Friday, 19 August 2011

Macro Level Trends - EU - Re-Viewing, Re-Fuelling & Re-Orienting the German Locomotive

The fundamental reality about the need for large scale economic and social reform across the EU may now have finally been digested by 'periphery' and even 'soft-core' country leaders. Until now it seemed that a ridiculous 'game of chicken' has been played-out amongst political leaders in reaction to financial market movements, but the economic growth figures for Europe in Q2 2011 are cause for increased concern, the German industrial hub itself - the European 'wunderkind, vormund und lokomotive' - may have momentarily run out of steam.

As investment-auto-motives has previously related, the fracture of Europe due to the fiscal mismanagement of 'periphery' countries is an event which has damaged even Germany's belief in the EU project, even though the central architect. Its own conservative population vexed by the apparent 'live for today', 'Manyana' attitude of its southern neighbours which exploited and assisted 'boom & bust'. Indeed betrayal is perhaps a better descriptor. In turn, the previous level of 'goodwill elasticity' necessary to traverse the rough road which leads to a unified Europe – an elasticity effectively created from Germany's own previous re-unification - has been seemingly stretched to near 'snapping point'.

Hence today is a watershed period for Germany, one in which it looks to its own short and medium term needs, as opposed to the long-term all encompassing ideology.

Yet given early & mid 20th century history, such an emergent attitude cannot be seen to be politically motivated, it must instead be a natural consequence of economic outcome, an outcome which clearly demonstrates that Germany itself is no longer able to 'carry the EU crowd'.

Over the last 3 years, with the boost from export income and internal restructuring of major corporations, Germany was indeed able to 'service' its role as lead EU member, the drop-off of previous European demand for its high quality consumer goods had been counter-acted by demand from China and Asia. Yet whilst the likes of VW, BMW and Daimler were able to announce extremely good earnings over the Q2 period given their foreign markets exposure, it appears that the broader realms of smaller German industry – the 'Mittelstand' and general supply chain – has suffered as a result of fast decline in Chinese and Asian exports, and possibly from a greater pricing pressure and payment scheduling from its own national champion auto-makers.

[NB if the latter issue is indeed the case, presumably the acceptance of the Mittelstand to swallow such terms was as part of a broader German export drive to gain market share abroad, and perhaps as an intended by-product allows the all important SME's which underpin the large corporates to instigate renewed cost containment measures of their own so ensuring boosted profits tomorrow.
However, this still doesn't detract from the apparent cut in capital goods orders previously enjoyed].

Even so, here and now the picture looks bleak.

Those Q2 2011 EU economic growth figures indicate that whilst the EU as a whole grew a measly 0.2%, within that the 'mighty' Germany grew by only 0.1% and France virtually nothing. The 'EU core' then, whilst exhibiting a notionally stronger structural economic framework itself has suffered greatly over April, May & June. This then creates the possible conditions for a 'downward spiral' inside Europe, where even a reticent Germany cannot physically afford to assist its neighbours aswell as securing itself during a period of increasing unemployment and thus government cost.

That will serve as a wake-up call as much for the 'periphery' nations - expectant of Germany - as for Merkel and her Christian Democrats party. Such an apparently vivid 'unquestionable reality' then greatly alters the negotiation playing field between (largely) Northern and Southern Europe. It re-writes the script from that of a set-piece drama of to-ing and fro-ing bounded by political ideology, to instead something which could slip into the realms of continental tragedy as Germany becomes forced to retract its level of commitment to the EU project; still of course in place as a member but renouncing its lead role and indeed seeking other self-preservation and self-enhancement scenarios.

Forming a future for the 'national good' is of course part and parcel of any country's economic planning agenda, yet that attitude and the level of effort applied therein is in itself moulded by past and present experiences. For Germany the emergence of the EU sovereign debt crisis itself highlights the age-old and still present cultural differences between Teutonic and Latin temperaments and world-views, the former long-term and broad, the later less so, that irresponsibility only compounded by yesterday's and today's 'begging bowl' expectations.

Critically, this political and cultural friction may well have instigated a low-level - but nonetheless important - desire by Germany to re-evaluate more deeply its relationships with economically 'right-leaning' and 'conservative' others, specifically: the UK, Scandinavia, Russia, Balkan countries, Turkey, the GCC area and CIS states.

And given the shudder of western stock markets recently such a desire could well gain greater momentum in order to create a new order of industrial, social and so economic reciprocity.

If the old adage that "a week is a long time in politics" is indeed true, the angst felt across western financial markets over the last 2 weeks or so has appeared as a "hellish eternity".

