What investors need to know about 2022 (part II)

France in charge

If you didn’t know already, France has now taken the reins of the EU presidency at a moment when the new German chancellor, Olaf Scholz, is still an unknown quantity, and the French president, Emmanuel Macron, faces the first round of his presidential campaign on 10 April.

Macron is going to spend the next three months wrapping himself in the European flag. This flag was even hung from the Arc de Triomphe, the emblem of the French republic, on New Years’ Day – until it was taken down by popular demand. He will advance the case for ‘more Europe’, cast in a French mould. And he will scold European leaders who do not share his liberal values, such as Hungary’s Viktor Orbán and Poland’s Mateusz Morawiecki. The latter is, amongst other things, highly critical of EU energy policy as embodied by the EU emissions trading scheme – so there are economic issues as well as social ones in contest.

At the presidential election, the French people will judge the incumbent’s record over the last five years. Macron has cut an assured figure on the international stage but his track record at home has been patchy. He failed to push through many of the reforms that he promised in 2017, such as a root and branch overhaul of France’s pension system. The Organisation for Economic Cooperation and Development (OECD) says that France must raise its pension age to avoid a debt crisis – but so far this has proven politically impossible. And while the rhetoric concerning France’s exciting hi-tech future was ambitious, the French economy still suffers from relatively lethargic growth.

France fell from sixth place in the world ranking of industrial powers to eighth between 2004 and 2019, in terms of manufacturing value added, as French companies lost ground to international competitors. State spending now amounts to 59 percent of GDP – the highest in Europe. Taxes are high even by European standards. Government debt stands at 115 percent of GDP compared to Germany’s 70 percent. France is the third-largest debtor in absolute terms in the world after the US and Japan. And France’s schools produce “mediocre” results, according to the OECD, despite costing more than the OECD average. All this amounts to moral and economic decline, according to the controversial polemicist and presidential candidate Eric Zemmour. In response, Macron has announced plans to pump an additional €30bn of government funds into strategic industrial sectors.

My best guess is that Macron will face Valérie Pécresse, the Republican candidate, in the second round on 24 April – and that he will narrowly defeat her. European stock markets will strongly endorse this outcome. In the unlikely event that Zemmour makes it into the second round, those markets could wobble; but the chances of Zemmour or of Marine Le Pen entering the Elysée Palace remain slight.

Whatever happens in France in April, the European Union over which France now presides is more divided and fissile than at any time since the Maastricht Treaty (1992) formally transmogrified an elaborate trading arrangement into an embryonic political federation. To the north-south divide between the countries which enjoy a structural trade surplus (like Germany and the Netherlands) and those which run persistent deficits (like Italy), is now added an east-west divide between the former communist countries and those of the liberal west, which have very different perspectives on matters such as immigration.

Italy: whatever happened to ‘la dolce vita’?

On 24 January the Italian parliament and regional assemblies will hold an election to select the country’s new head of state. The role of president in Italy is largely ceremonial; but they have more constitutional powers than say, the British monarch – especially in times of crisis. The Italian president appoints the prime minister and other cabinet ministers and can – and does – refuse the dissolution of parliament. In recent years, Italian presidents have exerted these powers in order to uphold the European consensus in the face of populist-inclined governments.

For example, in 2018, following the formation of a coalition between populist parties the Five Star Movement and the League, the new coalition submitted their choice of government ministers to the president for approval. Yet their proposed economic minister, Paolo Savona, was vetoed by President Sergio Mattarella due to his eurosceptic stance, forcing the two parties to compromise with Giovanni Tria, who was committed to Italian membership of the single currency.

Hitherto, it was assumed that the sitting prime minister, the technocrat and ex-European Central Bank (ECB) chairman Mario Draghi would be a shoo-in for head of state. But he presides over a government of national unity and there is no obvious alternative candidate for prime minister. If he is ‘kicked upstairs’ there may well have to be an unwanted election. Meanwhile Silvio Berlusconi, the former prime minister and founder of Forza Italia, who is still a member of the European parliament, has emerged as a ‘dark horse’ candidate. If he gets the top job, there will be ructions, and Italy could once again play the role of ‘joker in the pack’.

The real structural problem in Italy is its demographics. Nearly a quarter of the population is aged 65 or older and that is expected to grow to 35 percent by 2050. Italy’s population will, it is estimated, fall from 59.6m in January 2020 to 47.6m in 2070 – a drop of 20 percent in 50 years. That is why Draghi has talked recently about “huge” labour shortages in the economy, and quotas for non-EU immigrants have been raised.

