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Eye on the Market | July 25, 2011
J.P.Morgan

Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks and rising corporate profits are patiently waiting for both of them to end

The third concern: Germany as paymaster. We are often told that Germans across both major parties are unflinching supporters of the European project, and will do whatever it takes to prevent a break-up. The objections from members of the Bundesbank are described as lonely voices of opposition that carry no weight⁵. But how large are the costs going to be? German politicians and voters may see current circumstances as exceptional, and that if they just agree to one more package, the problem will go away. However, we are starting to see analyses of how costly a permanent transfer union may be for Germany. Bernard Connolly at Hamiltonian Advisors sent me a recent paper from the Centrum fur Europaische Politik⁶ in Freiburg, which provides some clues. They see three alternatives for the deficit countries:
• massive reduction in regulations and unit labor costs to regain competitiveness
• exit from the EMU, re-introduction of national currencies
• permanent transfer union from surplus countries to deficit ones

On the last option, they estimate a "creditworthiness gap" in European deficit countries of Eur 108 billion in 2010. The gap measures how much European deficit countries rely on capital inflows to fund consumption, rather than investment (which contributes to future GDP). Germany's share of the European surplus is around ¾, so let's assume a pro-rata burden on Germany to maintain the transfer union. As a result, the theoretical economic cost could be 3.3% of German GDP every year, which as shown, gets close to some expensive episodes in German history. If German citizens were faced with costs this high, it could be a White Castle hamburger-throwing moment of national proportions.

[Chart Left]
Cost to German taxpayers of major events
Percent of GDP, annual
[Bar chart showing: Peak Versailles reparations (1929) approx 3.2%; Unification (since 1991) approx 4.3%; Potential cost of EMU transfer union approx 3.3%]
Source: Carl-Ludwig Holtfrerich, Halle Institute for Economic Research, Zentrum fur Europaische Politik (Freiburg), J.P. Morgan Private Bank.

[Chart Right]
Europe equities, priced for the risks
Europe 10-yr trailing PE divided by US 10-yr trailing PE
[Line graph showing fluctuation between 0.65 and 1.15 from 1998 to 2010]
Source: Factset, MSCI.

Bottom line. At a time when European equities are trading close to 2009 lows relative to earnings and book value, this package could result in a relief rally for European equities, particularly banks. The chance of a disorderly default in 2011 has decreased markedly, and a process has been put in place to create more seamless transfers to areas (and banks) in need. But the size of the transfer union fund is not big enough to allay all concerns, particularly with Spain and Italy growing at anemic levels, and there is execution risk in Greece.

Recent bank stress tests conducted by the EU concluded that only Eur 2.5 billion of capital needs to be raised (70 to 80 billion sounds more reasonable to us). And in the package announced last week, the following Orwellian clause indicates how European policymakers feel about rating agencies these days:

Point 15. We agree that reliance on external credit ratings in the EU regulatory framework should be reduced, taking into account the Commission's recent proposals in that direction, and we look forward to the Commission proposals on credit ratings agencies

In Europe, denial appears to be an essential ingredient to the process (See "Five Stages of Greece", June 30, 2011). Last week's package is a bold step towards Federalization and the worst-case outcomes have been avoided (money market failures, bank runs, etc), but markets will remain nervous about Europe.

⁵ Bundesbank President Weidmann, in response to last week's package: "By transferring significant risks to the support-giving countries and their taxpayers, the Euro area has taken a large step to socialising risks created by unsound government finances and macroeconomic problems. This weakens the foundations of the fiscal self-responsibility that EMU is built on".
⁶ Centrum fur Europaische Politik, "Creditworthiness trends in European countries", Lüder Gerken & Matthias Kullas, 2011

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