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The End of the Beginning

27th June 2012

We need more Europe. We don’t only need monetary union, we also need a so-called fiscal union. And most of all we need a political union – which means we need to gradually cede powers to Europe and give Europe control.

Chancellor Merkel’s quote at a press conference with David Cameron, 7th June 2012. She added for good measure “We cannot just stop because one or other doesn’t want to join in yet."

Now is the moment of truth

However sub-optimal the Eurozone, regardless of the economic divergence caused by this currency union, and the subsequent loss of competitiveness, the answer seems to be ‘More Europe not less’. This is the view of the people who matter - the European Commission and the German hierarchy. Bamboozled, bankrupt and broken, their weak Southern neighbours will accept this milk as a short term palliative to their considerable woes. Long term may be a very different story.

While the fat lady has not yet sung, and their plans may still be derailed, we have argued that their political will towards a Federal Europe, remains undiminished.

Where do the countries stand?

Our brief analysis is that Germany arguably still sees a burden of guilt and perhaps a lack of trust in itself, hence its willingness to support a perception of the greater good. Many Southern European states were either military or fascist dictatorships in our lifetimes and could be considered to have weak governance. Perhaps they too don’t trust themselves? East European nations remain wary of Russia and perhaps look for a shield too?

The principal exceptions are certainly Britain which is not in the Eurozone, Scandinavia which has shown some concern at the process, and France. France remains the enigma. A proud, ancient nation with a very strong culture, its elite has arguably seen Europe as a method of enhancing ‘la Gloire de France.’ Coupled with concern at a more powerful neighbour who has flexed its muscle three times in the French direction in a hundred years, the French elite concluded that it is better to have Germany in the tent than outside.

Europe has not been a triumph

While the above comments are clearly a massive simplification of reality, we do believe they possess more than a grain of truth. The problem is that if populations convince themselves that more Europe is their national salvation and if, in time, ‘Europe’ is manifestly in charge and it does not work as expected, then we have a problem.

While in the short term ‘a European resolution’ will clearly be positive, for the longer term we have our doubts. That said, bad systems can and do survive for very long periods of time. Ask the peasant farmers of Maoist China or, closer to home, the proletariat in the good old USSR.

Predicting timelines of disaster is an imprecise art. While it is hard to believe Europe can return to any real, meaningful growth any time soon, unusual and distorting monetary practices can impact markets for long periods.

Markets versus imprudent monetary policy

The primary reason we have been equity market bulls since January 2009  (and we accept that that positivity has, of late, been tested to the limit), has been our belief that, when push comes to shove, Western Governments would effectively print money.

We are skeptical that such a policy creates real wealth, we believe it distorts asset prices and delays the inevitable adjustments. It surely has not helped real growth. Like it, or not, monetary policy in the UK and US has been extraordinarily loose. Germany has, to a degree, held out, correctly in our judgment, against Eurobonds and a pooling of liabilities. It has promoted southern austerity.

Markets have discounted European recession, in our opinion, hence the maintenance of even temporary monetary order in Europe would surely be positive.

The implications of a move to effectively a Federal Europe are profound indeed. Short-term markets have been ruled by fear; fear of collapse, banking contagion, confidence and very poor growth. If the EU can cobble together a sufficient monetary creation firewall, markets will rally. We believe the EU will move down this route, but this is essentially a political call, not an economic one.

Remember that the FTSE100 trades at a discount in excess of 40% of its long term average and trading on a consensus based PER of 9.7x for 2012 is less than 10% above the post Lehman low. Further, a 4.3% yield is reasonable compensation when the 10 year UK benchmark gilt yield a mere 1.7%. Further, balance sheets remain strong and corporate profitability, despite a highly uncertain macro-economic backdrop, elevated. Very bad news is priced in, in our judgement.

Implications for the longer term

These are fascinating and unprecedented times. What the Eurozone attempts to do will have implications far beyond it’s borders. If Europe federalises, what will be the British response? Will the UK seek to realign towards its historic partners in American and the fast growing commonwealth countries or will it be drawn further into the EU? What are the implications for migration flows of European policy choices and London’s position as de facto global financial capital? How will the Euro’s travails impact UK monetary policy? These are essentially political questions, but the implications will reach far and wide, with long and uncertain timelines.

Our conclusion is stark. Too much political blood has been spilt building this European home for the elite to abandon the estate. Germany will accept substantial short term transfers and monetary creation in exchange for a much tighter political control at the European level. The democratic deficit will become ever more apparent as voters still remain attached to national politicians who will be increasingly impotent. Longer term, this is a toxic mix indeed. Short term, markets will sigh with relief, rally hard and worry about the sand this European house has been built on tomorrow.

Ewen Stewart is Investec’s UK Equity Strategist and he mainly writes macro driven strategy research. His principal areas of expertise include public sector deficit and leverage related issues.

Please contact Investec's UK Strategy team by emailing Ewen Stewart at ewen.stewart@investec.co.uk if you would like to discuss this article further.

The opinions and views expressed are for information purposes only and are subject to change without notice. They should not be viewed as independent research, recommendations or investment advice of any nature.