Italian government debt is still rising, and the country’s debt-to-GDP ratio, at 157 percent (up from 135 percent pre-Covid), is akin to that which Greece sustained at the beginning of its debt crisis in 2011.

The bear next door…

Russia’s new round of gas diplomacy has been accompanied by a buildup of troops on the Russia-Ukraine border. Russian Spetsnaz special-forces units are probably operating inside Ukraine already. President Biden has threatened stiff sanctions in the event of a Russian invasion of Ukraine, including the exclusion of Russian banks from the SWIFT international bank-payments architecture – something that would harm Europe as well.

But the sad fact is that the EU depends on Russia for about 40 percent of its gas supplies (that’s about 180bn cubic metres per annum) and therefore cannot take a robust stance towards Russia without risking grave economic consequences, at least in the short term. Britain has provided military training to the Ukrainian army under Operation Orbital; and in November Britain signed a deal with Ukraine to supply 10 new naval vessels and a missile- defence system. Macron has told Ukraine’s President Zelensky that France “will help Ukraine preserve its integrity” – though it is not clear what that amounts to. Germany, for its part, has blocked the sale of weapons to Ukraine altogether.

In retrospect, Angela Merkel’s principal policy towards Russia was one of appeasement. But that may now have changed. In Annalena Baerbock, Germany’s foreign minister, and Robert Habeck, the economic-affairs minister and vice chancellor, the new German coalition government has two senior ministers who favour a harsher line with Russia – though the new chancellor is yet to be convinced.

The Russia-Ukraine military tensions, like the Belarus-Poland migrant crisis, have been entirely concocted by President Putin and his client President Lukashenko to destabilise the EU and the entire NATO alliance. Putin is peddling the idea for domestic consumption that NATO is on the offensive and that Ukraine might be about to seize Crimea (a territory Russia seized from Ukraine in 2014). He knows that the US military is fixated on China these days and the consequences of a Chinese military invasion of Taiwan. He will also have noted the lack of western resolve in Afghanistan. At the same time, he knows that any bloodshed in Ukraine will mean that the Nord Stream 2 gas pipeline (running directly from Russia to Germany through the Baltic) will be permanently mothballed.

As I explained in October last year, one reason that Russia has chosen to reduce the supply of gas to western Europe is that it is increasing the supply of gas to its giant neighbour and security partner, China. When Putin attends the Winter Olympics in China next month (4-20 February) he may announce a new energy deal with Beijing, involving an additional 50bn cubic metres of natural gas to be pumped to China along a major new pipeline called Power of Siberia 2. This would be gas from the Yamal and Urengoy fields in the Russian Arctic which are currently directed to the European market. In time, China may become a larger purchaser of Russian gas than the EU.

That means that gas prices are likely only to rise further, thus stoking European inflation. As China seeks (eventually) to reduce its reliance on coal (as promised at COP26), its demand for natural gas is rising.

As I write, the unfolding Russian military intervention in Kazakhstan bodes ill for European-Russian relations in 2022 and beyond. Kazakhstan is a strategically important country which, amongst other things, produces 40 percent of global uranium production. Not that there is anything that Europe can or will do about it; and Biden’s withdrawal from Afghanistan makes any western action in central Asia infeasible.

In November, the Polish government unveiled its “Defence of the Fatherland Act” which aims to more than double the size of the country’s armed forces from its current level of about 100,000 to 250,000. This reflects growing concern about “Russia’s imperial ambitions” on Europe’s perimeter. Poland has been an enthusiastic member of NATO since 1999.

Just before Christmas, President Xi endorsed Putin’s demand for binding guarantees from NATO that Ukraine would never be allowed to join the alliance. Xi said that: “Both China and Russia need to carry out more joint actions to more effectively safeguard our security and interests”. These two huge military powers seem to be edging inexorably towards a formal military alliance.

Market outlook

The euro entered its third decade on New Year’s Day − and possibly its most perilous one. That is because this is the first time that the single currency has had to contend with a sustained bout of inflation. Ostensibly, the euro has been a success: 19 European countries trade with one another without currency risk or transaction costs. It has survived numerous crises – most significantly the sovereign-debt crises of 2011-13 – albeit at the price of swingeing austerity across the “Club Med” members (and Ireland, by the way).

The first two decades of the euro’s existence were characterised first by globalisation and then by the global financial crisis of 2008-09. Both were fundamentally deflationary. The second decade was also one of near-zero interest rates. But an inflationary decade may now await us. Inflation in Germany, the manufacturing powerhouse of the EU, is already higher than that in the UK.

