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Chartbook X Unhedged: Europe

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Good morning. The Fed will allow its $9tn balance sheet to shrink by $95bn a month, starting soon, according to the minutes of its March meeting, which dropped yesterday. As we said in Tuesday’s letter, we don’t think anyone knows how this is going to play out. Anyone who assumes it will simply drive up the yields on long Treasuries might be in for a surprise.

More importantly, today marks the third and final part of the Chartbook x Unhedged partnership. Adam Tooze has really pushed Ethan and me into the deep end of the pool this time. At his urging, today’s topic is the future of Europe, in wake of the pandemic and in the shadow of war. 

There is a fascinating tension right now. On the one hand, the strong collective response of European governments to first Covid and now Vladimir Putin’s war in Ukraine suggests the possibility of a more fiscally and industrially unified and balanced Europe, one that could make co-ordinated investments, improve productivity and grow. On the other hand, though, resurgent populist/nationalist movements are pushing against this trend; witness Marine Le Pen’s surge in France’s presidential polls.

This is a lot for a couple of market columnists to handle. So we framed the question in a way we could grasp it: is there a bull case for buying a resurgent Europe? You can find our thoughts over on Chartbook (link here). Below, Adam argues that a US-style market renaissance in Europe would require nothing less than a shake-up of the continent’s class system.

Adam Tooze: can we be bullish on Europe?

What makes investors bullish?

You might bet on a propitious macroeconomic environment, in which one might include everything from buoyant aggregate demand, to a dynamic workforce and good trade relations with neighbouring economies.

You might bet on the next revolution in technology, or corporate organisation, or communications.

But what makes for truly sustained bull markets are big shifts in the political economy. Investors need to know that the political economy will favour them. They need to know that political and legal conditions will allow them to build and maintain what Warren Buffett with refreshing frankness calls “moats” — ie, defensible islands of oligopolistic profits. It also helps if taxes are low and there is little risk of regulatory challenges to investor interests.

On all three counts in recent decades the US has eclipsed Europe.

Since Alan Greenspan took over at the Fed, the US has had an investor-centred monetary policy that has supported decades of financial uplift. It has been an era not of fiscal or monetary dominance, but what Markus Brunnermeier at Princeton dubbed financial dominance. The refusal to accept or to inflict significant losses on investors and financial institutions dictated monetary policy.

The same cannot be said for the eurozone. Europe’s monetary policy has been dominated by a struggle over the structure of the common currency. The prolonged crisis between the north Atlantic banking meltdown in 2008 and former European Central Bank president Mario Draghi’s “whatever it takes” in 2012 was one of the greatest failures of macroeconomic policy on record. The upshot was to shock Europe’s aggregate demand and to generalise the chronic trade surpluses of Germany and the Netherlands to the eurozone as a whole. If corporate Europe was to prosper, it was not on the back of domestic demand.

But it is not just the macroeconomic conditions that have been far more favourable in the US. As Buffett has noted, again with admirable candour, the political economy of the US could hardly have been more favourable. As he remarked to The New York Times in 2006, “There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.”

Any honest assessment of America’s markets must surely conclude that despite the populist veneer — Mad Money, Reddit and all that — the bull market has, in large part, consisted of a party for the top 1 per cent. America’s wealth holders have compounded their affluence by investing in their own success.

No sector has exemplified this more than Big Tech. Silicon Valley has delivered a bona fide, world-changing technological revolution. Surviving through the dotcom bust and powering through 2008, it has also been the great legitimising force of US capitalism. It has driven massive market valuations inflated by promises of monopolies to come and thereby helped to produce huge wealth and huge inequality.

Europe is different. 

The old continent is by no means a paradise of social equality. As the data of Thomas Piketty and his colleagues show, in Europe inequality in wealth and incomes is centuries deep. What is more, in recent decades, notably in Germany, inequality has become more intense. Top salaries are growing. Trade unions are weaker. There is more unemployment and low-paid work. The profit share has gone up. But, after all is said and done, the balance has shifted nowhere near as much in favour of capital as in the US.

