Tonight’s podcast includes some insight on Europe’s current economic and political states, and how it translates into current economic trends.  We have seen the rise of the anti-European and anti-EU mindset all across Europe. This movement not only impacts European politics, but the entire state of the European economy as well, and has direct influence over Western economics in terms of trade agreements, investments in the European market, and the value of our currencies.

Megan Greene, an accomplished economist with a specialty in European economics, explores what Europe needs at the moment and what is most likely coming up in the European economy.

FRA:    Hi, welcome to FRA’s Roundtable Insight. Today we have Megan Greene. She is [the] Managing Director and Chief Economist of Manulife Asset Management. She’s responsible for forecasting global macroeconomic and financial trends, and analyzing the potential opportunities and impacts to support the firm’s investment teams around the world. Formally, she was with Roubini Global Economics, where she had a focus on the Eurozone, and she also holds a Masters [degree] in European politics from Oxford University. So, quite a focus on Europe and we would like to explore Megan’s thoughts on Europe. Welcome, Megan.

Megan Greene:    Thanks for having me.

FRA:    What are your thoughts, what’s happening in Europe? The political situation there, the rise of anti-Europe parties, how that all affects what’s happening as far as the economics and the financial situation of the Eurozone and the European central bank?

Megan:    Sure. So I would say, first of all, that the far greatest risk coming out of Europe for this year, probably the next year (too) is the political risk. Europe has an incredibly busy election schedule over the next year-the next election coming up is actually in France. It’s coming up quite soon; their two-round presidential election. It seemed at first very likely that it would be a runoff in the second round between the right-wing populist national front’s candidate, Marine Le Pen, and the independent candidate Emmanuel Macron. But more recently, actually, two other candidates had a lot of momentum and those are the right candidate Fillon, and the communist candidate Melenchon.  This matters in large part because Le Pen and Melenchon both are running on a platform that’s very anti-European, very populist, and both have said in some form that they would like to renegotiate France’s relationship with the Eurozone, and potentially hold a referendum to see if France might want to leave the Eurozone. There is a chance that the second round of that election could be a “Le Pen, Melenchon” runoff, and that would be a market event for sure; it would be dramatic. More likely is still a “Le Pen, Macron” runoff, and it does seem most likely that Macron will end up winning. Even if Le Pen, the most anti-European candidate won, there’s a parliamentary election at the end of this year, and it seems very unlikely that her party would do well in those elections. It does seem that parliament would still be controlled, in which case it might be very difficult for Le Pen to actually have a referendum on France’s membership in the Eurozone. Even if they had a referendum, actually, the most recent opinion polls suggest that the French would vote to keep France in the Euro(zone). I don’t think that it’s very likely that, first of all, Le Pen would win, but secondly, that even if she did, that France would go ahead and exit the Eurozone. It’s a very low probability event, but such a high impact event-it’s something worth looking at.

The much bigger risk of a Le Pen win isn’t actually exiting the Eurozone, it’s just a series of bank runs starting in France but maybe spreading a bit wider. That would obviously have implications on the markets. Even bigger as a risk for the Eurozone than the French elections, I think, are the Italian elections which are due to be held by March of next year. It’s possible they might be held early…but probably not before the fourth quarter of this year. In any case, according to most opinion polls, the populist, anti-European five star movement isn’t in the top slot. It’s unlikely in an Italian election that the five star movement would actually win in absolute majority. They would have to find coalition partners and that won’t be easy given their ideology and the ideologies of the other political parties in Italy that might want to form a coalition with them. So even if the five star movement were to win the Italian elections, it’s not totally clear if they would make it into government. But if they did make it into government, they said that they too would like to have a referendum on Italy’s membership of the Euro(zone). Unlike in France, Europe is much less popular in Italy so it does seem plausible that if there were a referendum in Italy that Italy could end up choosing to leave the Euro(zone), and that would be dramatic-to have Europe’s third-largest country leaving the European project, that could really pose an existential challenge for the Eurozone. So those are two countries that could end up following in the footsteps of the UK in terms of leaving the European project.

