Edward Harrison is the founder of the blog Credit Writedowns and is a finance specialist at Global Macro Advisors. Previously, Edward was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. He started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. Edward holds an MBA from Columbia University and a BA in Economics from Dartmouth College.
Since the EU had been a growth laggard due to the European sovereign debt crisis, the pickup in growth there is encouraging. In particular, Italy deserves mention as it has lagged and is where I believe the battle for the EU’s future will be won. Some thoughts below
At the end of October, I said I would catalogue exactly how the global economy had picked up steam and how this underpinned growth in the US. The figures out of Europe are a major factor here as the EU represents almost a quarter of the global economy. Eurostat, the European Union statistics office, announced that preliminary figures showed euro zone gross domestic product growing 0.6% from July to September, which is 2.5% higher than the year ago period. Not only is this the highest growth in the Eurozone in a decade, it is also means that Europe is now growing faster than the United States, where year-on-year numbers are 2.3%.
While the highlight in the figures released today came from Germany, EU’s largest economy, given robust 0.8% growth in the third quarter, the real standouts are Italy and France. France and Italy both grew 0.5% on the quarter, with France registering 2.2% in the year and Italy 1.8% in annual growth. These are important markers because Italy only averted a bailout during the sovereign debt crisis due to the intervention of the ECB and because France is where the EU’s reform agenda will live or die due to Emmanuel Macron’s election.
Italy’s banking sector is still struggling with non-performing loans and low levels of capital. The country needs growth to give banks time to recapitalize and to reduce the size of the government’s debt relative to the economy. The worst case scenario for Italy is still one in which a global recession occurs before the banks have been recapitalized and the Italian state is forced to bail in investors and bail out banks after the bail-in money proves inadequate. The combination of Italian saver losses due to the bail-ins and the likely spike in Italian interest rates due to the fiscal burden of bailouts would radicalize politics in a country that is too big to fail. The Eurozone cannot survive with Italy in crisis. The faster Italy grows and the longer this business cycle lasts, the less likely worst case outcomes become.
In France, because Emmanuel Macron has staked his presidency on reforming France’s economy to be more like Germany’s, it is imperative that any reform efforts he takes occur under ‘cover’ of robust macroeconomic growth since these reforms could weaken growth in the short term. As an OECD research paper put it last year, “the short-run employment costs from deregulation are aggravated by worsening economic conditions and attenuated in upswing.” If Macron’s reform efforts fail because of politics or the economy, it will have very negative implications for EU-wide economic policy harmonization – which would mean a bigger likelihood of crisis in the next downturn.
The bottom line here is that growth in the EU is now occurring everywhere – both in the periphery and the core, in the East as well as in the West. And this is necessary both to help the crisis nations rebuild their financial sectors and avoid a repeat crisis as well as to help Macron from failing in France. And ultimately, from a US perspective, growth in Europe will aid continued growth in the US.
There are two (bad) things to note here. First, the UK is a laggard n Europe. Not only was growth only 0.4% in the quarter and 1.5% annually for Britain’s largest economy, but equally problematic, inflation came in at 3.0% to boot. These poor figures are the clear result of Brexit’s drag finally kicking in. In the short-term, recession is not on the horizon. But Britain has moved into stall speed – and a cliff-edge break with the EU could send the British economy into recession in late 2018 or 2019.
The second thing to keep in mind here is the investing backdrop. Equities are expensive, high yield bonds and high-grade have low spreads to government bonds, indicating fixed income investors are taking risk to seek return. And government bond curves are shallow, indicating little room for monetary policy tightening before expectations shift toward slower growth or even recession. It goes without saying that these are late-cycle market signposts. Yes, all of these markets can continue to rally given the macroeconomic backdrop. But markets that rally strongly from this base would be poised for a violent fall. My view is that returns in risk assets – and even in safer investment-grade and government bonds will be sub-par in the coming years as a result. Places to watch for risk: European high-yield and leveraged loans, particularly in relation to commercial real estate.