Monday, September 3, 2012

An inflection point for Europe?

In a post last week, I had written about how the ECB was getting ready to unleash a round of bond buying (see The "wealthy white people" come through). The actions of the ECB must nevertheless be regarded as a temporary, kick the can down the road solution.

The real solution has to come from the politicians. The issue that plagues the eurozone has long been characterized as a lack of competitiveness between the North and the South, which appears to be to be an intractable problem. The solution suggested by many non-European analysts has been a full-blown fiscal union and federal Europe.

ECB board member Joerg Asmussen outlined what the ECB's version of a long term political solution was in an interview:

The June report of the four presidents has already outlined four building blocks for the upcoming reforms. They provide a good basis for discussion represent the four elements are:

1.A financial Union
2.A fiscal union
3.A genuine economic union
4.A political union
The interview (via Business Insider) is well worth reading in its entirety.

Hard working Germans, lazy Greeks and Italians?
The ECB's actions are meant to buy time. Surprisingly, the time that the ECB bought may have brought some genuine progress on the labor cost front. An article in Der Spiegel indicates that the disparity in labor costs between the North and South is falling [emphasis added]:
For the past three years, there has been little in the way of good news coming out of Southern Europe. But, on Wednesday, a new German study provided a rare glimpse of hope, suggesting that the crisis-struck countries may finally be turning the corner.

The study by the Association of German Chambers of Industry and Commerce (DIHK), commissioned by the Financial Times Deutschland newspaper, showed that the countries in crisis are becoming more competitive, based on two key indicators.

According to the study, unit labor costs have fallen significantly in Greece, Ireland and Spain. Labor costs particularly fell in Greece, dropping by about 15 percent since 2010.
Analysis from Richard Koo of Nomura Securities (via FT Alphaville) confirmed a similar decline in unit labor costs. Koo sounds positively giddy that the Greeks have little incentive to exit the euro [emphasis added]:

Koo pays particular attention to Greece — as if you take away the benefits of devaluation on competitiveness, you lose a large part of the argument for a Grexit.

Greece will continue to make progress:
That trend, says Koo, implies that Greek inflation and unit labor costs will continue to fall, and in fact unit labor costs have already dropped more than 10 per cent since the 2010 peak. Given the time lag between changes in the money supply and their impact on prices and unit labor costs, he anticipates further declines in the latter.
So much for the stereotypes of the hard working German and Dutch and lazy Greeks, Italians and Spaniards sitting around in the sun.

Political progress
Commission President Jose Barroso also announced last week that legislation to establish a banking union for the eurozone will be introduced September 12 (the day the German Constitutional Court makes its ESM ruling):
Legislation to establish a banking union for the eurozone will be tabled on 12 September, European Commission President Jose Barroso said in a speech Thursday (30 August).

Speaking at the Aspbach Economic Symposium in Austria, President Barroso described the step, which is expected to see the Frankfurt-based European Central Bank given extensive powers to supervise and intervene in the European banking system, as "the next concrete and immediate deliverable of our vision to generate confidence in the future of the euro area".

However, with Britain and other non-eurozone countries likely to opt-out of the system, the union is expected to focus on the single currency areas.

China continues its support
What's more, Chinese Premier Wen Jiabao continues to voice his support for Europe:
Wen said Beijing is willing to continue supporting the debt-stricken euro zone, and will step up talks with the European Union, the European Central Bank and the International Monetary Fund -- also known as the troika -- to help struggling EU nations.

"China is willing, on condition of fully evaluating the risks, to continue to invest in the euro zone sovereign debt market, and strengthen communication and discussion with the European Union, the European Central Bank the IMF and other key countries to support the indebted euro zone countries in overcoming hardships," he said after meeting Merkel.
Though the support is not unconditional and he has his doubts:
Premier Wen Jiabao told German Chancellor Angela Merkel that Europe must "strike a balance" between fiscal tightening and measures to promote growth. "Europe's debt crisis has continued to worsen, giving rise to serious concerns in the international community. Frankly, I am also worried," he said.

His comments mark a shift in Chinese policy. Beijing has until now backed austerity across Euroland, but the severity of China's own downturn has begun to rattle policymakers.
However, with the combination of ECB's support and the signs of genuine progress on the political and economic fronts, the funding costs of the eurozone periphery should gradually start to fall.

This is indeed good news (instead of the temporary "kick the can" variety). If Europe is really starting to heal, then this could be the start of an inflection point for Europe. Investors should be prepared for a melt-up in beaten down European equities and other risky assets some time in the near future.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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