There are historical precedents that suggest that fixed currency systems cannot cope with protracted inflation. The Latin Monetary Union managed to last from 1865 until it was blown apart by WWI and was finally disbanded in 1927 in the face of hyperinflation in Germany. The Bretton Woods currency apparatus lasted from the end of WWII (1945) to the “Nixon Shock” (13 August 1971). The system, which pegged the value of the US dollar to gold fell apart because the US sustained higher inflation than Germany and Japan – both growing rapidly – forcing them to revalue their currencies, while others suffered from dramatic devaluations.

Again, the European Monetary System – the precursor to the euro – was dealt a blow in 1992 when sterling fell foul of the FX traders. That was one of the key reasons, together with the consequences of the reunification of Germany, why the leaders of France and Germany concluded that the only way forward would be to lock into a shared currency.

But in the last 10 years the ‘priestly caste’ of central bankers has papered over cracks in the financial system by printing money under the guise of quantitative easing, even as interest rates have remained historically minimal. In the Eurozone, the Pandemic Emergency Purchase Programme has bought up €1.85tn of government papers to date. That has now got to stop – and economists are conflicted about what the immediate consequences will be.

The EU has launched its €800bn plus Covid Recovery Fund (though Poland and Hungary have been told they must behave if they wish to receive handouts). This will be funded with borrowed money. The fiscal rulebook on which the single currency was founded has been shredded. Few EU states will have recorded a fiscal deficit of just three percent or less last year. ECB president Christine Lagarde has ruled out raising euro interest rates in 2022, but there is bound to be dissent. The German tabloid Bild has dubbed her “Madame Inflation”. While provident German savers receive zero reward, inflation is running at a 29-year high of 5.2 percent. It will be interesting to see how the new German finance minister, Christian Lindner of the pro-business FDP, responds. At some point soon it is likely that the Germans will put pressure on the ECB (which resides in Frankfurt, after all) to raise rates, even if marginally.

What’s more, much of Europe begins 2022 in varying states of lockdown. There are still severe restrictions on travel. As in the UK, the people hospitalised in France and elsewhere seem to be mainly vaccine ‘refuseniks’ – hence the threat by Macron and others to get tough on the unvaccinated (the verb he used was emmerder – a somewhat vulgar turn of phrase). For all that, Europe is in a far better place than it was one year ago. Business confidence is low but there will surely be a resurgence in travel and hospitality once the threat of Omicron dissipates – until the next variant comes along, of course.

Just as in the UK, wage growth in Europe is unlikely to keep pace with inflation this year – and that will have political consequences. The great, global, supply-chain crunch which I analysed recently will persist in 2022, with sky-high shipping rates, shortages of semiconductors and other components, coupled with shortages of skilled labour.

The fundamental flaw in the monetary union – as both its advocates and opponents understand – is that monetary policy is concentrated in the hands of the ECB, while fiscal policy is distributed across its 19 members. That is what Macron will seek to challenge in the months to come. He will argue that pan-EU taxation must come within the purview of the European Commission. He will advocate some form of mutualisation of all EU sovereign debt – knowing that the Germans, the Dutch and the Nordics will not like that. And he will promote “strategic autonomy” – meaning a European army and navy.

My advice to Macron would be to stop telling the Poles how they should appoint their own judges (while ignoring some ‘exotic’ practices in the Spanish judiciary) and to concentrate on making Europe more competitive. Sir James Dyson has recently been complaining about the EU’s flawed and unfair energy-labelling regulations which he claims misled millions of European customers (and favoured certain German manufacturers). His legal action against the EU finally succeeded in getting the labelling regulation scrapped – at a cost of nearly €100m.

All told, the outlook for European markets this year is highly uncertain and will ultimately depend on what happens on Wall Street – something that I would like to consider next week. Geopolitical risks threaten a positive outcome, as well as the unknown endgame of the pandemic. I hope and pray that peace will prevail during 2022; but in the medium to long term, the aggressive revisionist stances of China, Russia and their unlikely ally, Iran, betoken trouble ahead.

PS

Twelfth Night has passed but in my household the Christmas lights are still twinkling discreetly. I subscribe to the medieval observance that Christmas lasts until Candlemas (2 February), at which point we can start thinking about the privations of Lent. Forget ’Dry January’ – this is the time of year when a glass of wine in the evening is most necessary. Abstinence should be confined to the early spring, as the equinox approaches and the promise of renewal looms.