Scotland is another country that could end up, actually, leaving the EU in its attempt to leave the UK. Its hopes given, of course, how pro-European Scotland is would be to rejoin the EU but they might end up having to get in the back of the line. That’s one concern. And then of course one issue that has been at the forefront of European risks since the beginning of the crisis, the global financial crisis, is Greece. Greece hasn’t been solved by any stretch of the imagination, it’s just garnering a lot less attention from the markets these days. Whereas before, the real concern was that there would be a stand-off between Greece and its creditors, and Greece would end up leaving the Eurozone almost by accident. Now, it’s very different. It’s very clear that the Greek government will just end up caving every time its creditors ask new reforms of this government, and just recently they came up with a deal for another round of funding  to ensure the government is signed up to what the creditors demanded. The problem now is that creditors themselves can’t agree on what they want, so the IMF would really like to see Greece have debt relief, which is necessary in my view. The other creditors, particularly Germany, don’t want to commit to debt relief now, particularly not in advance of the German elections coming up. If they don’t come up with a solution, the IMF could end up leaving the bailout program in which case there is a real risk that Germany, and more recently the Netherlands, has said that they wouldn’t participate without the participation of the IMF. If these countries don’t participate, then the bailout program would fall apart. Greece would have no means for funding, and could end up leaving the Eurozone, not because it was specific strategy on the part of the government or even on the part of the creditors, but again, almost by accident. There is a risk that you could have some EU and Eurozone breakup, even though the risk isn’t as high as it once was.

In terms of the actual economy in the Eurozone, in aggregate, I think that the Eurozone is roughly a 1.5% growth economy, but again that’s in aggregate so it masks the big divisions between the core countries like Germany and the weaker countries like Greece and Portugal, and Italy as well. Data has been looking better; much as in the US, much of the confidence data has looked good, a lot of the soft data, the PMI data for example, has been really improving. It’s the hard data that’s not looking as great so things like industrial production, new factory orders, that hasn’t really come in yet. Lending is actually expanding, so we might expect some improvement of the hard data such that there is a sustainable economic recovery in the Eurozone. That recovery can only really be so strong as long as the approach remains that if all the weaker countries doing all the adjusting and all the core countries just carrying along as they always had. Evidence in that is Germany’s current account surplus which continues to hit new record highs every month. Germany and other core countries aren’t adjusting at all and the weaker countries continue to cut their wages and pensions. In Greece’s case at least, we haven’t seen much wager-pinching growth, and they continue to try to increase their national savings as a percentage of their GDP to match Germany’s again, and that just means there’s not a lot of consumption or investment happening in the weaker parts of the Eurozone. That really cuts off any avenue towards domestic demand, it means that most of the Eurozone is relying on exports for growth. There is an economic recovery happening in the Eurozone, it’s just muted by the fact that it’s all the weaker countries doing all the adjusting and none of the stronger ones. I think that we can expect that to continue in the absence of any major policy change, so I think the Eurozone in aggregate will continue to be a 2% growth economy.

In terms of what the ECB is doing, the ECB would love to normalize monetary policy but it’s just taking them a while because the recovery is so weak and because inflation isn’t coming in. I think that the ECB will probably announce a tapering of their QE program at the end of this year, and at the end of next year, they might have to wait until the beginning of the following year. The ECB is very much going in the footsteps of the US in trying to very, very gradually normalize monetary policy. I think that if some of these political risks I mentioned materialize, then it’ll be incredibly difficult for the ECB to hike rates in to that for sure. There are other risks, in the banking sector for example, particularly in Italy, that might make it really difficult for the ECB to tighten monetary policy.

FRA:    You mentioned earlier on bank runs, could those be initiated from a catalyst of something other than one of the countries pulling out, like Italy or France, pulling out of the European monetary union? Would it be other factors potentially, in terms of the bank runs?

