Europe, bloody hell

“Europe, bloody hell!”, as Sir Alex Ferguson might have put it had he ever chosen to swap the permanently febrile, money-driven world of football for the normally febrile, money-driven world of the financial markets. Recent disappointing growth and earnings data have underlined how fragile the European economy remains. It has, inevitably, forced a rethink by all those investors who have been enthusiastically driving equity prices up and bond prices down since the euro’s existential crisis in 2012.

It is not just the simmering crisis in Ukraine that has caused these jitters, an important factor though that clearly is. According to Bank of America Merrill Lynch, consensus earnings expectations for 2014 in Europe have fallen from 12% at the start of the year to little more than 6% now. They may fall further still. Start-of-year broker optimism on earnings is as timeless as the seasons, but there is no gainsaying the deterioration in the economic outlook that the latest miserable figures imply. Sanctions over Ukraine are a factor, but not the primary cause of this trend.

Against a background of generally low market volatility, the scale and breadth of the recent market setback in Europe is striking. Even the Dax has fallen by more than 7% peak to trough. With Germany reporting a contraction in GDP in the second quarter, the yield on 10-year German bunds has fallen below 1% for the first time. General fears of deflation have sent periphery bond yields to their lowest levels since before the crisis.

In this context market expectations that the European Central Bank will (and should) come riding to the rescue with a programme of quantitative easing seem both premature and complacent. Some form of QE by the ECB will come in due course, of that there seems no doubt. But will it be enough to pull Europe out of the debt deflation nightmare that otherwise seems to be on the cards? There are reasons to have doubts.

The most obvious one is that the ECB’s freedom to manoeuvre is much more limited than that of other central banks, something that markets frequently forget. Even in good times, it takes months to build a consensus for action amongst the key member states, and the issue of QE remains highly contentious, both as to its wisdom and its legality. Assuming that primary purchases of government bonds are ruled out, it is open to question whether there are sufficient assets that the ECB can legally buy to achieve the necessary market impact.

Secondly it is clear that the ECB needs (and wants) to get its stress tests of Europe’s banks out of the way before going much beyond the further monetary policy measures announced last month. To be credible, publication of the results in October needs to be followed by a period of market review and demonstrable improvements in balance sheets. A QE programme could also create conflicts of interest with its bank supervisory role. That makes it virtually certain that, in the absence of some new market-driven crisis, the ECB will inevitably find itself “behind the curve” in implementing a QE programme.

More fundamental still is that any steps by the ECB to move into the breach will inevitably pull Europe towards greater de facto economic and fiscal integration at a time when the political dynamics are clearly pulling in the opposite direction. Political leaders have no appetite (and no mandate) for changing either the German constitution or negotiating a treaty change to ease the obstacles to large and decisive intervention by the ECB. As Scotland is discovering with the sterling question in the run up to its independence referendum, willing a helpful outcome, however desirable, is not the same as being able to make it happen.

And finally there is the problem that a programme of asset purchases might well not do much more than buy some time. Whatever else the history of QE programmes has shown, it is evident that it does nothing in itself to generate economic growth, the outcome that Europe desperately needs. Only structural reform and appropriate fiscal measures can do that, and on that score progress across the Eurozone remains painfully slow. Even the youthful, energetic Signor Renzi is struggling to make any progress with his political and economic reforms in Italy.

It is true that the path of European market performance since 2012 has followed a familiar market-driven pattern. The relief rally that greeted Mr Draghi’s “whatever it takes” intervention in mid-2012 was followed a year later by a predictable surge in fund flows into European equities and periphery bonds, driven by the spreading and self-reinforcing belief that the crisis had in practice been solved. That in turn became a momentum trade running into the New Year. It has now stalled as investors wake up to the fact that the implied revival in economic and corporate fundamentals is failing to materialise.

Lurking behind these market gyrations lies a far more serious issue. Mrs Merkel said at the height of the crisis two years ago that “if the euro fails, Europe also fails”. She has masterminded the policy of doing the minimum necessary to keep the single currency (and by extension the European dream of political and economic integration) alive, despite all the political obstacles. George Soros, who also has form in these matters, takes a profoundly different view. The danger now, he argues, is that “jettisoning the euro” may be necessary to save the European Union itself.

While European equities fell by 4% from their high point in the latest market move, the MSCI Eurozone index was down by 10% over the same period. Although oversold in the short term, the recent sentiment shift in the European financial markets is a reminder that Europe’s future economic recovery remains intimately tied to the fate of its single currency. That ambitious project is unfortunately far from resolved, just as most of us suspected two years ago.