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What have we been up to


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Markets shrug as European fragility starts to return

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As JCRA’s German-in-chief (which is quite an easy role to attain, given that I am the only one) it seemed only natural that I should write the first European Market Briefing following the German election, in an attempt to say something more or less intelligent about it. But, boy, that seems like a dull topic given Macron’s speech last week on his vision for Europe and the Catalan referendum this last Sunday!

So, I won’t comment on the worrying success of the far-right Alternative für Deutschland (AfD) or the crushing loss of votes experienced by the two main parties, Merkel’s CDU and Schulz’s SPD. Instead, I’ll offer a few thoughts on what I think the German election results mean for Europe. This seems more apposite in light of the noises coming out of the Elysée Palace and what is going on in Cataluña at the moment. Long story short: I don’t think it bodes too well.

The unified and borderless Europe I grew up in is a wonderful place. However, even a Europhile like me can’t help but admit that it now looks fragile and economically vulnerable. At the very heart of the problem lies an incomplete currency union without fiscally integrated economies. In principle, there are three potential ways of fixing the common currency. The first is to do nothing at the supranational level, and hope that the countries converge from an economic perspective to the point where they exhibit similar levels of competitiveness and preferences for inflation and employment. This is something that has been attempted for the last 17 years, resulting in mindboggling (youth) unemployment in the periphery while Germany’s trade surplus runs at 8% of GDP. The second option, unlikely for political and practical reasons, is to admit that the euro doesn’t quite work as envisaged and attempt to unwind it with the least possible disruption. The third way is to face reality, admit that what’s done is done and initiate reforms for fiscal integration. Whether this implies simply having a banking union and common deposit insurance scheme or a full-blown mutualisation of debt - including a European finance minister - I will leave to others to decide. At the very least Europe’s too-big-too-bail problem needs to be addressed, and a banking union would be a good start.

Reform in Europe is always tricky; but historically, agreement between Paris and Berlin has been crucial. When France voted liberal, pro-European Emanuel Macron into office, the chances for European reform increased significantly as a Merkel victory in Germany’s parliamentary election was pretty much a done deal. With Macron and Merkel as the dream team leading Europe into a brighter future, hopes were high.  

Make no mistake, however: the new German parliament is notably less pro-European than the one it will replace, and assuming that Merkel will build a coalition with the Liberals and the Green Party, as is currently being discussed, the next government will be much more Eurosceptic than the grand coalition between Merkel’s CDU and Schulz’s Social Democrats. Yes, the internationalist Green Party has argued for debt forgiveness for Greece; however, the Liberals, while proclaiming to be “pro-Europe”, are also “pro-fiscal responsibility”, which doesn’t strike me as overly supportive for a fiscal union. Unless the Social Democrats make an about-face and renege on their stance of never governing with Merkel again, I find it near impossible to see how the next German government can join Macron in taking steps towards further European fiscal integration.

While we Germans are busy figuring out who is going to run our country for the next four years, 90% of the 42% of all Catalans eligible to participate in last Sunday’s referendum on independence voted “yes”. No-one seems to know what this means or what will happen next. That said, a constitutional crisis in Spain is the last thing Brussels and the European elites need at this moment, which is probably why they have been noticeably silent regarding the occurrences in Barcelona, and the Spanish government’s questionable way of ‘addressing’ the Catalan referendum.

And then there is Macron, who last week gave a passionate speech on the future of Europe, which couldn’t be more ironic in light of the obstacles to his vision re-emerging across the continent. Admittedly, the EMU has had a good run lately: economic growth has been accelerating; employment increasing and signs of inflation can finally be seen on the horizon, yet it looks like fragility is slowly staging its return. So how have markets reacted thus far?

Fairly mutedly, I’d say. Following the German election, the EUR sold off slightly against the USD and GBP, dropping about one big figure from 1.1951 to 1.1848 and 0.8850 to 0.8798 respectively; Bunds rallied by 5bps down to a yield of 0.40% (they are now back at 0.45%). European stocks were more or less unfazed by the outcome of the German vote and have kept advancing since. One may think that the turmoil in Spain might get the government bond market worried, and indeed 10-year yields on Spanish government bonds shot up from 1.60% to 1.69% on Monday. Bonos have sold off further since, with yields currently in the 1.78% area. But what does this really tell us?  Markets clearly haven’t pressed the panic button yet given that Spanish govvies were trading at around 1.90% earlier this year (although this was arguably driven by the Trump reflation trade).

For the time being, it looks like the encouraging economic data coming out of the common currency area is fending away any concerns over Europe’s future that might start to take hold again in light of recent events. And why not? If the world economy keeps performing and spares us a global recession, I don’t see why the EMU shouldn’t continue to recover, even in the absence of any meaningful reform. Yet one doesn’t need to be a doomsday prophet to assume that at some point in time an economic downturn is inevitable, and the question then becomes whether Europe will be prepared for this. It probably won’t, which is why we will likely find ourselves once more in a situation where national governments and parliaments, the ECB and Brussels are scrambling for haphazard fixes. With Macron in office, a German government with a strongly pro-European mandate could have paved the way for European financial and fiscal reform, but the German electorate chose otherwise. A squandered opportunity, but for now without consequences. 





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