Megan:    Yeah, you could see bank runs happening as a result of financial instability in in of itself. Particularly in Italy, there are a lot of banks that are still requiring recapitalization, non-performing loans in Italian banks. Portuguese, Irish, Greek, even French banks are really elevated and it used to be that they would work at their non-performing loans by creating bad banks because they can’t create the same bad bank that they used to be able to. That’s no longer a solution which means that none of these countries really know what to do with the massive heap of MPL’s that are sitting on their balance sheets, and so if you see those non-performing loans start to be realized and turned into defaults you could end up having a real scare.

The Eurozone has made some progress on institutional change in terms of creating a banking union, but they haven’t gotten all the way there yet so rather than saying they have a banking union I’d say they have a loose banking federation. There’s still no risk sharing in terms of banks in Europe so that means that not only is there not a common deposit guarantee in Europe, but I do think that if any country that has a big bank that really needs to be wound down. Now, governments aren’t allowed to step in and bail them out, and I think that wounding down a big bank is absolutely politically toxic for any leader so faced with that choice, most leaders would just break the rules and completely undermine the banking union and that in itself could spark off bank runs as well.

FRA:    Do you see the potential for a move towards a fiscal union in terms of creating an actual European bond or just conducting fiscal policy across the entire Eurozone?

Megan:    I think part of a fiscal union is needed, though I don’t think we need, for example, a common fiscal authority. I think we do need to see asset class in Europe that is liquid and deep enough to withstand any sudden stops, so I do think they need to create mutualized debt like a Eurobond. But then actually I think that the private sector can go ahead and step in rather than having a fiscal authority. If we had a capital markets union, I think that that could go a long way towards achieving what a public fiscal union could achieve and I think that’s necessary because I just don’t think that there’s any political will either in the core or in the periphery to actually have a fiscal authority and have everyone sign up to the same rules. So I think that it’s unlikely and would be a waste of political capital to try to create a fiscal authority.

One way of explaining what I think that the Eurozone needs is a mutualized debt so a Eurobond, but then in terms of the private markets governing cross border investments and exposure, it’s a bit like our credit card companies like VISA and MasterCard, that’s mutualized debt with no real central authority to manage it. There is some precedent for, I think it’s possible, but I don’t think it’s possible to see a full fiscal union with a single fiscal authority. Unfortunately, Eurobonds aren’t at all on the agenda now. It would require several more acute crises, and existential crises in the Eurozone to get the core members and the peripheral members to sign up for it, but particularly Germany because Germany doesn’t really see why they should accept other countries’ risk, and they’re worries about creating a moral hazard by going ahead and mutualizing bonds. So I think it’s very unlikely, but I do think that we need Eurobonds eventually for the European project to stay together.

FRA:    And actually just recently this week US president Donald Trump made some comments on the dollar that it was too strong and so there was some movement on the dollar going lower; pushing the euro higher. Could that be a trend, and if that were to happen, if the euro would strengthen, could that cause global havoc and the countries’ struggle on their economy and debt burden?

Megan:    Well, I think that’s its really unlikely that the general trend will be that the dollar weakens, I think that it’s much more likely that the dollar ends up a bit stronger even though the US president is trying to talk down the dollar at the moment. It’s really hard to conceive of a situation in which it’s in the US government’s best interest to see the dollar depreciate. The only scenario I can really think of is if there were huge problems in other economies, and the US fed opened up slop lines with other central banks to essentially fund their QE program so the Bank of Japan and the ECB, and the Bank of England. I think that’s really unlikely. We have seen the dollar weaken a little bit but the general trend is for the dollar to strengthen and that’s relative to a basket of currencies but that includes the Euro. I think generally the Euro will be weaker. Also, we will have movements, depends on your time frame of course, but I think if the French election results in Macron at the helm of government, then I think that the Euro could strengthen off the back of that.  But if Le Pen were to win for example, I think the Euro would weaken off the back if that, so it will depend to some degree of political developments and in the long term, I do think that the Euro will probably weaken relative to the dollar. Not so much necessarily because of the factors that mean the Euro should be weak but in large part because of what the US and the fed are doing.

