European markets – what could possibly go wrong?

The eurozone is humming with robust synchronised growth, right? So why has the biggest Wall Street hedge fund shorted European markets to the tune of $22 billion?

A very big short

Last week CNBC revealed that Bridgewater Capital, a Wall Street hedge fund with $160 billion under management, had taken out short positions on European bourses – mainly Germany, France and Italy – amounting to a staggering $22 billion[i]. Until then, Bridgewater was known to have been net long in Europe. But under European regulations, unlike in the USA, large-scale short positions have to be disclosed.

Bridgewater’s investment strategy is not to take a view on individual stocks but to trade on a macro analysis of market direction. So the good people at Bridgewater Capital think that the German, French and Italian markets are about to fall. Why?

Inside the mind of a hedgie

Let it be clear that I am not privy to the thought processes behind this investment strategy which are driving billionaire founder Ray Dalio and his team – but I can try to imagine what they are.

The markets, the financial establishment and the mainstream media have been bedazzled of late by the eurozone’s return to growth. After several years of laggardly growth, the German economy grew by 2.5 percent last year. Exports are buoyant and the fiscal surplus is at 1.2 percent of GDP. Growth for the eurozone as a whole is projected to be 1.8 percent this year – marginally ahead of the UK.


But while Germany and France, the eurozone’s two biggest economies, remain in robust shape, business executives are somewhat less upbeat than they have been of late. Surveys of private sector purchasing managers issued on Wednesday (21 February) by IHS Markit for both countries revealed falling confidence this month. The German PMI slipped to a three-month low of 57.4, from 59 in January; while France’s PMI clocked in at 57.8, a four-month low[ii]. But that is not necessarily a harbinger of doom.

The European populist uprising did not happen. Back in the summer of 2016 I foresaw another 1848 in Europe; but it was – so the European elites see it – the Anglo-Saxons who fell prey to populism. And yet creeping xenophobic nationalism is still on the rise in Europe – in the Netherlands, Italy, Spain, Greece, Poland and Hungary…

Germany

Since 08 February, Frau Merkel leads a new grand coalition of the two main parties – her centre-right Christian Democrats (CDU) and Martin Schultz’s centre-left Social Democrats (SPD). Normal service has been resumed in the Bundestag and in Willy-Brandt-Strasse. Alles gut! Except that a much weakened Frau Merkel presides over a fragmented government which can do little to allay the disaffection that is mounting in large parts of the German population. And the anti-immigrant Alternative für Deutschland (AfD) is now, de facto, the official opposition.

Actually, the final say on the coalition deal rests with the SPD’s 460,000 card-carrying members who will pronounce their verdict on 04 March. The party’s youth division is running a vigorous NO campaign, but it is probable that the SPD will endorse the deal. Even if they do so Merkel 4.0 will be a much diminished political entity. Her party gained just 32.9 percent of the popular vote on 24 September last year. (For comparison, Mrs May’s Tories garnered 42.4 percent last June). The SPD won 20.5 percent of the vote. AfD got 12.6 percent of the vote and 94 of the 598 seats in the Bundestag.

The coalition is not so much a marriage of convenience as one of necessity. CDU supporters rankle at the SPD having been handed so many key cabinet posts, including finance (Olaf Scholz – who defines himself as not Wolfgang Schäuble) and foreign affairs (Sigmar Gabriel). SPD supporters widely believe that the SPD got the worst of the deal last time round. It is certainly true that smaller coalition parties tend to get punished worst – just look at the fate of the Liberal Democrats in the UK after the dissolution of the Cameron-Clegg coalition.

Creeping xenophobic nationalism is still on the rise in Europe.

But both parties are desperate to avoid another general election in which, they fear, AfD will do even better. An air of lethargy has settled over the German political establishment – the dynamism and optimism of Merkel 1.0 and 2.0 have faded into a climate of grievance.

Frau Merkel’s decision to allow nearly one million immigrants to settle in Germany in 2015 still arouses resentment in some quarters. Germans think that their country finances the eurozone periphery by massive annual transfers. They are deeply suspicious of the money-printing ECB and the accompanying low interest rates which penalise provident German savers. In fact, these interest rates are negative in real terms given prevailing inflation of 1.8 percent.

What are the chances of the Merkel 4.0 coalition surviving before the next federal election in 2021? When Frau Merkel installed Annegret Kramp-Karrenbauer, the premier of Saarland, as Secretary General of the CDU on 19 February, this was widely interpreted inside and outside Germany as the Chancellor anointing her chosen successor. A close confidante of the Chancellor, Frau Kramp-Karrenbauer is widely referred to in the German media as Mini Merkel. This development has intensified the sense of an ending: we are in the final phase of Merkelism – the sure-footed, pragmatic common-sense political economy of the proverbial Schwabishe Hausfrau. What lies beyond it remains unclear.

