Why I am relatively upbeat about Europe

I continue to anticipate a recovery in Europe in the second half of this year. The manufacturing PMI data that were released this morning suggest we could be in recovery before the end of the quarter. This makes me relatively upbeat about the medium-term. However, problems remain.

Two weeks ago I penned a post highlighting some thoughts on Europe, most of them positive. The lead-in was that European policy makers – who I believe are more committed to the European Project than most Americans – had ever more incentive to keep the euro zone together with the revelation of a hegemonic US spying on everyone. Acting as an American economic counterweight is an important animus in the face of some difficult economic circumstances. The overall gist of the post was that the data suggested a trend toward lessening pain and eventual recovery in the second half of the year. As I wrote in June, watch second derivatives in the Eurozone; they are pointing up. The upshot of the post, however, was that the debt deflation was still an impediment which could result in sovereign defaults down the line. 

In the two weeks since then, the data have borne out my thesis. First, there is today’s PMIs. The BBC gives a good overview:

The Markit eurozone Purchasing Managers’ Index (PMI), which measures business output, was 50.4 in July. A figure above 50 indicates expansion.

July’s figure was up from 48.7 in June, and marks an 18-month high.

The eurozone has been in recession since the end of 2011.

“The best PMI reading for one-and-a-half years provides encouraging evidence to suggest that the euro area could – at long last – pull out of its recession in the third quarter,” said Chris Williamson, chief economist at Markit.

He said the revival in the economy was being led by a broad-based upturn in manufacturing, and signs of stabilisation in the services sector.

But he warned that employment was continuing to fall, although at a slower rate than earlier in the year.

This is it exactly. We are seeing a move into a weak recovery, one that is much weaker than the one currently ongoing in the US. The recovery should be aided by the recent move away from front-loading austerity to back loading it. With the notable exceptions of Greece and Portugal, backloading has been the policy course now throughout Europe since at least May. And the ECB is now de facto monetizing eurozone government debt via its new forward guidance approach. That means that the policy approach in Europe is turning less restrictive just as the economy is improving. I expect this to give a tailwind to the recovery.

Overall, when briefly comparing the Fed and the ECB two weeks ago, my conclusion was that fiscal policy as well as monetary policy in the eurozone were moving in the accomodative direction – but less so than in the US. I wrote that “European policy makers recognize the need for easing in both fiscal and monetary policy to counteract private sector debt deflation and the lack of public sector monetary sovereignty. But the existing economic paradigm only allows Europe to go so far. When Europe looks to America, time and again, it wants to be more responsible and less dovish. Over the medium term, that is going to mean lower growth. And I expect this paradigm to hold for years to come.” Unless Europe can move beyond this paradigm, it will mean less room for investor upside via multiple expansion in Europe’s equity markets. It also will mean redenomination and default risk in the periphery will linger.

And this is the big problem. Just a few days ago, we saw that everywhere you look in Europe, government debt is going higher and higher. Overall, there is now 8.75 trillion euros of government debt in the euro zone alone. And the average debt to GDP ratio is 92% in the eurozone. (link in German). And remember, this is not Japan where you have QE and a central bank backstop that can get you up past 200% debt to GDP. Default and redenomination risk are real.

Greek debt is at 160% of GDP. This is the highest in Europe. And Merkel and Schäuble are saying that Greece should not even think about haircuts right now – even though they know the burden is unsustainable. A Merkel ally let it slip that a restructuring in 2014 or 2015 is likely. This is why Greek yields are so high. Italy has government debt to GDP of 130% and Portugal has 127%, with Ireland close behind. While Italy is protected by its primary surplus and status as too big to fail, Portugal in particular is questionable given the continued front-loading of austerity there. Greece is the model when one looks at the macro numbers: debt, unemployment, decline in GDP. That’s the path Portugal is on, and it leads to restructuring more than in, say, Ireland or Spain.

So Europe is not out of the woods by a long shot. Future sovereign defaults are still on the table and debt deflation is a problem. A lot of this could be cleaned up if Europe would just recapitalize its banks properly. But no one wants to do that because it means heaping yet more debt onto the sovereign when everyone including Germany is in fear of having still more sovereign debt – and no explicit central bank backstop. The Eurozone is trying to repeat Japan’s lost decade. That’s where this is headed using the current extend and pretend paradigm. At least we are seeing incremental moves toward recap, as in the case of Deutsche Bank earlier in the week. We have a long way to go though.

Bottom line: Europe is moving in the right direction. The economy is moving toward recovery, policy is giving countries more breathing room, and banks are slowly being recapitalized. That makes me relatively upbeat about Europe over the medium term. Unless problems in China and the emerging markets spoil the nascent swing to recovery, the macro picture at the beginning of 2014 will look better in Europe than it did at the beginning of 2013.