It is difficult to work out which of the many potential worries is most contributing to the recent bout of equity market nerves. The list of suspects is prodigious – ebola, Middle East tensions, cessation of the US QE programme, weakening Chinese growth, slowing UK residential housing market. All are having an impact. If I had to put my ten bob note on one thing, though, it would likely be the ever-worsening economic picture coming out of the core of the Eurozone. Recent industrial production numbers added more weight to the view that the core of the Eurozone is starting to collapse in on itself. Germany, so long the last serious engine for growth in the area, saw a 4.3% decline in monthly industrial production – the second largest fall in the whole region. With France teetering on the edge of recession, and Italy already there, the three largest economies in the Eurozone are in danger of dragging peripheral countries with a modest amount of momentum back into the mire. Indeed it is cause to be concerned.
Yet, this trend is not only typical of the continent’s recent history, it seems to be the only way in which its reform minded politicians can deliver any kind of progress. Where there is momentum in the region, it is in the peripheral nations that have had to endure the long years of austerity and as a result were forced to accept the need to address unaffordable social models and dysfunctional labour markets. In August, Spain recorded its first annual increase in employment in six years, and earlier this week Ireland announced that it would generate a primary surplus in its government finances in 2015. The Spanish progress is vindication of structural changes made to labour markets in 2012, which freed companies from the need to bargain collectively in wages and working conditions. The increased flexibility of the labour markets has allowed the Spanish economy to create jobs at lower levels of GDP growth than has historically been possible. A situation very similar to that in the UK in the early stages of its economic recovery.
By contrast, the French government hasn’t balanced the books in over 40 years, whilst Italy has a debt to GDP ratio of 130% – only Greece has a higher level of public debt relative to its economic capacity. Yet both French and Italian governments have relatively new Prime Ministers who are at least talking the talk of making the necessary reforms required to improve the performance of its labour markets. And reform is desperately needed. The unemployment rate in both countries has barely budged in the last year from their highest levels since the financial crisis began. The question is: having talked the talk, can they walk the walk?
And this is why the current slow down in European growth may not be such a bad thing after all. Without the pressure of facing up to the torpor blighting these economies, politicians will take the path of least resistance, and backslide on unpopular social and economic reform. Yet without that reform, the capacity for these economies to grow in a global environment of labour and fiscal efficiency is always going to be compromised. Again, it seems to be the role of markets to keep their feet firmly on the necks of politicians – using enough force to make them do what is required; but not so much that inflicts any kind of permanent damage.
Interestingly, Germany’s role in ensuring economic recovery is being reappraised. The Teutonic dogma of balanced budgets is mainly only being adhered to by the Germans themselves; which is ironic as it is the one economy that could afford to loosen the purse strings slightly and prime the pumps with some much needed infrastructure investment to help the Mittelstand. They could also try and throw off the curse of history and accept that deflation is worse than inflation, and finally allow Mr Draghi to “use all the available tools” at his disposal to reflate price expectations in the region. Like changing the French and Italian mindset, this is much more likely if there is pressure from market forces.
Like all of the challenges facing equity markets at the moment, there will not be a quick fix to this issue. Yet equity markets are by their nature forward looking. The direction of travel is as important as getting there. If the political classes in Europe can be bullied into making necessary reforms, the market forces will then start to give them the benefit of the doubt. And this particular worry will start to fade.