Meanwhile, a recent headline stirred feelings of apprehension in those like this writer who admire Germany: VW tested diesel fumes on monkeys…

In 2014, Volkswagen AG (ETR:VOW), Daimler AG (ETR:DAI) and BMW (ETR:BMW) conducted an experiment in which caged monkeys were forced to inhale car exhaust fumes. The car manufacturers’ aim was to show that the NO2 emissions found in exhaust fumes are harmless to humans — although the opposite had already been scientifically proven.

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Netflix (NASDAQ:NFLX) broke the story in Dirty Money, a TV documentary first broadcast during the week of 22 January. Since then, the three German auto giants have expressed regret for actions that were “wrong, unethical and repulsive”. But, as the Financial Times observed, the scandal is much more than about animal cruelty. It reveals appalling governance within corporate Germany. Where was the debate over the ethics? Or an effective compliance team? And, more fundamentally, where was any sense of historical awareness?[iii]

These latest revelations are only the most recent scandal. Two years ago, VW admitted installing software in its cars that artificially lowered NO2 levels under test conditions – but pumped out more in normal driving. The brand of Germany’s most iconic company was tarnished and the extent of fines in the USA is still not known. (VW has refused to countenance any compensation to European buyers). Moreover, Germany’s brand image as a green-minded and progressive country is tarnished too.

The Germans legitimise their industrial pre-eminence through the European ideal: the German state only became normalised by being a founding member of what in time became the EU. As the Germans themselves say: better a European Germany than a German Europe. But a less purposeful Germany implies a weaker Europe.

Italy

The Italians will go to the polls on Sunday, 04 March. This election is likely to be messy – all Italian elections are. And the Italian economy has been heroically sclerotic for decades. There will be horse-trading, post-election; populists will parade through Rome fulminating against Brussels and the Euro; there will be a coalition of bounders and coves. So what?

The “5 Stelle” (Five Star) movement, led by a superannuated clown, will win a substantial slice of the popular vote. They once made noises about having a referendum to leave the Euro. But, like the Greeks, they now realise that changing currency would be a terrifying leap in the dark. One thing provident Italians understand is the need to safeguard their nest eggs. If the Greeks couldn’t bring themselves to do it, even in the depths of economic implosion, then the Italians – richer, and with more assets and more savings – will be disinclined to do so.

I therefore believe that we can relax about the Italian election – there will be much opera but little material fallout. For the moment, I can’t even remember the name of the Italian Prime Minister (oh yes, Signor Gentiloni) but it doesn’t really matter because he will be out very soon. The Italian elections will be inconsequential at a macro level – though that does not mean that Italy does not matter: it is a huge economy, the third largest in the eurozone.


The most important Italian in the world is Super Mario. Over at MoneyWeek, John Stepek thinks that the real test will be when Mario Draghi, whom he regards as the greatest central banker in the world, steps down next year as Chairman of the European Central Bank (ECB)[iv]. He has led a benighted currency out of crisis into the promised land of monetary stability. The euro has become the Deutschmark swathed in blue. (That, of course, is the central problem.)

If a German central banker takes over at the helm (Jens Weidmann is the current favourite) he/she will surely put up rates. That could mean trouble ahead.

Meanwhile, back in beautiful Italy, the national debt continues to edge upwards. According to National Debt Clock, Italy’s state debt now amounts to nearly 137 percent of GDP. Now, if the putative German central banker does raise rates across the eurozone, that will cost the Italian government dear in terms of additional interest payments. But the Italians are largely unconcerned: they know that Italy, unlike Greece, is just too big to fail.

France

France is the most confident nation in the EU at present. Under President Macron, France has propelled itself out of Germany’s shadow and can claim, in a tangible sense, to be the real leader of Europe.

This is partly a result of Monsieur Macron’s dynamism, and partly timing. Emmanuel Macron came to power – succeeding a decidedly dull and flaccid French leader – at the precise moment that Britain’s influence in the EU (and to some degree, though temporarily in my view, on the world stage) had been eclipsed by Brexit. (Alone in Western Europe, Britain and France are nuclear powers with permanent seats on the UN Security Council.) And simultaneously, when America’s global leadership role had been abnegated by President Trump. Then Frau Merkel was immobilised by the German federal election. This left the histrionic President with an empty stage on which to strut his stuff.

