Is Europe really lagging?

Three reasons to question the consensus

Reporting of the fiscal policy responses to last year's crisis tends, unsurprisingly, to focus on the big headline-grabbing announcements. The UK and US have surely been far more aggressive in terms of headline policies. But why is that? What commentators often miss is that the scaled-down unemployment benefits and welfare systems of the UK and US generally mean that, having become unemployed, a citizen can quickly descend from leading a comfortable first-world affluent life-style to having to live off savings or an income close to the bread line. This is also true in most emerging markets.

In much of Continental Europe the transition from employment to unemployment is far more gradual. In France, workers receive a substantial payment on redundancy and the state pays nearly two thirds of their income for 18 months. In Germany, the Kurzarbeit system (reduced time working) has been criticized for 'hiding unemployment' by allowing companies to reduce the working week, with the state making payments to top up workers' income as if they were still working full time. In fact the policy makes perfect sense. Under the German welfare system an unemployed worker costs the government so much that it is better to pay to keep them in work, and to give the company time to decide how much capacity they will really need in the long run.

Meanwhile, in Italy hardly any new fiscal policies have been announced - but the welfare policies are so generous that the additional fiscal spending in relation to these alone is enough to make its increased fiscal expense second only to the US in relation to its economy!

These welfare nets are sometimes refered to as 'automatic stabilisers' by economists because they act as automatic buffers in a slowing economy. No new headline grabbing policies are required. When economists take account of these non-discretionary increases in government spending in Continental Europe, in fact the overall response of government spending as a proportion of GDP is comparable to the other major developed economies.

This is one reason why consumer confidence and consumer spending in Europe has been relatively resilient during the crisis. Households do not have as much to fear from unemployment and they did not come into this crisis with huge debt burdens. However, the European consumer has never been as important to European economic wellbeing as their counterparts in the US and UK. The real challenge has been the unprecedented collapse in exports and world trade.

The perception is that the ECB has been an outstanding laggard in its policy responses, that it lacks a clear mandate and that it has too many people (22) sitting on its governing board to enable it to be aggressive.

How then do we explain the ECB's €442bn fiscal injection on 23rd June? In an unprecedented single-step easing of monetary policy, it conducted a one-year 'repo' by which banks could deposit a very wide range of assets with the ECB for a year in return for cash at a borrowing rate of just 1%. That is equivalent to 10% of the eurozone's narrow money supply being made available in one day, or €1,300 per eurozone citizen. 1,100 banks benefited from this largesse. Quietly, but effectively, the ECB has been flooding the system with liquidity from the onset of the crisis. Its balance sheet is actually now bigger as a proportion of eurozone GDP than the Fed's as a proportion of the US economy.

If the ECB has been so aggressive, why is there a popular perception that it has not? The answer is simply because that is what the ECB wants the world, especially bond and currency investors, to think. Based in Frankfurt and modelled on the Bundesbank, the ECB regards a strong currency and inflation credibility as indispensable in good central banking and the maintenance of sound money. Having so many national governments to answer to also gives it a unique freedom: Europes' central bankers can do what they think is best because they have no single government to report to.

Just two weeks before this huge liquidity boost, the ECB released a report suggesting that the European banks would reveal another €283bn in losses by the end of 2010. The losses would be split between further security write-downs and traditional loan losses. This is alarming given that the European banks have not had US style 'stress tests' and have clearly fallen behind in raising new equity.

Well, it would be alarming if the bulk of the losses were going to come from the large quoted banks. If the crisis so far is anything to go by, non-quoted banks (particularly the German Landesbanks) are sitting atop an array of toxic (or potentially toxic) assets, and the record so far suggests that it would be taxpayers rather than the equity markets that would foot that part of the bill. Finally, it is worth mentioning that banks tend to go bust owing to liquidity struggles (that was what undermined Lehman Brothers in the US and Northern Rock in the UK) rather than because of loan losses, which tend to build up more gradually and allow time for remedial action. The ECB has just made sure that European banks have unlimited amounts of cheap liquidity through to the summer of 2010.

In late 2007 we wondered why European equities were following US and UK equities down measure for measure. Surely with less leverage in the financial system (we know better now) and ever-growing trade with the BRIC countries (Brazil, Russia, India and China) and other emerging markets there was a case for Europe being able to decouple from its "Anglo Saxon" peers? However, within six months, European corporate earnings began to track US earnings downwards. We learned a lesson: do not mistake a time lag for a changed relationship; the equity markets were never fooled.

Economic data appears now to have stabilised or to have started to improve in other parts of the world: the US, UK, Asia, Latin America - but not so much in Europe. Yet the equity markets are rallying just as much as in those other regions. The equity markets are effectively saying that 'greenshoots' around the world are likely to benefit Europe's enormous export machine as well, just with a time lag.

IBES consensus earnings forecasts for the US market are actually being revised upwards now, while for European corporates the downgrades are slowing markedly. Is it therefore just a matter of a few months before we start to see upgrades in Europe? The average European blue chip company is much more globally diversified than its US or UK counterparts so, if the global improvements are real, underweighting the European corporate could be a dangerous consensual calculation.

European equities have looked cheaper, but not very often. Generally, depression, deflation or double-digit inflation and interest rates have been required to drive valuations lower. The chart below shows how attractive the dividend yield looks in relation to bond yields, and of course comparing the market to the yield on cash is even more flattering. These comparisons have their flaws, but they do suggest that, if the deflation risk has really gone, asset allocators may need to make a very large switch into equities at some point.

The long-term headwinds presented by deleveraging (the repayment of debt) persist and will do so for many years to come. However, the overall policy response has been both unprecedented in scale and global in scope. Europe has been a part of this. To the extent that economic data elsewhere in the world has been improving, Europe has clearly lagged. However, this is attributable to a disproportionate dependence on exports, and export activity will only improve with a lag. Europe's very globally diversified blue chip companies should benefit fully from any upturn. The equity market is not being fooled by the time lag.