So extraordinary has the surge in American inequality been that it has spilled over to Europe — through salary differentials, investor expectations of return and through US investment in European financial markets. Of the record dividends paid out by companies included in Germany’s Dax 30 index in 2019 whose destination we can track, less than 40 per cent went to German investors. American investors, led by BlackRock, held 22.3 per cent of Germany’s blue-chip index.

It can be little surprise that in looking to maximise their return on their capital, European businesses and the most talented workers look to the US and further afield. Of the leading corporations in the respective equity indices, foreign revenue flows make up a far larger share for European companies than they do for American ones. In this sense, a bull case for European equities might not be about Europe at all.

In Europe, the far more moderate social changes of recent decades go hand in hand with a relatively static technological environment. In the global rankings, what remains of European corporate strength is in relatively old-fashioned sectors, industry, luxury goods and the like. Europe does not have big players in tech. A veritable gulf separates venture capital investment in Europe from that in the US and Asia. As The Economist recently pointed out:

Of the world’s 142 listed firms worth over $100bn, 43 were set up from scratch in the past half-century, 27 in America and 10 in China. Only one was in Europe: SAP, a German software group founded in 1972.

As far as European regulators are concerned, US Big Tech is a foe, not a friend. It is not for nothing that America’s new generation of neo-Brandeisian antitrust activists, bent on pricking the country’s tech bubble, look to Europe for inspiration and support.

This is not to paint Europe as the innocent or the victim. The EU permits several of its member states to operate tax havens through which the US tech industry has long-channelled its profits. But it is telling that it is the Netherlands and Ireland that service Apple and that it is Luxembourg that plays home to the funds from Connecticut and New York, and not the other way round.

So what are the chances of this balance of advantages and disadvantages shifting in the coming years?

I agree with Armstrong and Wu that the tendency in European economic policy is in the right direction. After the ECB’s performance in 2020, the chances of another debacle in the eurozone style seem slim. The ECB has converged with the Fed in pursuing quantitative easing and addressing financial instability with massive bursts of liquidity. If anything, in the current tightening cycle, the ECB lags behind the Fed. That may give a fillip, if only a temporary one, to European stocks.

It may also be the case that we are entering a new phase in the development of digital technology in which the EU is relatively less disadvantaged than it was in recent years. This is a case advanced by analysts at Goldman Sachs. For the internet of things it may matter that Siemens is in better shape than General Electric and that Volkswagen is bigger than General Motors and has better partnerships in China.

Though it is hard to imagine how any rival could match the explosive growth in Tesla’s valuation, in the broader energy transition Europe should, by rights, be a leader. Europe’s governments have a far more credible commitment to investing in wind and solar power. Whereas the stand-off with Russia reinforces the American fossil fuel lobby, in Europe it adds impetus to the transition.

It is a striking fact that leading American money managers like BlackRock, in seeking to shape the ESG revolution, see Europe as a crucial battleground.

If we follow the neoliberal playbook and the energy transition is driven by property rights and prices, then Europe has, with the establishment of the EU’s Emissions Trading System, stolen a giant head-start on the US. Being required to purchase emissions certificates raises the price of energy, but it also creates a new class of assets and powerful incentives for innovation.

But a technological revolution does not by itself a bull market make. To get a Gatsby-style bull market, you need not just supportive macroeconomics and technological dynamism, you need Buffett’s class war too.

There are politicians who have advocated a radical shake-up of European class relations. For some, Margaret Thatcher remains an icon. The Hartz IV labour market and welfare restructuring in Germany were as dramatic as anything seen under the administration of Bill Clinton in the US. Angela Merkel was initially attracted to thoroughgoing market economics but shied away when an excess of enthusiasm, almost costing her the election in 2005. Merkel’s successor as leader of the Christian Democrats, Friedrich Merz, ex-BlackRock, would no doubt like to take the party in a more market-oriented direction. But Merz’s party, once the dominant force in German politics, is polling at a disappointing 26 per cent. Meanwhile, new Chancellor Olaf Scholz’s government is cut from a different cloth. The Social Democratic party promised its voters respect and security, not radical upheaval.

