Don’t be fooled into thinking that Europe is out of trouble and heading into calmer waters.
European markets have enjoyed a positive summer spell thanks to the QE balm being applied by the European Central Bank. For financial markets it is a clear case of making hay while the summer sun shines. But Europe could be heading into a winter of discontent later in the year.
Despite the ECB’s money printing extravaganza and the boon of negative interest rates, euro zone growth is losing traction, austerity cut-backs are still biting hard and unemployment remains at dangerous levels, especially in the distressed parts of Europe.
And there is still the expected after-shock from the UK’s Brexit vote to contend with at some stage. It is casting long shadows of risk across an already troubled European outlook.
It is not just the threat to European economic confidence at a vulnerable point of the business cycle, but also the precedent set by Brexit for one or more euro zone nations to go a step further, break away from the single currency and go it alone outside of European monetary union.
Growing political discord, increased hostility towards Brussels and spreading euro scepticism are bringing these pressures to a head.
Judging by the latest data, Brexit is already beginning to make its mark. Germany’s bellwether IFO business climate index suffered a sharp drop in confidence in August, showing its sharpest fall since spring 2012. If Europe’s powerhouse economy has fallen into a summer slump, then it will be even worse for the weaker economies. The recent slippage in euro zone manufacturing new orders underlines that output intentions face much tougher times ahead.
The risks for euro zone growth are clearly skewed to the downside right now. Expectations for 1.6 per cent GDP growth for the single currency area this year and 1.8 per cent next year are being overshadowed by the weak global picture and the lacklustre state of domestic demand across Europe, even with the ECB’s massive QE bolster.
It means Germany will be hard pressed to hit its 1.6 per cent growth target for the next two years, while the weaker economies like Italy, Portugal and Greece will struggle to keep up.
Europe needs strong growth to boost employment, spread prosperity and foster a better spirit of political accord. Without it, Europe will be heading into troubled waters of greater inequality, growing hostility to Brussels and increased political rancour.
Even before Britain’s Brexit vote, the germ of euro scepticism had been spreading, not least in core countries like France and Holland. Critically Brexit has sparked calls for copycat EU membership votes in a host of other countries.
Elections in Germany and France will be the key ones to watch next year. Any shift in sentiment from Europe’s traditional euro-centric populism will be a bad omen. It will take just one country to make the break with EMU for the whole house of cards to come tumbling down.
This was what spooked markets during the height of the Greek sovereign debt crisis in 2011-2012 and it is a threat which is just as real for the euro today.
Yield convergence trades between peripheral European government bonds and core Germany have been lifeblood opportunities for the markets in the last few years.
But they are not guaranteed one way bets just because the ECB has been openly intervening, buying debt and flooding the market with extra the liquidity generated from QE operations.
The apparent calm in European government bond markets could be turned on its head quite quickly. Germany’s Bundesbank could easily call time on open-ended ECB super-stimulus.
A spike in support for anti-austerity, anti-Brussels populist movements in Italy, Spain, Portugal and Greece could send shudders across European markets.
Italy could have its Lehman moment given the fragile state of the nation’s banking system. It is all too perilously poised on a knife edge.
Should just one single country exit the euro, it will cause chaos in European markets and a contagion crisis for the rest of the world. How the ECB deals with re-jigging its bloated balance sheet, loaded to the gunnels with low grade peripheral debt is beyond comprehension.
It is the nightmare scenario for markets that not only spells the end of the euro, but also portends a dangerous setback for European economic integration and future political unity. It could be the catharsis for cataclysmic shock from which there would be no easy way back.
David Brown is chief executive of New View Economics