, do not like the probing questioning on their management of public corporations characteristic of hedge fund managers. Some business people cannot be bothered with the obligations that result from controlling and running a public company. On the other hand, the large French banks were going through a near death experience at the time, largely because they were cut-off from the US dollar commercial paper market because some hedge funds questioned their solvency. These investors may have jumped to conclusions in their analysis of the very thin layer of capital that covered creditors from any losses in the loan book, the securities book, or very large derivatives positions but the damage was done, the Grandeur was questioned, and these banks ended up selling their US dollar funded businesses in distress.

In any case, the corruption that plagued Sarkozy’s party (the UMP) opened the door to Macron’s success to capture the centre right vote. Sarkozy for all his good intentions and braggadocio accomplished very little and spent most the European sovereign and banking crisis laying low just in case anybody noticed that France also had some deep structural issues. Unfortunately, President Macron has not proven to be the great engine of change and progress that his backers voted into office. The mob has often-ruled France and Macron’s term in office is no different from the past. Unfortunately for the European dream, Marine Le Pen is the emerging alternative. As of today, she leads the polls for the Presidential election of April or May 2022. She leads not just in the first round but also in all second round face-offs. The EU Commission’s handling of the vaccination will be one of her best arguments to win on an anti-EU platform.

The EU is a recreation of the Age of Enlightenment’s politics, not so much in its content as in the form. It is a top down political construct designed by professional politicians and bureaucrats to stifle an EU level democracy from the crib. It is also a Marxist arrangement in the spirit of Groucho, not Karl. This Union has no enduring principles. Politicians and bureaucrats address each crises with ad hoc policy responses. Investors and the business community deplore these tactics but they make policy wonks very happy. The framework does not respond well to problems, as there was not much planning for contingencies.

The euro is the best example of the wishful thinking that passes for building a more perfect union. Most Europeans, except for those in more open and democratic societies such as Sweden, Denmark, or the UK, were cajoled into accepting a single currency as a political target throwing caution to the wind on such important matters as whether it made economic sense to do so. The euro area is very far from meeting the characteristics that economists associate with optimal currency areas and it shows. In addition, there was no plan for the rather frequent events of bank failures or sovereign financial crises. In terms of economic growth, wage growth and employment the euro has been a success for Germany and a few other northern countries, and a catastrophe for many of the periphery countries. Nominal GDP per capita was 22% lower in Greece in 2019 than in 2008 even before the pandemic[contexto id=»460724″] ravaged the economy again. Italy’s GDP per capita has stagnated since 2007 while it is slightly lower in Spain. Conversely, it is up 8.8% and 16% in France and Portugal respectively. It is a mixed bag of mostly anaemic growth but importantly for the near future, government debt has grown faster than incomes in all of these countries.

Try as you might, you will not find an EU version of the Federalist Papers. The EU’s founding fathers were full of good intentions following a war that all these countries had lost, France included in spite of the national delusion that they were part of the winning side. The Federalist pro-EU faction is also acutely delusional. They will argue that the process of EU integration needs crises such as the pandemic to advance. They see the NextGeneration Fund as the precursor to sovereign debt mutualisation. They see the weak form of banking union rules as a banking union. These Pollyannas also believe that because there has not been a war between Germany and France for 80 years we are going to have a political union soon.

Back in the real world, many EU citizens are probably scratching their heads as they sit-out yet another lockdown wondering how is it possible that the UK, a country they were told was destined to sink in the ocean blue following Brexit[contexto id=»381725″], is vaccinating its citizens at such a fast rate. Some of them may also wonder why the EU Commission did not focus on developing vaccine supply security instead of worrying about setting industrial policy targets for the EU reconstruction funds. A few may even understand that the relaxation of the fiscal rules for one more year is another way to kick the can down the road. The argument that debt levels do not matter when interest rates are so low misses the point that financial repression is a tax on savers, and so far, savers in the euro zone have consumed less and saved more in response, thus increasing the output gap, perhaps permanently. This high Eurozone savings rate is also a problem for the global economy as it is a brake on the global recovery.

The very low age of retirement in the Eurozone is another contributing factor to low productivity growth especially in the periphery. While in the US a 55 year old has reached her mid-career point, over in the Eurozone, many companies try to gain efficiency by sending employees in their fifties into early retirement schemes with Government support. Ageism is morally wrong and self-defeating, it is also the result of rigid labour laws designed to protect manual labour from abusive practices in the first half of the 20th century. These restrictions are ill suited in a knowledge-based economy and yet very little is done about it other than to agree it is a problem.

To summarize, the Eurozone is a rapidly ageing, generally un-innovative, low growth, and as result of all three factors a much-impoverished region of the world in relative terms. Mercantilism and anti-liberalism are very popular here. Eurozone politicians believe they will fix these problems by choosing winners in industry and financial services, raising tariffs with schemes such as carbon footprint penalties or by creating new taxes, such as the Google tax, or by becoming the regulatory centre of the world.

We cannot see how this is going to work any better than all previous attempts and we all see more room for corruption. Experts recommend buying cyclical stocks to capitalize on the end of the pandemic including Eurozone banks. We still have fresh memories of the previous bout of cyclical recovery dash for trash in 2013 and we see no reason to believe this rally will be any less misguided. The total return of the Euro Stoxx Banks Index since January 2013 is 0%. This return is largely a function of survivors bias as the index weight of a large number of zombie banks keeps getting smaller; on an equal weight basis, that portfolio is deep under water.

Thus, 2021 may play out as a transition year. By year-end, we will also have more data on how Brexit works for all parties. We will also see whether the cyclical recovery has any legs and whether the current enthusiasm is warranted. Scorn for minority shareholders is not an exclusively French problem; most European family controlled companies see them as a necessary evil. Some of these firms went public to avoid wealth or estate taxes for the controlling shareholders or as a back door to cheap bank funding. Access to equity capital markets reassures their bankers’ supervisors that these companies may tap this source of financing if needed. They are usually wrong to hold that view. In the interim, these families continue to run their businesses as they run their country estates. In addition, family members hold most key executive positions and independent board members are uniquely dependent as most of them are professional board members with no other source of earned income. Not surprisingly, most of these companies are subscale and not very profitable for public shareholders as the owner-managers milk them at will. Even very large companies suffer from poor management decisions and weak governance. When the late Emilio Botin passed in 2014, Banco Santander was the largest bank in the Eurozone by market capitalization. Six and a half years later, the book value per share has declined 22% and the book value has declined from €75 billion to €71 billion, even as management tapped shareholders for €20 billion in equity issuance while paying paid just €13.4 billion in cash dividends. Not surprisingly total shareholder return stands at a loss of 34.5%, including dividends reinvested in the stock. All things considered, we will sit this one out.