Europe is in an untenable position. It is being challenged on many fronts. A weaker euro need not result, but it is the path of least resistance.
The economy has lost its momentum. What was first written off as a soft patch, now looks a bit more serious. This will be driven home by the flash PMI later this week, which is expected to fall to a two-year low. Draghi is likely to still put an optimistic spin on things, as he did last month, pinning the hopes on the tightening of the labor market that will spur both demand and price pressures. Eurozone growth is likely a little above trend but the direction is south.
The Bundesbank warned today that the German economy may have stalled in Q3, citing new emission testing in the auto sector as a headwind. The Bundesbank's admission follows similar remarks by the Economic Ministry last week. Earlier this month, the ministry shaved this year's and next year's growth forecasts, claiming weaker external demand. Both the Bundesbank and Economic Ministry suggested a recovery is likely in the current quarter after stagnating in Q3. Both the manufacturing- and service-sector readings are expected to have fallen. The ECB staff, which updated its economic forecasts last month, won't do it again until December.
The bar to extend the ECB's asset purchases at this juncture is very high and the disappointing data is not sufficient to prompt a reversal of the decision. In lieu of this, Draghi could play up the continued purchases of recycling the proceeds of maturing issues and several other elements of the extraordinary monetary policy, including negative deposit rates and full allocation of fixed rate refi operations, as well as less stringent collateral rules.
There are bigger and more urgent issues. A Brexit without an agreement, as distinct from a hard Brexit, is an especially odious outcome and it cannot be ruled out. As we have argued, the closer that May moves toward striking a deal with the EU, the more tensions arise within her government and Parliament.
With Brexit in the West, the EU is being challenged by the East as well. The European Court of Justice ruled yesterday against Poland's government, demanding that it suspend its attempts to reform the Supreme Court. Brussels is concerned that the changes are not technocratic in nature, but political and a threat to judicial independence. The immediate issue is the forced retirement of 24 Supreme Court judges and others that had been removed. The situation will escalate if a Polish court rules that national laws have priority over EU laws.
Fiscal issues have also moved back to the forefront. Italy is serving as a lightning rod and its fiscal push is the most egregious. France and Spain are also proposing to backtrack from their previous commitment. The EU and Italy want to avoid a repeat of what happened with Greece and everyone is well aware of next spring's European Parliament elections. Italy's challenge to the EU will likely be protracted. Rhetoric, including threats, are one thing, actions and especially sanctions require actual results, not just forecasts. That means that the EC and Italy will be at odds most of next year.
The European Parliament election is a part of a two-year period in which the leadership of Europe will change. With the European Parliament election will come a new European Commission. The top posts at the ECB have already begun changing. There is a new vice president and Draghi's term ends in the middle of Q4 19. Heads of several of the new institutions that grew out of the crisis will also be replaced in the coming year.
Many observers, recognizing that it was Germany's turn to hold the ECB presidency, had settled on Bundesbank President Wiedmann as the obvious choice. We demurred and argued that with the punchbowl slowly being taken away, the ECB presidency will be a thankless job. We thought that once again German Chancellor Merkel was being underestimated. Given the inflection point that Europe finds itself in, what Germany needs more than anything else is to project its interests in the European Commission presidency. In recent months, Merkel has indeed played this card. Of course, she has not ruled out seeking both positions for Germany. However, it is clear which is the bargaining chit. Moreover, the quickness to which Weidmann condemned the Italian fiscal proposal, where the EC asked questions and Draghi was diplomatic though forceful, suggests he may still be to divisive a figure.
That said, many of the national leaders in Europe, including Merkel, appear weak. There may be a political realignment taking place. In the four biggest eurozone members (Germany, France, Italy and Spain) the main political parties have seen their support collapse. Macron is one expression in France and the League-Five Star Movement in Italy is another. Macron is unpopular and it is not clear that he can consolidate power, though he has managed to further wreck both the Socialists and Republicans. Spain has a minority government as the new political forces are not strong enough to seize power themselves.
Merkel held on barely a year ago and was forced to cut a deal with the Social Democrats, but the erosion of support for the CDU/CSU and the SPD continues. Indeed, the latest polls suggest the Greens are eclipsing the SPD for the number-two slot behind the CDU. The weekend election in the state of Hesse may offer a microcosm of what is happening. The CDU will likely lose support. The Greens may gain support but not enough to offset the CDU's loss. A third party may have to join the coalition – the Free Democrats, which failed to solidify on a national level. Meanwhile, the AfD will likely garner enough votes to be represented in the state parliament. Hesse is the last German state to yield.
Italy's government is precarious. The League, representing the nationalist and small business interests, is not a natural ally of the protest movement that evolved into a political party, the Five Star Movement. That it even exists is a testament to the power of ambitious leaders. Salvini has emerged from the shadow of Berlusconi, who has dominated center-right Italian politics for two decades. The MS5 is still evolving and like other political movements, it is a coalition. Its leaders are getting much-needed experience in governing. A split between the fundos and realos appears to be favoring the latter, but ultimately the results will likely be decisive.
Meanwhile, both the US and Russia have reinvigorated efforts to project their power. Trump is not a globalist, but he is not an isolationist. He is reasserting US power to shape the institutions that it helped build so that more of the distributional benefits of the liberal trading system come to it. We have argued that Trump is the first post-cold war president who puts an emphasis on economic rivalry over ideological differences. Europe's large trade surplus and a euro that makes German exports hyper-competitive irks the US Administration.
The formal end of the Intermediate-range Nuclear Forces (INF) Treaty could spur a new arms race. It is unlikely to discourage Russia from pursuing asymmetrical warfare tactics on what it considers its near-abroad. Many observers warn that the US uses sanctions too frequently and this will undermine the role of the dollar, but Europe often participates similar sanctions, including against Russia, where it sometimes has led the US. Now Germany appears to have suspended arms sales to Saudi Arabia, while there is no sign that the Trump Administration wants to go down this route, though Congress may try to force his hand.
The combination of US tax changes and corporate repatriation and the upward pressure on US rates, including what is a likely a mid-December (December 19) Fed hike, may have created a shortage of dollar funding. These financial conditions could also weigh on the euro as year-end approaches.
The general point is that Europe is beset by challenges, both domestic and foreign, that require strong leadership at the moment in time where it is scarcely supplied. We see the divergence of monetary policy still favoring the dollar. Agreed, much is priced in, and allocation of the stock of savings reflects this. However, the new incremental flow sees that the US pays an unheard of 350 bp more than Germany to borrow two-year money (what exorbitant privilege?), for example. The interest-rate divergence and the US policy mix still augers well for the dollar.
We have long argued that those anticipating the demise of one of the great experiments – European Economic and Monetary Union – have habitually underestimated the political will, and continue to believe that is the case. The challenges do not represent an existential crisis for Europe and like the debt crisis, it will grow institutional capacity from the experience. However, Europe will have a low-grade fever for some time and one cannot but conclude that this probably will have negative economic consequences.