German Elections Endorse Merkel’s Slow, Steady Approach to Eurozone Recovery (And So Do the Markets)
Germans went to the polls on September 22 to elect parliamentary representatives. They handed a resounding victory to “Mutti Merkel” as the chancellor Angela Merkel is affectionately known — Germany’s “mom.” Her center-right party, the Christian Democratic Union (CDU) along with its sister party from Bavaria, the Christian Social Union, won 41.5 percent of the popular vote — coming within five seats of an absolute majority in the 630-seat Bundestag. The only time the CDU ever achieved such a majority was in 1957. This is the best result for the party since the reunification between East and West Germany in 1990.
Ms. Merkel had good reason to shed her somewhat stodgy demeanor for a moment of elated victory when she greeted supporters once the results were in. After cautiously and shrewdly navigating five years of crisis in the Eurozone, she has emerged as one of the world’s most powerful and respected politicians.
The result is an endorsement by the German people of the course Ms. Merkel has charted in response to the crisis. That course could be summed up as “deliberate and stubborn.” Throughout the crisis, the Germans have been dominant in the Eurozone both economically and politically, and to their Eurozone partners they have often seemed to move with glacial slowness.
CDU’s Strategy: Winning At Home and in the Eurozone
That deliberate strategy has paid off for the CDU — both domestically and internationally.
Domestically, it has cemented the view of voters that Ms. Merkel is defending their interests against profligate southern Europeans. Germans believe she’s doing what’s necessary to avert disaster, and at the same time resisting as much as possible the commitment of German resources without demanding painful and constructive reforms in return.
And on the European stage, the economy is picking up, growing “green shoots,” as we discuss below. There are signs that the Eurozone is returning to health. Better data has been seen in Spain, and in the once-maligned periphery, there are increasingly positive data points coming out of Ireland, and even Greece.
Source: The Economist
However, the election results were not as good for her former coalition partners, the Free Democrats — a once significant voice for classical liberal policy in Germany, which has now fallen below the 5 percent threshold needed to secure any seats in the Bundestag.
Coalition Options
The upstart Euro-skeptic party Alternative for Germany (AfD) also failed to reach the threshold, even though it performed strongly. That leaves Ms. Merkel the prospect of trying to form a coalition with either the center-left Social Democratic Party (SPD) or the Greens. Meanwhile,The Left party, a post-communist relic, won 8.6 percent, but both the CDU and the SPD have expressly refused any participation with it in a coalition government. Either the SPD or Green coalition option has difficulties — mostly for the prospective junior partner in the coalition. The SPD governed with Ms. Merkel’s CDU in a so-called “grand coalition” of the left and right from 2005 to 2009. That ended badly for the SPD, with their share of the vote dropping to an all-time low in 2009, and they are not eager to renew the experiment. Ms. Merkel has proved very adaptable at stealing her opponents’ thunder, and the SPD fears being marginalized. The same holds true for the Greens, although there is some hope for them because the party has gotten rid of its hard-core environmentalist leadership (“fundis,” as the Germans call them), and seems poised to embrace more moderate policies of the party’s “realo” wing. Ms. Merkel also took a step toward them in 2011 when she embraced the shutdown of Germany’s nuclear power sector.
Continuity
Whichever coalition emerges, there is likely to be firm continuity in Germany’s approach to the Eurozone recovery. That was Ms. Merkel’s platform during the campaign, and nothing has changed in her stance afterwards. CDU officials, such as finance minister Wolfgang Schäuble, emphasize the positive progress of the Eurozone under Merkel’s influence – without absolutely relentless austerity. Schäuble has already emphasized that he would “examine” a Greek request for further funds, and therefore almost certainly approve it. It means more steady, slow, and cautious action from Germany.
The potential partners for the CDU, especially the SPD, know that if they join the coalition, they may risk being sidelined. But if they refuse overtures from Ms. Merkel, they will probably be seen by German voters as irresponsible obstructionists — especially with the prospect of new polling if a government can’t be formed. So, analysts believe that after some grousing, they’ll agree to join the CDU in a government. A dominant CDU will likely throw them some policy bones — raising the minimum wage, for example — and steam ahead with the course they’ve already charted.
Investors can read this as continued German support for the European project. After the election, Ms. Merkel said her victory was “a very strong vote for a united Europe.”
Green Shoots in Eurozone Economies, Equity Markets
All this is in the context of increasing economic signals that Germany’s course of action is getting results — even in the hard-hit periphery of southern Europe.
Wolfgang Schäuble wrote in the Financial Times just before the elections:
“What is happening turns out to be pretty much what the proponents of Europe’s cool-headed crisis management predicted. The fiscal and structural repair work is paying off, laying the foundations for sustainable growth. …We have seen [all this] before, many times and in many places.”
Of course Mr Schäuble is being a bit self-congratulatory (since he was one of the people providing “cool-headed crisis management”).