FRA:    Given these political developments, do you see Germany continuing to bear the debt of the rest of Europe in terms of transferring its current account surplus to the less fortunate states of the union…or could it be that Germany considers on leaving the Eurozone?

Megan:    I think that Germany has really been taking on risk through the target to balance this at the ECB, so the target to imbalances is now at record high, or higher than they were back in 2012, when there were much greater concerns about countries leaving the Eurozone. That’s largely because of Italy, actually, so it’s largely because of German investors pulling out of Italy. Now that only becomes a problem if a country actually leaves the Eurozone and that seems unlikely, I think. It’s certainly not my base case scenario over the next couple of years. Otherwise, Germany isn’t really funding everybody else’s debt, but I do think that there is a discussion about whether it’s really in Germany’s best  interests to stay in this project. I think that it definitely is. Germany benefits from an artificially weak currency because it is connected to so many weaker countries, and that’s been really helpful for Germany given that their growth model has been pretty reliant on exports for the past several years so the domestic demand now stand for a slightly larger percentage of GDP than it has in the past, but its only really slightly larger. Germany is still dependent on exports for growth. If Germany were to go ahead and leave the Eurozone, it would probably see its currency appreciate massively and that would completely undermine its entire growth model so it would have to come up with an entire new model and that’s not really in Germany’s best interests so I do think it’s in Germany’s best interests to stick in the Eurozone.

I will say that I’ve spent a lot of time talking to the EU governments and my argument with them has always been that Germany always had a very high national savings rate, and so they’ve had a really low national investment rate, which hasn’t really served them well. I mean they’ve invested in Greek government bonds, and Portuguese retail, and Irish property, which (those investments) turned out to be really bad investments. It also means that German investment domestically has been really low, so Germany suffers from chronic underinvestment and as a result their roads are in bad shape, their bridges are in bad shape, so my argument has always been that maybe the German government should encourage domestic investment and that would boost Germany’s growth, and that would also trickle out and help the growth of the rest of the Eurozone. The German government’s response to me every time is to ask me why they should care about growth, which as an economist you can imagine, seems like a weird question but according to them, they don’t have incredibly high growth but they have a really high standard of living and very low unemployment. In their view, growth is kind of an Anglo-Saxon obsession and they’re doing just fine. So this approach to growth in Germany, and this approach in the entire region whereby Germany does the same as its always done and everybody else tries to look more like Germany, I think that’s here to stay for a number of years.

FRA:    Interesting. And what are your thoughts on the UK and Brexit, how that’s playing out, and could there be any changes between now and the next two years after they receive their Article 50 notice like a few weeks ago?

Megan:    I think there are still some that are hoping that the UK will take back triggering Article 50. I spoke with the guy who wrote Article 50, John Kerr, and he says you can and he intentionally left wiggle room in it. I think it’s very unlikely that the government will do that given that they’re acting on a mandate that was given to them by the people. Also if they were to go ahead and revoke it, they probably would have already damaged their relations with the rest of the EU given that they’re negotiating to leave.

