The crisis might be over, but Europe's problems persist
Serious Money:Major stock market averages across Europe enjoyed a significant upward move during the second half of last year as bold action by the European Central Bank (ECB) erased fears of a euro break-up.
The reduction in systemic risk allowed for a significant drop in yields across sovereign bond markets in the troubled periphery. Investors’ renewed love-affair with risk assets began in July after Mario Draghi, the ECB’s president, said that the monetary policymaker was “ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.
The shift gathered momentum in the autumn, following the announcement of the central bank’s latest unconventional policy, known as Outright Monetary Transactions (OMT), which implied that the ECB was ready at last to accept the de facto role of “lender of last resort” to governments.
All told, European stock prices jumped almost 27 per cent from their depressed levels last summer to their high point for the year towards the end of December. A continuation of the risk-on rally through January brings cumulative gains to more than 30 per cent.
The outsized performance has not deterred most market commentators, who believe the worst of the crisis is now behind us and that further advances in stock prices can be expected in the months ahead. But is the optimism justified?
It is beyond dispute that the bears underestimated the political will to save the single currency. But even the most ardent bulls cannot claim that economic performance has been anything other than disastrous. Indeed, the euro zone entered its second recession in four years during the third quarter of last year and most macro-data point to a deepening of the contraction during the final three months of 2012.
Importantly, economic output languishes well below its pre-recession peak in the euro zone while activity in the US, the original source of the global financial crisis, has expanded to new highs.
Further, real economic growth in the US outpaced the rate of GDP increase in the euro zone by the widest margin since 1993 last year, and the divergence in economic performance is set to persist in 2013, even though the US is currently enduring its weakest recovery/expansion in modern history.
The euro zone continues to sport debt ratios, both public and private, that will weigh on growth for several years, and could well result in long-term economic stagnation or permanently lower growth.
The unsustainable level of sovereign debt in many member countries is well documented, but the high level of private-sector debt across much of the union is less widely reported, even though stress in the latter sector was a key factor in precipitating crisis in the former.
Importantly, the deleveraging cycle in the non-financial private sector has barely begun. As a result, neither households nor businesses are likely to provide any significant boost to domestic demand that could potentially offset contractionary fiscal policies.
Indeed, private-sector debt relative to GDP has dropped just five percentage points from the peak set in the second quarter of 2010, and the current reading of 210 per cent remains 35 percentage points above the level that has been demonstrated to retard growth.
The private sector’s desire to reduce its debt ratio is not difficult to understand given the magnitude of the economic decline during the Great Recession. As a result, the sector’s financial surplus remains at abnormally high levels relative to GDP in many countries.
However, efforts to repair balance sheets continue to be hampered by contractionary fiscal policies across much of the region, as stagnating household incomes and lacklustre growth in corporate profits keeps debt ratios high.
Furthermore, growth is also being restrained in the union’s relatively “bright spots” by the continued tightening of lending standards among the region’s banks, as the financial sector’s own deleveraging cycle remains far from complete. Indeed, the banking sector’s equity cushion persists at historically low, and potentially dangerous, levels in countries including Belgium, France, Germany, Italy, Portugal and Spain. All told, the dismal economic background has pushed the unemployment rate up to a record high of close to 12 per cent, while private sector investment has dropped almost 17 per cent over the past five years.
The optimists may well be right that the worst of the euro crisis is now over, given the political determination to avoid the unthinkable – a destructive exit of a member country from the single currency. However, a return to robust economic growth is unlikely anytime soon, and as a result, the euro zone’s woes remain far from over.