When he talks about “many times and many places” he’s referring first of all to Germany’s own labor market and social welfare reforms under Gerhard Schröder, which helped bring Germany from being a “sick man of Europe” in the 1990s to being as competitive as it is today. Schäuble’s perspective, at least as it is expressed here, is that governments don’t create growth; they allow it or prevent it. Growth itself is created by free market participants coming together in a marketplace.
Schäuble believes that what was true for Germany is true broadly for Europe, and that the application of the same kinds of policies that restored Germany to health are working for Europe as well. Here is his conclusion:
“Structural reforms take time to work. Those responsible for them need patience and an aptitude to ignore the siren calls of quick fixers and the protestations of special interests… however bad the times, we should fight the human tendency to extrapolate the present forever into the future. Systems adapt, downturns bottom out, trends turn. In other words, what is broken can be repaired. Europe today is the proof.”
The data is beginning to bear this out.
Eurozone Manufacturing PMI: Looking Up
Souce: Forbes
PMI indicators are particularly encouraging throughout Europe. They’re up to 51.4 in August from 50.3 in July for the Eurozone as a whole. Germany itself is up to 51.8 from 50.7, with stronger production, exports, and domestic demand. Italian manufacturing output rose at the fastest pace since 2011.
In Europe’s periphery, Greece showed signs of a return to positive territory, with PMI hitting a 44-month high of 48.7. The Greek economy is not out of recession, but its contraction is decelerating. Spain’s PMI reached 51.1 in August, as the government produced a post-austerity budget for next year — forecasting GDP growth of 0.7 percent, and putting aside its steady diet of spending cuts and tax hikes. (The European Commission has shown flexibility in allowing Spain to miss deficit targets.) And Spain is also looking at an improvement in its borrowing costs.
Ireland has exited recession, with GDP growing 0.4 percent quarter on quarter in 2Q 2013 — not as good as hoped, but still positive. Analysts expect further positive news from employment and the housing and retail sectors when the summer’s data come in.
In terms of GDP growth, the Eurozone as a whole exited recession in the second quarter with a 0.29 percent growth rate. In short, we believe a genuine European recovery is underway, most strongly visible in Germany, but with positive signs even in the periphery. Greece will need more help, and others may as well. We don’t believe this contradicts the basic picture that is emerging.
European Equities
As a result, we believe European equities currently have some characteristics to commend them. Equity valuations in Europe took a big hit from the crisis and from the perceived danger of Eurozone instability, or even disintegration. With an average P/E multiple for the S&P 500 of 14.9 forward earnings, and for the Stoxx Europe 600 of 13.1, there may be some attractively-priced equities to be found.
Collectively, European equity markets have outpaced the U.S. and emerging markets, over the past three months. We think that with supportive action continuing from the ECB to European banks, and with profit margins possibly bottoming, there is still room to take advantage of Europe’s recovery.
Bank Reforms Are Key, and Remain an Open Question
Although there are positive data near-term, there are still structural problems lying in wait for the Eurozone. And unless the member states reach a meeting of the minds about them, they could sabotage medium-term prospects.
Chief among these is the issue of bank regulation. One reason that the United States was able to deal more effectively with the challenges of bank regulation during and after the crisis was the relatively centralized character of its regulatory bodies. Europe until now, has lacked such robust and centralized regulation. This has been the theme of overaching criticism of Europe since the crisis began: it is a currency union without financial or fiscal union.
Fiscal union is still out of the realm of discussion (even though it has been a theme of post-war European dreamers since the days of Oswald Mosley’s “Europe A Nation” movement in the 1950s).
On the other hand, a union of financial regulation has taken a shaky but real step towards reality. On September 12, the European Parliament adopted a legislative package to bring the prudential supervision of Europe’s banks under a new regulatory arm of the ECB (European Central Bank) — the SSM, or “Single Supervisory Mechanism.” Although the SSM will have supervisory responsibility for all the Eurozone’s banks, it will leave most of those tasks to national governments, and concentrate on some 130 banks judged to be of critical systemic importance. After approval by government ministers in October, the ECB will be assuming this new role definitively in the latter half of 2014.
Immediately, however, the ECB has pledged to conduct an “asset quality review,” which — it is hoped — will reveal the true state of health of Europe’s banks (unlike the “stress tests” done so far, which have not been stringent enough to reveal problems like those that emerged at Belgian bank Dexia after it passed tests in 2010 and 2011 and then encountered serious problems).
Where Does the Buck Stop?
Unfortunately, critical details are still unclear, and critical problems remain — the problems, as always, having to do with sovereignty and financial responsibility. Although the ECB will have supervisory powers, it will have no powers to create a final resolution. If it turns out that more is needed to recapitalize zombie banks than member states can contribute themselves, where will the money come from? If allowed to tap the European Stability Mechanism, banks will certainly face the imposition of conditions by the sound economies such as Germany. And that would bring us full circle, back into the infighting that has characterized the European approach to the crisis since the beginning.
If Ms Merkel and her coalition are able to navigate this “final frontier” with the same methodical determination they have exhibited so far, there may be is long-term hope for European economic health.
