We have extensively commented on the economic and political situation in the United States. However, what about other regions? All investors should be globally diversified, so the situation in other parts of the world matters greatly for US investors. In this commentary we’ll start with Europe. We’ll discuss the Asia-Pacific region in due course.
It’s All about the Virus
As Larry Summers outlined in an interview recently, time should nowadays be measured not in calendar time units but in virus time units. In virus time, Europe was the second epicenter of the coronavirus pandemic after Asia. As of now, the new epicenter is the Americas with most parts of the continent being severely impacted. While it may seem like the worst of the virus outbreak is over in Europe, nobody can be certain. While the worst might be over from a narrow medical point of view, the economic impact has been severe and will be long-lasting even if we do not see a second wave of the virus. Of course, if a second wave is realized, then we will have to reassess our outlook.
Even before the coronavirus, the European economy had been stagnating even though the European Central Bank (ECB) had implemented ultra-loose monetary policy. The European economy has been artificially propped up by irresponsible ECB policies since the financial crisis in 2008. Most of these policies are short-term in nature or purely cosmetic, such as, for example, the measures taken to prop up otherwise bankrupt European financial institutions by “embellishing” their balance sheets in various ways. In classic Italian tradition the former ECB President Mario Draghi has managed to sweep most of the fundamental problems with the European economy under the rug. Moreover, the European economy as well as its political system has been weakened by Brexit. While the impact of Brexit is likely to be much more severe for the United Kingdom than other European nations, it has been a disruptive force that can be felt in all of Europe. Conceptually, the idea of Brexit has some merit, its implementation, so far, has been somewhat disastrous. The fact that the task at hand has now been handed to someone who is often labelled a “European Trump” is extremely unlikely to help matters. Trumpian politics seems to revolve around carrying a big stick and using Twitter to insult anyone who offers constructive observations. Crudeness has replaced civility.
The advent of the Virus
Developments in Europe have been dominated by the coronavirus since the beginning of March. Italy was the first country to be affected and the virus has had devastating effects on both the people and the Italian economy. Despite the fact that the European Union exists on paper, most things of importance are still done on an individual country basis. In that spirit, we have seen almost no coordination on a Europe-wide level to address the virus. As a result, borders were closed, and different European countries adopted completely different policies to fight the virus. While some countries such as Germany and some Scandinavian countries (and notably Greece) started preparing for the pandemic in a timely manner, other countries, such as the UK, procrastinated all actions until the last moment and then muddled their way through. The results of these differing policies can now be seen very clearly.
The economic consequences, just four months after the crisis started, are devastating. Many companies have gone out of business. The unemployment rate has not skyrocketed yet because of furlough schemes that have been put in place, financed by public money. These furlough schemes, however, cannot continue for long because they are extremely expensive. Economic uncertainty has increased exponentially and thus consumer spending has plummeted. In many areas, even though lockdown measures have been lifted, consumers have meaningfully reduced spending, presumably because they don’t know whether they will still have any reliable income in a few months’ time. Interestingly, European talking heads, like in the US, try to spew platitudes of recovery in an effort to alter the behavioural impact of the past several months. Who can believe them? What else are they going to state? They can’t state the truth as that would exacerbate the situation. Once free money is expended, then what? That’s when we’ll begin to observe the true economic consequences of the virus.
While some companies received emergency loans and subsidies that have kept them alive for now, these are short-term measures that are impossible to sustain in the longer term. The way the global economy works nowadays is that most industries are very competitive. This means that if an entity has meaningfully reduced revenue as a result of health mandates (eg, social distancing), it will result in substantial losses. Reduced revenue is a very realistic prospect for many companies nowadays, such as airlines, restaurants, small business owners, etc. Most of these companies know that by continuing to operate, they lose money. If they are unable to address this dynamic through cost cutting (eliminate employees) they will go out of business. This cycle will take time but, in our opinion, it is inevitable despite fiscal profligacy.
European growth was anemic prior to the pandemic. It is difficult to believe that over the near and intermediate term the pandemic doesn’t severely dampen this low growth environment further. European exposure will need to be tactically selected in any well diversified portfolio.
Political Problems resulting from the Economic Crisis
As has been the case for decades, the stronger and more responsible countries in Europe (e.g. the northern countries) will have to bail out the other countries (e.g. the southern countries). The Mediterranean countries (with the possible and notable exception of Greece this time) will have to be bailed out again by other stronger economies. While the German government at the beginning categorically denied this basic fact, they have now already initiated an enormous transfer of wealth together with France. This further highlights the fact that the EU can only work as long as richer nations pay for the poorer ones. However, unlike their governments, people in richer nations are increasingly frustrated by this fact. They ask themselves, why as a German citizen with a comparatively high income, do I have to pay more than 50% tax on my income to support poorer European nations that have never acted responsibly and which have to be bailed out repeatedly? The consequence will be a shift to the right along the political spectrum. That has happened to some degree already but, in our opinion, it is likely to increase in the coming years. One problem with this shift to the right is that in many European countries the right is made up of primarily populist political parties. We already have populist governments in the UK, Italy, Hungary, Poland as well as a few others. Populism is more about retaining power and very little about a disciplined ideology that voters can understand and depend on. Populists exploit a frustrated and desperate electorate. They generally aren’t leaders with a clear vision on how to make their country a better place for its citizens. Exploitation of anger is not a productive plan. However, the more ideologically disciplined parties have created this environment by refusing to adhere to any kind of principles. They deserve to be ousted. In the end, this political chaos will not lead to sound economic growth for a very long time. The EU as an experiment will end as it is a source of great angst across the populations of many countries. Populists will use its destruction as a rallying cry. It’s just a matter of time. Again, European exposures must be tactically managed within any investment strategies.
So, where do we stand?
While Europe, at least in the most optimistic scenario, might be over the worst of the coronavirus, the problems caused by the virus and those that came to the surface because of the virus are severe. The pandemic has exacerbated an already fragile EU structure. Some would argue that the timeline toward an inevitable end of the EU may have been accelerated by the pandemic. It is very hard to imagine a good outcome anytime soon, even if a coronavirus vaccine is found before by the end of the year. Many problems that have existed for a long time and which have now prominently resurfaced will haunt the European economy for the foreseeable future. Once the ECB has run out of productive policy ammunition to push up financial markets, investors will exit rapidly. Tactical exposures that properly account for risk and liquidity are the only sensible approach.