For three years, the euro crisis has dominated the headlines. To understand Europe and its impact on the world, we had to focus more on politics than on straight economics. Will Germany support Greece? Will Greece accept the strings attached to that support? Will the ECB finally step in as a potential lender of last resort? These were the questions we had to ponder to understand how things may play out in Europe.
At the start of this year, we made the big call that 2013 would see the return of economics. We argued that, thanks to the ECB as well as due to the progress made at the euro periphery, the euro crisis would continue to fade throughout 2013. As a result, we could eventually focus more on global and European economics than on the politics of Europe to understand what is driving the economic and financial outlook.
Looking back on the first four months of the year, that call has worked pretty well. But it did so with a twist. The euro crisis has not gone away, not at all. However, it has become less vicious. The ECB has successfully contained the contagion risk. That the near-default of Cyprus had little impact on bond yields in Italy and Spain and that the levy on big bank deposits in Cyprus did not spark any outflow of deposits from Greek, Spanish and Italian banks in March shows very nicely that the systemic risks in the Eurozone are now much smaller than they used to be. Countries have problems. But big problems in small countries no longer endanger the Eurozone as a whole. That is excellent news.
Also, Europe has avoided the biggest tail risk we had identified for this year. If Italian politics had gone wrong, the euro might have faced an existential crisis. The ECB and Berlin can and will support only countries that play by the rules. They cannot save a country that chooses to commit suicide. Political chaos in Italy or a government that would simply undo the Monti achievements could have triggered a massive new wave of euro crisis. It did not happen. Instead, after two months of unfortunate uncertainty, Italy now got a government that is backed by exactly the political forces that had supported Monti until last December. Chances are that this government may even get a few useful things done even if it may not last a full term..
In addition, Berlin and Brussels are granting euro members more time to meet fiscal targets, the Greek adjustment programme is finally on track and even France has started a serious debate about economic reforms. All that is progress. It is reflected for instance in much more bearable bond yields for the euro periphery than we had six, nine or twelve months ago.
As we had hoped for, financial markets are reacting less to the turns and twists of European politics and more to normal economic fundamentals. We are very pleased with the progress in containing the euro crisis, despite the odd Cypriot and Slovakian risks out there. So far, so good.
However, we are not fully pleased with all economic news. China has not suffered a hard landing and the US economy has not been sunk by a fiscal cliff. But some loss of momentum in China and in a number of resource-dependent emerging markets such as Brazil poses a challenge for Europe’s export outlook. The much weaker Yen compounds the problem. As a result, German business confidence has retreated modestly in March and April while Greek leading indicators have actually improved. This is the twist. Some indicators for core Europe and the world have come in somewhat below our expectations in the last two months.
No, we are not very concerned about Germany. Fundamentals remain solid. Helped by ongoing gains in employment and a fall in inflation to a mere 1.2% in April, German consumer confidence has risen to a five-year high. Along with parts of the world economy, Germany’s export-dependent manufacturing sector is just taking a little breather before growth is likely to pick up again over the summer.
This is exactly what the “return of economics” means. We are back to old-fashioned questions such as “how much does the Yen exchange rate matter for the German and European economy” – instead of spending most of our time explaining to clients across Europe and the US why Frankfurt and Berlin will not allow the euro to founder.