The large suitcases are being dusted off in anticipation of a much more affordable summer vacation in Europe this year. Whereas the avid traveler, knowingly or not, can embrace the policy stance by the European Central Bank (ECB), having resulted in a far better euro/dollar exchange rate from our U.S. perspective, the financial world still holds its proverbial breath. Investors in European bonds and equities have been rewarded generously for these engagements in the first weeks of 2015, but only if measured in local terms; from any other angle, performance has been eroded by the nearly 20 percent decline of the euro, when measured against its recent high of 1.40 vs. the U.S.-dollar.
In previous posts,"Kraftwerk (or powerhouse) Germany,” and "Next Stop: Europe," I pointed to attractive pockets of value in Europe, but given the continued political and structural gridlock across the pond, I am becoming increasingly concerned that efforts by the ECB may just be ill-guided after all. We have to realize that central banks, ultimately, will not be able to fix the financial perils of the world, and, more specifically in staying with our example, the policy path undertaken by the Federal Reserve (Fed) can never be a comparable blueprint for Europe’s economic malaise. Three different aspects apply:
(Dis)organization: It is easy to judge from afar, and to assess the European policy gridlock as enacted incompetence, especially after former U.S. Federal Reserve Chairman Ben Bernanke appeared to have saved the U.S. economy and financial system almost effortlessly. I beg to differ: the ECB’s mandate is clear, and is fundamentally different from its U.S. counterpart—and the rest of the world. Whereas the Fed’s objectives (the dual mandate) are laid out in the 1977 Federal Reserve Act as "maximum employment, stable prices, and moderate long-term interest rates," the ECB has only one primary objective: to manage inflation, or, currently, a lack thereof.
Optimal Currency Area (OCA): Much scholastic work has been done in defining OCAs. One of the preconditions for this type of union is a similarity in business cycles or economic ties between unified economies, which is clearly one of the biggest challenges facing Europe today. Admittedly, U.S. states also produce different economic outputs and performance, but it is the free movement of labor that allows for the equalization of diverging trends. Whereas European Union (EU) laws allow for the very same flexibility, the barrier of entry for individuals attempting to take advantage of imbalances in the system is anchored by the variety and difference of languages.
Design: The introduction of the euro came in book-entry form in 1999 (three years before physical money was issued), mainly in an attempt to ease the adaptation of businesses across the European Monetary Union (EMU). Governments, on the other hand, have done little to “practice” a disciplined governing approach; to this day, there are no reliable enforcement measures to punitively address the lack of fiscal and financial discipline of EU member countries, especially in adhering to the Stability and Growth Pact. On the other side, the EMU is simply incomplete, as a currency union without a fiscal transfer union, which is one of the reasons why Germany has been accused of running high surpluses vs. other EMU countries.
Investors allocating to European stocks and bonds are advised to not only monitor actions of the ECB, but also to closely follow the progress of structural reforms. A united Europe, as we have explained before, was mainly a political ambition and a “safety measure,” born out of hostilities anchored in World War II. Now, policymakers need to address the inherent design flaws of the EMU. Even if ample progress is made, the “State of the Union” cannot be more different compared to the U.S., as Europe is driven by varied national interests, and maintains a fragmented political setup. In the end, a noble idea may not turn out to be a good one.
Matthias Paul Kuhlmey is a Partner and Head of Global Investment Solutions (GIS) at HighTower Advisors. He serves as wealth manager to High Net Worth and Ultra-High Net Worth Individuals, Family Offices, and Institutions.