Under President Macron, France has propelled itself out of Germany’s shadow and can claim, in a tangible sense, to be the real leader of Europe.

The bantam President is big on gesture. He gave a white horse to the President of China in the Year of the Horse. The thirty-nine-year-old hosted President Putin at Versailles exactly 300 years after Peter the Great had been feted there by the seven-year old King Louis XV. He took the Donald up the Eiffel Tower and kindled a passion in the Orange One for military parades. And he kindly offered to lend Theresa May an embroidery depicting a frail English leader having his eye poked out by a French thug. (It’s mostly a piece of eleventh century fake news, by the way.)

Where is the meat? While Frau Merkel has been consumed by turgid negotiations with Herr Schultz and company, Monsieur Macron has pushed a package of labour reforms through the tame Assemblée Nationale. He has articulated a vision of France as a tech hub and he has charmed the global plutocracy over canapés at Versailles.

The new Secretary General of the European Commission, Martin Selmayr, has been described as a Europhile theologian who regards the British as guilty of heresy. But President Macron has no such religious scruples. He just wants to milk Brexit for all he can get for France – particularly in so far as City of London business is concerned. Though I doubt that he wants the City to collapse – he is sophisticated enough to understand the importance of the London financial market to Europe’s financial health.

Furthermore, Brexit represents an opportunity. The UK was always a break on further European integration: the Anglo-Saxons could be relied upon to resist grandiose French initiatives. Now they are leaving, this is the perfect moment to advance an agenda long suppressed by circumstances.

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In an important essay, Brexit – A French Perspective, Professor Christian Lequesne of the prestigious elite school Science Po in Paris, explains the long-term reasons for French ambivalence about the UK’s role in the EU. Britain’s most lasting contributions to the EU were the single market (which ironically Mrs May’s government plans to leave, even though it was one of Margaret Thatcher’s greatest achievements) and the EU’s expansion into central and eastern Europe.

Neither of these achievements is “considered as unequivocally positive in France”, writes Professor Lequesne. In fact, they are “often perceived as neoliberal policies” that pushed the EU in a direction detrimental to France’s interests. A Europe without the UK is a bird cage in which the French can stretch their wings at last.

Most positively, President Macron understands that there are already two Europes. There is the eurozone, which he believes must harmonise its fiscal policies just as it has a single monetary policy; and there is the European periphery outside the eurozone where looser arrangements might apply. It is a pity that Monsieur Macron’s presidency did not coincide with David Cameron’s premiership in the UK – they could probably have done business together. But that was not to be.

European fundamentals

European banks are still carrying a huge burden of non-performing loans; anti-EU sentiment is still tangible; trade imbalances between the surplus countries (principally Germany and the Netherlands) with the rest of the eurozone are still financed on the never-never by a gargantuan overdraft extended by the Bundesbank to the other national central banks.

Yet, for people on median or above-average incomes, the three countries discussed above remain amongst the most congenial places to live on the planet, for all their failings. The quality of life in Germany, Italy and France (these things are largely a matter of judgment rather than measurement) is superior to that enjoyed in America. But Europe’s relative advantages vis-à-vis Asia and the developing world at large is narrowing as the tigers race to catch up.


What could go wrong? Anglo-Saxon commentators have repeatedly predicted the fall of the eurozone – and indeed it came close to happening over 2010-12 (and would probably have happened without the intervention of Mario Draghi). But another eurozone crisis, despite the inherent structural flaws in the single currency, is not imminent.

The greatest risk to the European economy short-term is that the super-strong euro will price European suppliers out of the market. American tourists now find countries like Greece absurdly expensive – why not just head down Mexico way? This week, however, the euro softened somewhat against the dollar – but not enough to restore European competitiveness.

The toppiness of the euro –and its likely correction – is causing some US fund managers to re-allocate out of Europe and back to the US. That is the real logic inside the mind of the hedgies.

[i] See: https://www.cnbc.com/2018/02/15/hedge-fund-bridgewater-makes-22-bln-bet-against-european-firms.html

[ii] See: https://www.ft.com/content/f2e28d00-16dd-11e8-9376-4a6390addb44

[iii] Ursula Weidenfeld in the Financial Times, 31 January 2018. Available at: https://www.ft.com/content/b5d61eaa-067e-11e8-9e12-af73e8db3c71

[iv] See: https://moneyweek.com/ecb-mario-draghi-jens-weidmann-eurozone-power-shift?utm_campaign=money-morning-newsletter&utm_medium=email&utm_source=newsletter