Market revolutions in Europe are unpopular. It is with good reason that radical welfare reforms have been driven in Europe less by direct political assault than through the institutions of the EU. Brussels delivers the market revolution thoroughly but also coldly. If anything, it takes its devotion to neoliberal doxa rather too seriously. Market reform comes with ample helpings of fiscal austerity and too much competitive discipline to be conducive to really handsome oligopolistic profits.

Among Europe’s politicians today, the most American, the most uninhibited in his embrace of a pro-business model, is French president Emmanuel Macron. Since his meteoric rise in 2017, his model of reform has been impatient, lopsided and at times authoritarian. He has raised the labour market participation rate and the rate at which French people register as self-employed. But in 2018 it was his astonishingly ill-judged tax cuts for the rich that triggered months of violent protests by the gilets jaunes. In the upcoming presidential election, Macron had been riding high in the polls until rumours began circulating about his government’s fondness for paying high-priced consultants, and then, on March 17 he announced his election manifesto. It is a remarkably radical package that calls for raising the retirement age and consolidating the welfare system so as to push even more people into the workforce. Macron may have gambled that his lead in the polls was unassailable. It may prove a miscalculation. Since mid-March, Jean-Luc Mélenchon on the left and Marine Le Pen on the far right have surged. Both of them are promising to counter Macron’s attack on the French welfare state. In a head to head, Le Pen vs Macron now looks like a close-run thing.

Even if Macron remains odds-on favourite to retain the presidency, it is clear that on his economic and social agenda he faces serious opposition from a large part of the electorate and that his party, La République en Marche, has little chance of winning a majority in parliament. As the political economists Bruno Amable and Stefano Palombarini point out in their illuminating book, The Last Neoliberal, fundamental divisions in France’s society and politics have contributed to Macron’s meteoric rise to power, but also limit his ability to govern. There is no single dominant social and political bloc in France. Macron’s demand for radical, pro-business policies may please the markets, but in the absence of an actual social majority for his programme, he rules by splitting his opponents along social lines and over wedge issues such as immigration and the position of Islam in French society. That progressively erodes the legitimacy of the political system. And the risk is that Le Pen will in fact unite a nationalist and identitarian majority against him.

Every European political system has distinct dynamics. But the basic diagnosis holds true more generally. There is no society in the EU whose political system will generate a solid majority for painful pro-business policies.

Right now there is relative calm in European politics. But if the French right scores big victories in the coming weeks, against the backdrop of Viktor Orban’s decisive election victory in Hungary and the prospect of a rightwing victory in Italy in 2023, it puts the future of centrist politics in Europe very much in doubt.

So what then is the broader outlook?

Will Europe do better in macroeconomic policy terms than it did in the miserable years between 2008 and 2020? One must sincerely hope so, for everyone’s sake. Barring another derailment of monetary and fiscal policy, one would expect growth to pick up and unemployment to continue to decline.

Europe may also make a large contribution to the green tech revolution we urgently need.

But will Europe deliver a bull market in the American sense of the word? Don’t bet on it.

The kind of equity market boom that the US has witnessed in recent years is the expression of a gigantic economic and social upheaval from which a tiny minority with concentrated ownership of financial wealth, have derived huge benefit.

That isn’t lost on Europeans.

The citizens of the EU may not be particularly pleased with the status quo. They may not have a clear idea of what an alternative growth model looks like. They may not be able to stop top-down institutional reform driven by agreements struck between national governments in Brussels and implemented by European institutions. But don’t bet on a majority of Europeans any time soon voting for the sort of comprehensive market revolution that would sustain an American-style bull market.

One good read

Every word Andrew Solomon writes is worth reading, especially on the most painfully imaginable subjects.

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