In the opening session of the CFA Institute Fifth Annual European Investment Conference in Prague, Czech Republic, Anatole Kaletsky, co-chairman and chief economist of GaveKal Dragonomics, dissected enduring European political and economic dilemmas and evaluated a range of potential scenarios. Surprisingly, Kaletsky downplayed the real economic importance of Europe to the global economy and told hundreds of delegates there is a chance that Germany might even leave the eurozone to ensure the euro’s survival as a currency.
“Europe has been generating tremendous amounts of noise,” said Kaletsky, “but most of the signals for financial markets have come from the United States.” The eurozone has contributed nothing to global growth over the last four years, and as such a negligible contributor to incremental growth, its role is often overstated. “Europe has been the main source of day-to-day and week-to-week volatility in financial markets, but it hasn’t set the trends. The trends have been set by events in the United States and China,” stated Kaletsky, who argued for a more proportionate view of Europe by investors. Popular beliefs about the correlation between “risk off” trades and the euro are regarded as completely spurious by Kaletsky; the euro is more or less where it was in 2009, whilst the S&P 500 Index has more than doubled over the same period.
Kaletsky argued that the necessary conditions for euro survival are political, fiscal, and monetary federalism. He scoped out a range of scenarios that all are afflicted by a “time inconsistency problem.” Stark differences and inconsistencies exist between political time horizons and financial market time horizons. Financial markets demand solutions much faster than politicians can provide them. The good news, according to Kaletsky, is that the European Central Bank (ECB) now recognizes that it has a role in providing a safety net to control tail risks and stabilizing the inevitable process of managing the cycle of hopes, expectations, and disappointment, thus facilitating change.
One of Kaletsky’s boldest suggestions, that Germany could leave the eurozone, derives from his perspective of rising monetary and economic divergence within Europe, especially between northern and southern Europe. He highlights easier fiscal policy in Germany, where domestic consumption is being marshalled to replace falling exports to southern Europe. “Germany almost needs to accept the boom in construction in order for the euro to survive,” said Kaletsky. Monetary expansion in Europe has also been greater than in most other countries and taken different forms (lending through the ECB). Almost none of this monetary expansion will benefit southern Europe; it has instead ended up in northern Europe, sowing the seeds of a boom there. So the next couple of years will see the north getting richer and the south poorer, a rosy prospect for the north at least. “There is a 10% or 20% probability that Germany will say we are not prepared to create the conditions that will allow Europe to again become a convergence zone as opposed to a divergence zone, due to the euro,” Kaletsky added.
Kaletsky stated that a eurozone without Germany would probably consist of France, Italy, Spain, and Portugal — all of which have “similar economic structures and similar traditions of high inflation, devaluations, and relatively weak currencies, which actually served those countries well from 1946 to 1999.” A eurozone without Germany would easily be a fiscally sustainable bloc, according to Kaletsky. Gross national debt as a percentage of GDP for such a zone is actually lower than in the United States, Japan, and Great Britain, whilst current account balances are comparatively respectable.
Kaletsky finished by sharing the investment implications that follow from this provocative analysis. Equity valuations in Europe are already over-discounting bad news. European export stocks have tremendously outperformed. Kaletsky argues that both of these phenomena may reverse, although not immediately. “The attractive companies to look at in Europe are now the ones that are focused more on domestic demand in northern and central Europe,” he said. There may also be one big bond divergence trade left. “France has been treated as if it were a province of Germany, when it is almost inconceivable that if the euro breaks up France will be on one side of the barrier and Italy and Spain on the other,” added Kaletsky. The economic and political traditions of France are much closer to Italy and Spain than to Germany. Finally, the pound sterling, which has so far offered a safe haven from currency turbulence, is likely to suffer an unpleasant reverse if the euro crisis deepens because over the long term, it has never been an effective hedge against the euro.