The last couple of weeks have probably witnessed the widest gap ever between the eurozone bulls and bears. The former have been coming for a while but the numbers were few and the noise level was minimal given the lack of economic data to support their belief. On the other hand, the bears have hardly been seriously challenged.
Recently, the eurozone bulls have been provided with some economic ammunition. Data which, prima facie, seems to indicate that Europe is on the mend and that the worst seems to have passed, at least for now. On the other hand, the bears believe that the eurozone was doomed to fail from day one and that the latest set of economic data does nothing to change this belief.
In all probability the true state of the eurozone is probably somewhere between these two extremes. Taking a closer look at this economic area from different perspectives will show some interesting but potentially inconclusive truths (for now). Earlier this month, European Central Bank president Mario Draghi provided the market with an update on the European economic situation. This was not a straightforward and easy exercise, as Draghi was fully aware that the market was looking for hints and indications of what the next ECB actions would be. This time round, Draghi seemed to want to convey a cautiously optimistic message – hence the difficulty in achieving a successful delivery.
The optimism stemmed from the recent economic data which reflected improvement, not deterioration of the underlying economic state of the eurozone. In the meantime, however, caution was necessary since one set of data does not provide evidence of traction and sustainability. On the contrary, it seems that the eurozone may still be heading towards some economic headwinds. This may be the case because of the initial, reactive response to this financial mess via the various austerity programmes.
Draghi will be very wise to be more cautious than optimistic and keep expectations anchored to the ground
Let us pause here for a moment and rewind back to the events which took place a couple of years ago which followed the 2008 financial crisis – the sovereign debt crisis. At the time, it seemed like a number of European member countries were about to collapse and this was evidently reflected in the interest rate premium these nations had to pay (to borrow) over the risk-free rate. Greece did go under during this process and the market was ready to take other nations to the cleaners. Austerity was the only credible and immediate solution the various governments had to address this situation and ease the market concerns.
The austerity programme implemented was the type which could address the short-term problems but at the same time could also potentially become a long-term evil. This form of austerity manifested itself in spending cuts (which could be a positive if such cuts reduced inefficiencies, but a huge negative if they choked off growth) and tax hikes. Clearly, the fire-fighting operation at the time should have commenced much earlier, but at that point in time the decision-makers were running out of options.
Fast-forward to today and we are now witnessing the results those austerity programmes have produced with economic growth still almost non-existent. If we look at the ECB’s forecast for 2013, the GDP is still expected to shrink by 0.4 per cent while next year GDP is predicted to grow by one per cent (after being revised downwards from 1.1 per cent). It is also important to remember that the peripheral European (problematic) countries are still running a budget deficit which ultimately only makes the problem larger.
Another fact is that the austerity programmes which reduced investment and hence impacted any potential growth produced a tax bill which was and still is far smaller than expected, making the recovery timeline even longer. Marry these two facts together and you will potentially see the next headwind the eurozone has ahead of it.
Draghi will be very wise to be more cautious than optimistic and keep expectations anchored to the ground. However, it seems like the market is already racing ahead of itself by being more optimistic than cautious, which potentially only leaves room for disappointment.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Karl Micallef is an executive director at Curmi and Partners Ltd.