Twenty years ago last weekend, people across Continental Europe started handing euro notes to shopkeepers and café servers—and a new physical currency was born. To many economists we follow, this began an experiment playing out in real time: How could low-inflation northern European countries share a currency and monetary policy with higher-inflation southern Europe, especially if the bloc wasn’t a fiscal transfer union? (A fiscal transfer union is a political entity that shares tax revenue and debt service obligations, like the United Kingdom.) Commentators we follow have warned about this north-south divide dogging the currency ever since—and it still hogs headlines we read today, despite the euro surviving a trial by fire in the past decade’s regional debt crisis. Yet since the regional bear market (typically lasting, fundamentally driven decline exceeding -20%) that accompanied said crisis, we think this existential question—and the long-running, slow-moving efforts to solve it—have largely faded into the background, with little sway over stocks for good or ill.[i] In our view, this is helpful to keep in mind as commentators we follow once again warn the euro could split and send markets reeling: Stocks are very familiar with the euro’s structural issues, and there is little surprise power left.
The threat euro critics we read still see: The north-south divide is too wide to surmount, in their opinion. At the heart of the debate, according to our observations, is whether one monetary policy—the European Central Bank’s (ECB’s)—fits all, especially with German Consumer Price Index inflation hitting a 30-year high in December.[ii] (The Consumer Price Index is a government-produced measure of goods and services prices across the broad economy.) We have seen many commentators claim the ECB’s winding down its pandemic-spurred emergency monetary policy programmes will prove too early for many countries still struggling (southern Europe). Or they say it will be too late, risking overheating and runaway inflation in others (northern Europe).
Our analysis of financial history suggests this isn’t just a theoretical fear. The collapse of the European Exchange Rate Mechanism (ERM) in the early 1990s—and the subsequent European recession (broad-based decline in economic activity)—we think illustrates the risks.[iii] Back then, Germany’s Bundesbank was keeping rates high to quell inflation after reunification, forcing all other participants in the region’s fixed currency exchange rates peg to do the same.[iv] That didn’t work well for southern European nations, which needed lower interest rates to support the recovery from their economic contractions in 1990 – 1991.[v] As countries first defended, then discarded the fixed currency exchange rates, it brought monetary chaos and a true double-dip recession.[vi] (A double-dip recession is a broad-based economic contraction that ends but resumes after a very brief period of economic growth.)
Some commentators we follow say a similar situation could be arising now. This time around though, their view is southern Europe has the better side of the argument—and ear of the ECB—based on how big the monetary policy institution’s long-term bond purchase programme is and how long it has kept its main policy rate negative.[vii] If inflation-phobic northern Europe disagrees, they suggest the euro could splinter.
Underlying all this, we think, is the notion of a two-speed eurozone. According to this theory, if southern eurozone economies, e.g. Italy and Greece, remain structurally uncompetitive, they allegedly might be subject to rolling bailouts in one form or another. It then contends that the eurozone’s lack of a fiscal transfer union, where wealthier countries’ taxes make up budget shortfalls for those less well off, supposedly makes financial crisis inevitable. Set on this apparent path, weaker countries can rack up debts until they can’t pay them—or they are cut off. Unable to stoke inflation by vastly increasing money supply, they enter deflation and potentially default. Since banks hold lots of sovereign debt, that can spell trouble for the financial system.
Which leads to the ostensible endgame: If this happens repeatedly, it would seem northern powerhouses, fed up, would either force southern stragglers out or leave to form a league of their own. Or, as some policy analysts we read have suggested, they could create a second-tier currency to relegate countries to that don’t measure up.
We think all these issues have been well known from the start, though. It isn’t as if the euro’s architects weren’t paying attention during the ERM crisis. In our view, the problem is solutions for them are politically contentious. Somewhat helpfully, though, it appears to us Europe’s rolling sovereign debt crisis from late 2009 through the early teens, which caused a regional bear market and recession, brought them into the spotlight—spurring (slow-moving) action.[viii] In typically bureaucratic fashion, the eurozone has since launched several long-running initiatives to address its underlying structural weaknesses.[ix]
At the time, we thought that the solutions under discussion wouldn’t take months, but years to work out, becoming part of the long-term structural backdrop as they played out in fits and starts. That has largely happened, in our view. Take efforts to establish the banking and fiscal unions that many commentators we follow think are necessary for the monetary union to work. Banks once regulated mainly at the national level are increasingly supervised by the EU under a single rulebook—to monitor for financial problems and resolve any failing institutions under a common framework.[x] However, some policymakers don’t think a banking union will be complete until there is an EU-wide deposit insurance scheme.[xi] Whilst officials have proposed one, the bloc hasn’t adopted it yet.[xii] Without EU-insured deposits, some proponents we follow have said banks will remain beholden to national governments, likely meaning they will continue holding lots of national sovereign debt.