I did a lot of consulting on Brexit and testified in the House of Lords, and before Brexit I would’ve said that the worst possible option was the UK going for a so-called “hard Brexit”, which means leaving the single market all together. Now, I think that’s no longer the worst option, I actually think it’s the most likely option. The prime minister has said that’s what they’ll pursue. I think there’s a worse option out there which is that after two years of negotiating, both their divorce from the EU and their new relationship with the EU, they actually don’t have any agreement on what their new relationship with the EU should be, at which point the UK would just kind of stumble out of the EU. They would have to rely on the WTO for their trade relationships. The problem with that is that right now the WTO has relatively robust rules and some credibility, but in two years from now it actually might not, so, you could conceive for example the US government trying to implement a border adjustment tax which is most likely illegal according to WTO rules. Having the WTO turn around and say, “Well, that’s illegal you can’t do that” and the US administration could just reply by saying well, “We don’t care anyhow”. That would completely declaw the WTO. That’s just one example and there are a number of potential trade policies coming out of the US in particular that could really undermine the WTO, so the UK’s plan is to actually rely on WTO rules so that at the end of two years the WTO might be severely undermined by then, in which case, that’s a terrible plan for the UK. I think that’s the worst scenario.

The only way, I think, that the UK could actually have a deal at the end of two years is if they cut and paste it from somewhere else. Two years is not a lot of time to negotiate their divorce from the EU first, and of course not much will get done before the French elections, and then the German elections in September, and then the Italian elections in March, so, there will have to be breaks in negotiations. They’ll have to negotiate the divorce and then they’ll have to negotiate an entirely new relationship-that’s a lot to do in two years. If they can cut and paste a new relationship from somewhere else, they might be able to pull it off. One way to do that is to copy the deal that Canada and the EU struck: the Ceta deal. The problem with that is that it doesn’t include anything on services and more than half of the UK’s economy is services so they’d have to write an entire new chapter to cover services, and that in itself could take two years. That’s problematic. There’s one other option that’s currently being discussed behind closed doors in the UK and that’s to copy the deal that the EU just struck with the Ukraine which does include services so that is really feasible. It is mainly being talked about behind closed doors because the UK doesn’t want anyone to realize that they’re trying to follow the Ukraine as a model. That is one option but it’s too early to say whether really is possible or not but it’s something that they’re looking at.

FRA:    Finally, just wondering your thoughts on the investment environment, what this all means, not mentioning any specific companies or securities, any thoughts on asset classes or types of investments that could make sense in Europe given all the scenarios, assuming there could be some investments that could make sense regardless of all the different scenarios like whether Germany stays, whether they pull out and different countries leaving, the effect of political parties getting elected. And would it make sense for Europe in general now from a contrarian perspective? Perhaps like German corporations or German real estate, if they were to pull out their currency would appreciate, but if they stay in there could be more inflation generated to ease to burden of debt across the Eurozone. Your thoughts?

Megan:    German real estate certainly is one potential opportunity but generally I would say given even all the risks that I’ve highlighted particularly the political risks, I think that the most likely scenario over the next year or two is that we go through all these elections and actually in the end we just have the status quo, which would be market-positive. I’m hesitant to get too excited about that because I do think that there are real restraints on the economic recovery in Europe because of the politics as they currently stand, so the status quo means that would continue. Still, I think that would be a risk on development in which case given that you have the ECB continuing to ease now and I think that they’ll continue to maintain accommodative monetary policy going forward, and you have the fed in the US tightening actually, that does means that there might be opportunities and equities in Europe generally so I do think that that is one place that investors could look. In terms of banks in Europe, there are some real problems in terms of the health of bank balance sheets particularly in Italy, Portugal, even France, but banks are incredibly cheap so there might be some valuable investments there. Generally I do think that the valuations for companies in Europe will go up so I would say that European equities are probably a good opportunity now.

FRA:    Great. Great insight. How can our listeners learn more about your work?

Megan:    You can follow me on twitter, its @economistmeg to not only see what I write myself but to also see my commentary on the latest, greatest in Europe and the rest of the world.

FRA:    Great, thank you very much for being on the show and again, thank you.

Megan:    Pleasure, thanks for having me.

Abstract by Tatiana Paskovataia, tatiana-p28@hotmail.com

LINK HERE to the podcast

Disclaimer: The views or opinions expressed in this blog post may or may not be representative of the views or opinions of the Financial Repression Authority.