This may be enough for markets to trend higher in the short term but what is still lacking is any sense the collection of countries that constitute the eurozone can agree on where they are going, let alone how they are going to get there. There is a leadership vacuum in Europe which still has the potential to destroy the project.
Europe needs political union
The only way the single currency can survive is by moving toward political and fiscal union. We remain a long way from that. Although the latest summit has probably done enough to remove the likelihood of the doomsday scenario of euro break-up anytime soon, it will be back at some point.
Prior to the summit there was a lot of bad news. Our UK equity risk premium was higher at the end of May than it had been in March 2009 when the last bear market ended. It came down in June, but remains at a level only seen previously in February and March 2009.
There are now 11 stock markets where the dividend yield is at least double the local bond yield, including the UK and the other main European-but-not-in-the-euro markets of Sweden and Switzerland.
At one point last month the dividend yield on the Swiss market was five times the local bond yield. It’s now down to four and one-third. I would be surprised if another developed world equity market has ever had a dividend yield five times the local bond yield. On annual US data since 1871, the highest I can find is the dividend yield on the S&P 500 index being 3.8 times the bond yield in 1950.
There is one segment of the investment world that is taking advantage of the values on offer in equities. This is US companies, which have recently increased their buy-back activity to a pace of around $14bn per week. European companies have not been so courageous and indeed buy-backs have weakened in recent weeks to just $0.5bn per week. This discrepancy between the two continents is unusually large.
There have also been some signs of corporate merger and acquisition activity. Corporate confidence remains muted in this cycle, even though investment grade companies can today finance deals at record low interest rates. This lack of confidence is a problem given that it is not central banks and governments that create jobs, it’s companies. Yet the combination of a sluggish economic backdrop and considerable policy confusion on both sides of the Atlantic is making companies slow to expand.
For US corporations, the policy confusion is not necessarily just about Europe. Fiscal policy, broadly defined, is also causing confusion. At the end of this year the US faces the so-called fiscal cliff, when assorted legislation conspires to produce a situation where tax increases and spending cuts will go into effect on some estimates this could reduce GDP growth by up to 4% in 2013, almost certainly causing a recession.
More leadership required
No mainstream economic forecast is suggesting this will happen, so the presumption is that Congress and the President will, after the November election, do something they failed miserably to do last year and compromise to avoid this outcome.
But the upcoming Presidential election could be even more heated than it was already shaping up to be, thanks to the Supreme Court’s decision to leave President Obama’s signature healthcare legislation as something for the electorate and politicians to decide the fate of, rather than the judiciary.
Now that the individual mandate is officially a tax, ‘Obamacare’ is also a fiscal issue. The atmosphere after the November election could be far from conducive to the much-needed compromise to avoid the fiscal cliff, whoever wins the election. This uncertainty isn’t going to help make corporations more confident about the future.
That may well be overlooked for now on the basis of relief that Europe is not imploding. But there is still a lot to be done to get the eurozone onto a sustainable path.
In 1963 an American President went to a European city to show solidarity with a populace getting by with airlifted handouts from the US and other countries. He made it clear that West Berlin would not be abandoned, but rather that all free people were in some sense Berliners in their time of trouble.
Today the euro needs a true friend, like President Kennedy was for Berlin. Until someone has the courage to lead both fellow summit attendees and the electorates behind them, toward fiscal union that is the creation of a sovereign European entity, senior to the nation states comprising it the single currency will remain dependent on the periodic, partial fixes it gets at these summits.
What is needed is someone to stand up in Berlin and state “Ich bin ein Europäer” (I am a European). When that happens, the euro will have a much more certain future. And so will all free markets.