On the fiscal side, the pandemic brought a bit of a breakthrough. For the first time, to fund its recovery efforts and green initiatives, the EU issued its own bonds, which global investors snapped up, and distributed the proceeds amongst member states.[xiii] This may only be a one-off though, in our view—we haven’t seen much to indicate the EU is ready to go to the well regularly to establish a deep and liquid EU bond market, like for US Treasurys.
Meanwhile, we think the EU has made some strides toward greater political integration. For example, in November, after years (and years) of negotiations, the European Parliament finally overhauled its Common Agricultural Policy, governing the EU’s extensive farm subsidies—although the reforms won’t take effect until 2023.[xiv] Whilst seen as more fair by its advocates, some detractors say it doesn’t go far enough to protect the environment and prevent climate change.[xv] Other issues abound, from migration and the rule of law to the recent energy crunch and geopolitical friction.[xvi] Like everything else, in our view, the EU is tackling these methodically—with steps forward and backward.
Through all of this, we think European political institutions have demonstrated a remarkable will and level of commitment to hold the currency union together. Such tenacity is also underappreciated, in our view. One case in point: the aftermath of Greece’s 2015 referendum. After Greek voters rejected a bailout and the tough financial conditions it imposed on the nation—and prepared to Grexit (leave the eurozone)—Greece stayed a euro member anyway after a certain amount of persuasion and coaxing.[xvii] How did that turn out? To take one indicator, Greek 10-year government bond yields now stand at 1.38%, below equivalent maturity US Treasury yields’ 1.73%.[xviii] There is no way to prove a counterfactual, but we don’t think this would be the case if Greece was out of the eurozone. In our view, this underscores the political motive to support the euro: The clear economic benefit it can bring—and with it, the shared European identity that helps forge to bridge historical divides, which so often led to counterproductive conflict in the past. We imagine this is likely especially important to EU leaders now, with Russia on the move and China ascending.
For markets though, this seems to us like a lesson they learned a while ago. We doubt stocks are too interested in all the detailed steps and political niceties to keep the eurozone whole—and to expand it—so long as a big sudden change doesn’t create winners and losers. Absent that kind of regulatory or policy outcome, which doesn’t appear likely for now, in our view, these efforts are probably just part of the structural backdrop, not cyclical drivers. (Meaning, we think they are largely immaterial to whether the economy expands or contracts.) But our research shows stocks are far more concerned about the cyclical outlook over the next 3 to 30 months. We think what the economy and earnings do in that timeframe are of much greater relevance to investors than incremental policy progress (or setbacks) on the long road toward completing a more perfect euro.
[i] Source: FactSet, as of 7/1/2022. Statement based on MSCI EMU return with net dividends, 3/5/2011 – 12/9/2011.
[ii] Ibid. German consumer price index, January 1992 – December 2021.
[iii] “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Mathias Zurlinden, Federal Reserve Bank of St. Louis, September 1993. Recession dates based on Euro Area Business Cycle Network’s peak-to-trough identification, Q1 1992 – Q3 1993.
[vii] Source: European Central Bank, as of 7/1/2022. Statement refers to the ECB’s main deposit rate.
[viii] See note i. Recession dates based on Euro Area Business Cycle Network’s peak-to-trough identification, Q3 2011 – Q1 2013.
[ix] “Possible Avenues for Further Political Integration in Europe,” Federico Fabbrini, European Parliament, May 2020.
[x] “What Is the Banking Union,” European Commission, accessed on 7/1/2022.
[xi] “European Deposit Insurance Scheme,” European Commission, accessed on 7/1/2022.
[xiii] “EU Commission to Borrow 80 Billion Euros in 2021 to Finance Recovery,” Staff, Reuters, 1/6/2021. “EU Launches First Green Bond With Record Size and Demand,” Yoruk Bahceli, Reuters, 12/10/2021. Accessed via MSN.
[xiv] “European Parliament Gives Green Light to Huge Farm Subsidies Deal,” Staff, Reuters, 23/11/2021. Accessed via Yahoo!
[xvi] See note ix.
[xvii] “Greek Debt Crisis: What Was the Point of the Referendum?” Mark Lowen, BBC, 11/7/2015.
[xviii] Source: FactSet, as of 7/1/2022. 10-year Greek government bond and US Treasury yields, 6/1/2022.
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