However, Europe’s problems are exacerbated by low (or negative) underlying growth, as well as a common currency and monetary policy that applies to countries possessing differing outlooks.
Politics have added uncertainty, which will likely stay elevated for the foreseeable future for the following reasons:
- In France, we believe newly-elected President Hollande could be a negative for the French economy, and his presence could exacerbate near-term concerns regarding the eurozone debt crisis. Hollande’s ability to govern will be subject to the outcome of parliamentary elections on June 10 and 17, where anti-austerity sentiment could remain elevated. However, longer-term, campaign promises have to contend with reality, and Hollande may be forced to soften his anti-austerity stance.
- Greece remains highly uncertain. Fractured voting on May 6 likely results in the inability to form a government, which could bring another election in mid-June. The next vote could become a vote on staying in the euro, with the possibility of a better outcome. While the May quarterly bailout funding from the European Financial Stability Facility (EFSF) has been authorized, further aid for Greece could be withheld until guarantees of commitment to austerity are received; and because fiscal targets have likely been missed with economic growth below expectations. There could be renewed calls for Greece to exit the euro as the year progresses.
- Ireland's vote to ratify the eurozone fiscal pact on May 31 could be threatened by increased regional anti-austerity sentiment. Joining the fiscal pact is required to access to the longer-term bailout fund that starts in July, the European Stability Mechanism (ESM). Without the backstop of the ESM, investor concern could rise and hurt Ireland’s hoped-for return to capital markets later in 2012.
The French and Greek electorates voted against austerity, but absent reforms to improve potential growth, there are few alternatives to austerity. Economic growth in the eurozone is forecasted to fall 0.8% in 2012 and grow a mere 0.3% in 2013 according to the International Monetary Fund (IMF). In this environment, running fiscal deficits when debt is already elevated becomes unsustainable. As debt grows to elevated levels, investors require higher interest rates to compensate for the higher risk. As such, austerity isn't a choice, it is a requirement.
However, austerity needs to be accompanied by reforms to improve growth prospects. Additional austerity and growth changes we favor include:
- Substantial labor reforms to allow businesses to adjust workforces to demand, which could improve labor productivity and economic growth.
- Reduce bureaucracy and regulations that hamper innovation by lessening the incentive to start new businesses.
- Tax reform—simplify regulations and improve tax collection. Tax cuts could improve compliance.
- Cut spending on social programs such as health care and pension systems that remain generous by US standards.
We view Hollande's "growth" plan of fiscal stimulus for infrastructure spending as misguided, as it merely provides a temporary boost. As for monetary stimulus, the European Central Bank (ECB) remains constrained.
Weak European banks pressure economic growth
The ECB's three-year loans to banks earlier this year staved off a global banking system crisis. The loans provided a new buyer for maturing bank debt, with the ECB acting as an intermediary, or substitute, for capital markets; but new capital was not injected into banks. Therefore, eurozone banks likely remain weakly capitalized for the problems in the region, and the IMF estimates eurozone banks need to reduce their balance sheets by $2.6 trillion (2.0 trillion euro) over the next 18 months, with about 25% of this achieved via reduced lending.
Spanish banks in particular are under the microscope due to a housing bubble that is still deflating while a recession deepens and unemployment at 24% continues to rise. Plans for government aid to Bankia—the second injection of public funds in two years—may validate concern that banks have overvalued real estate assets on their books. Estimates of Spanish bank capital funding needs range from 50—200 billion euros, with many converging on a 100 billion euros forecast that equates to 7% of eurozone real GDP.
