Strong economic growth in core Europe is masking the weaker performances of the peripheral economies, writes Alexander Scurlock.
Until recently, the defining theme of European economic monetary union since its introduction in 1999 was the convergence of the peripheral economies (ex-Soviet bloc and outlying countries) and core Europe (France, Germany, the UK and so on).
The move to a single currency provided the impetus for fiscally weaker, less-competitive peripheral economies to catch up to the stronger, more-competitive core.
Short-term interest rates converged once the European Central Bank (ECB) began to set monetary policy for the entire eurozone.
Over time, inflation declined in the periphery, which brought down long-term bond yields and reduced the risk premium for peripheral markets.
Further economic benefits followed as the ‘one-size-fits-all’ eurozone policy benefited the periphery more than the core. Interest and exchange rates were invariably too high for Germany, for instance, which meant that its export sector struggled.
The eurozone debt crisis of 2010 has upended this situation.
Faced with steep unemployment, broken banking sectors and indebtedness, economies in the peripheral south and west, such as Greece, Ireland and Spain are enduring the deepest recessions of the financial crises.
At the same time, economies in the centre, such as Germany, France, the Netherlands and Belgium are enjoying stronger growth. Germany is the standout; buoyant activity there is, in fact, masking weaker performances at the periphery in overall measures of eurozone activity.
German exports are more competitive because, after the asymmetric impact of the financial and sovereign debt crises of 2010, eurozone interest rates have been kept low to support struggling peripheral member states and the euro fell.
This is, however, just one aspect of the reversal of core-periphery fortunes. As table 1 shows, a range of political and economic factors are combining to reinforce the continued outperformance of core Europe.
Still partly the preserve of national governments, fiscal policy has become the weak point of the eurozone experiment.
At the periphery, large public deficits exacerbated by banking sector bailouts have led to unavoidable and painful austerity measures, which have caused sovereign spreads to rise precipitously for Greece, Ireland and Portugal.
When the euro was introduced on 1 January, 1999, sovereign bond spreads in the periphery converged to record lows.
From 2001, the average spread over German government bonds stayed within a 10 basis point range until 2007 (based on an unweighted average of bonds from Portugal, Italy, Ireland, Greece and Spain).
It was at this point the prevailing forces that had favoured all countries in the eurozone first showed signs of abating.
As we now know, the credit crunch caused a serious de-convergence in sovereign spreads that continues to remain with us.
There has been a positive correlation between higher peripheral sovereign spreads and funding costs in the aftermath of the credit crisis, suggesting that there is a meaningful spill-over effect from the public to the private sector.
That increased cost of corporate funding is a significant headwind for companies in the periphery that reinforces my view that divergence will remain a defining theme in the eurozone for much longer than investors expect.
Divergent labour trends also seem here to stay.
Peripheral countries face significant unemployment. Spain must deal with nearly 20 per cent of its workforce being out of work. Ireland and Greece also have double-digit unemployment, which, in the case of Ireland, has encouraged an upturn in emigration.
Part of the explanation is the fact that labour costs surged in peripheral countries during the good times (by more than 30 per cent in Ireland and Spain from 2000 to 2008), when wage indexation agreements were often a feature.
Germany’s unemployment rate (at about 7.5 per cent) is less than the European average. Once ‘the sick man of Europe’, a perceived lack of competitiveness several years ago encouraged deep labour market reforms and collectively bargained minimum wages were effectively abolished.
As a result, Germany controlled unit labour costs, meaning the economy became more competitive relative to its peripheral peers.
With strong demand for its high-quality capital goods as well as for premium auto brands like BMW, the German economy can be expected to benefit from further growth in emerging-market consumption for years to come.
And the good feeling is not confined to the export sector; the domestic economy is also humming.
The German consumer, so often a laggard historically, appears to be enjoying a welcome revival of confidence. If the Bundesbankers were still in charge of national monetary policy, they would be applying the brakes.
Peripheral eurozone countries, meanwhile, must overcome major hurdles to be competitive again.
This will become more apparent as competition from emerging economies intensifies.
Without the safety valve of a floating exchange rate, their economies face ‘internal devaluations’ (deflation) that could have painful social costs.
In terms of European Union (EU) governance, the outlook is similarly polarised.
The EU and International Monetary Fund have already announced a €750 billion (A$985 billion) package to cover several years of deficit financing.
However, European leaders have been keen to respond to the accusation of ‘incremental reactive policymaking’ in response to the sovereign crisis.
As a result, the EU summit in March was expected to see policymakers deliver a ‘competitiveness pact’, designed to draw a credible line under the debt crisis.
Significantly, however, now that the negotiating power of peripheral states has been weakened, the architecture of the pact has been dominated by a vociferous Germany and France.
Beyond the expected expansion of the European Financial Stability Facility lending capacity to €440 billion, the focus of change is away from austerity and more structural-debt brakes, an end to automatic wage indexation, increases to retirement ages and corporate tax harmonisation.
All of this points to further pain for peripheral Europe. While there may be investment opportunities for the agile, from an asset-allocation perspective I believe that investors in Europe can profit from concentrating the focus of their portfolios on the core eurozone economies that are benefiting from powerful and self-reinforcing trends.
Alexander Scurlock is portfolio manager, European equities, at Fidelity.
