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Sunday, December 24, 2006

Europe: About Decoupling, Reforms and Tensions


Eric Chaney | London

The short-term outlook for the euro area is clouded by major macro uncertainties, from the nature of the slowdown in the US to the consequences of a three-point VAT rate hike in Germany, effective on January 1. Yet we believe that the domestic recovery, fuelled by a powerful monetary stimulus and structural improvements such as faster productivity and more flexible labor markets, should provide a robust base for growth next year. While GDP growth should decelerate significantly, from 2.7% in 2006 to 1.9% in 2007, on our forecasts, the consequences of the VAT hike in Germany should be limited, being fully anticipated by German consumers and companies operating on the German market. Nevertheless, uncertainties are so high that financial markets may turn much more volatile than they were in 2006. These uncertainties will likely also cause the ECB to approach further tightening more cautiously (see Elga Bartsch’s “The ECB’s Balancing Act” in this issue).

While increasing risks for investors, volatility also generates investment opportunities. Here are three macro themes that could provide investors with such opportunities: US-Europe decoupling; labor market reforms and tensions between capital and politics.

1. A ‘soft decoupling’ between the US and Europe. A widespread view in the markets is that Europe follows the US cycle with a six-month lag. This theory may regain popularity, but for the wrong reasons, we believe: growth is likely to slow in Europe in the first months of 2007, for domestic reasons — a 150 basis point monetary tightening by the ECB and a 0.6% of EMU GDP fiscal tightening in the German and Italian budgets. Rather, we anticipate a ‘soft decoupling’ between the US and Europe: GDP growth falling significantly below trend in the US while decelerating towards trend in Europe. Because domestic demand is the main driver of growth in both regions, business cycles are not necessarily synchronized. For sure, financial linkages matter, as we learned during the previous downturn, when European companies slashed investment projects from 2001 to 2003. Massive capital outflows to the US — mostly driven by acquisitions — at the outset of EMU had made investment projects by European companies highly sensitive to the US capex cycle. However, this time, the US slowdown is coming from housing investment, to which neither companies nor investors in Europe seem to be exposed. As we see it, once fiscal policies relax their grip, growth should re-accelerate in Europe, where the personal savings rate should decline further, while the US economy is likely to continue to grow below trend speed, as the personal savings rate rises. Thus, ‘hard’ decoupling could become a popular theme in the course of the year.

2. Labor markets: end of ‘easy reforms’? So far the rapid decline in euro area unemployment hasn't fuelled wage inflation, a sign that structural unemployment is steadily declining. Policies aimed at reducing the cost of low-skilled jobs (by cutting social contributions most of the time) have worked, but their unwelcome side effect was the creation of two-tier labor markets. Also, the secular upward trend in the female participation rate is increasing the share of flexi-jobs, on trend, which helps reduce structural unemployment. However, with euro area unemployment likely to ebb towards 7% in the next 12–18 months, tensions in labor markets may appear, leading to higher wage inflation. Since dual labor markets generate inefficiencies and social tensions, governments will have to consider more far-reaching reforms, such as relaxing wage-bargaining systems, removing obstacles to redundancies or simplifying labor contracts. Labor market policies are likely to be hotly debated ahead of the French presidential election but could also return to the forefront of political debate in Italy and Germany. More ambitious reforms would probably help the ECB keep rates lower, thus boosting growth and profits.

3. Watch tensions between capital and politicians. Together with ample liquidity, rising cross-border capital flows within the single currency area and divergent dynamics in domestic demand have fuelled rising current account imbalances. While Spain is heading towards a double-digit current account deficit to GDP ratio, Germany and the Netherlands are both running a current account surplus to GDP ratio of similar magnitude. A potential rise in intra-EMU imbalances may fuel political tensions, we think, against a general backdrop of anti-globalization sentiment. Interestingly, in the new EU member states, capital inflows also seem to fuel political tensions here and there. With slower growth ahead and large war chests accumulated in previous years making companies more aggressive, tensions may rise further next year. Taking a longer-term view, political leaders seem to have largely underestimated the practical implications of the European Monetary Union and of the EU enlargement: with capital easily crossing borders, restructuring has become a permanent and obsessive theme for European companies. The result is that companies operating on a pan-European basis and having global ambitions have a growing influence on economies, while governments have less. The tug-of-war between the power of capital moving freely across borders, while most workers won’t, and institutions changing slowly, creates investment opportunities. For that, investors need to pay attention to two elements: political resistance, which differs across countries and sectors, but also the long-term picture, which is in my view the emergence of large global companies operating from their historical European base.