Watching US and French bank stocks initially plummet then regain traction, only to see the FTSE fall 4.5% on Thursday – itself dragged down by bank shares - has re-generated cause for concern. Questions about the innate substance of the West's banking sector and its strength to overcome near-term economic adversity are re-raised. Lost confidence and short-selling became, for a time, the nightmare of 2008 relived. Although immediate 'over-reactions' also hail a prime time to buy, and so re-plug the market, innate doubt still echoes.

This event demonstrates that although the last 2-3 years have buoyed corporate stock confidence, resultent from the boost effects of those early public & private measures such as QE1, sector restructuring & corporate 're-shaping'; such confidence may have naturally diminished relative to the law of marginal returns.

So, today without such immediately available and powerful 'confidence injections' which created that upward trajectory of stock prices, it may be well to assume that the next 2 quarters or so could well witness 'see-saw' market instability: nominal profit gains from previous price floors quickly captured, a reactive market then rapidly deflating stocks and so effectively creating a trend which ostensibly 'flat-lines' the market between short-run 'floors and ceilings'.

This the story for the US at least, and without any of Mr Taleb's 'Black Swans'.

Europe however, without such a singular macro-approach could well see a period of where its bigger indexes are affected by smaller but more frequent stock falls, given a combination of a typically less reactive market compared to the US, yet set within a context of greater EU intra-national complexity which is prone to more varied 'intra-national shock sources'. The reveal that German national productivity has been so massively hit perhaps the greatest real-world shock.

This very generalised market-read then derives from recent interventionism on both sides of the Atlantic.

Firstly, the initial news that the Federal Reserve would retain a "0%" base rate until mid 2013 perhaps went against the view that a inched-up base rate might be introduced along with a far smaller QE3 exercise so as to try and stave-off core inflation and maintain a modicum of fiscal stimulation. But such an obvious QE replay may have yet spooked the markets and seen a USD out-flow, so instead (as well observed by the FT's Lex video/column) the Fed sought to gain a QE3 type of outcome by effectively lengthening the 0% rate and thus promoting short-term (2-year) government bond sales. (As John Authors highlights) this then depicts itself as QE3 “by the back door”. The initial view then of a more tangible QE3 accompanied by a slight raise in rates appears to have be deemed a 'self-cancelling', and may have indeed started calls for wage demand increased in private and public sectors, thus hampering the de-leveraging process. Instead, the 0% announcement provides a notional firm foundation.

By its very nature it conveys an inexpensive borrowing climate. A climate useful to both the US government to service its national debt obligations and importantly those well-placed US national and multi-national companies which can seize advantage of an ensured no-cost borrowing period and combine it with their substantial cash reserves. (Global Finance magazine quotes 3rd party research indicating that US S&P500 companies have over $1.1 trillion available in cash & cash equivalent reserves). So whilst Washington 'kicks the debt can down the road', the private sector will be looking at a 'round 2' opportunity to re-shape their businesses at home and abroad. The steady flow of poor domestic economic indicators the basis for a new round of domestic cost-containment. Whilst they are also able to identify M&A targets both at home and importantly abroad in across first and second-order EM regions which have respectively entered BRIC slow-down and “next 12” stability periods.

That initially dour but opportunistic US macro-policy play is counter-pointed by the complexity, political friction and so economic stagnancy of the EU.

The creation of the ECB's 'ESF' (European Stability Fund) and IMF's EFF (Extended Fund Facility) to 'bail-out' indebted 'periphery countries' has indeed succeed in deflecting the markets' attention from ravaging those fragile economies – at least for now. However, unlike say the Middle East where a rapid fall-off in private sector activity since 2008 has been replaced by petro-dollar supported public sector activity and new PPI schemes, Europe has the dual challenge of still constrained private sector activity and cross-region fiscal inability by governments to try and pump-prime productive activity; having already used such measures previously to little lasting effect. An invisible fracture of the EU has inevitably appeared as a consequence of the sovereign debt crisis, even to the point where expected new members such as Poland (and especially Turkey) are becoming more reluctant to push the entry procedure, at least until the present situation has receeded. Moreover, there is a real concern in Brussels and Berlin that the 'paper-based' austerity packages put in place for Greece and Portugal are effectively unworkable, the requirements of workforce and industrial structural reform unable to simultaneously deliver the required government income to meet the targets set. The bail-out assistance funds are to be delivered on a 'gateway' basis, a common-sense approach to ensure incentivised progress in reforms and state income, whilst limiting IMF & ESF exposure. Yet given the oppositional forces created by simultaneous reform and income, it also heralds a drawn-out period of growth stagnation.

As a result the global financial markets are undoubtedly taking black & white viewpoints on their corporates and governments. A necessary action so as to limited risk, dissect the good from the bad and furthermore examine the plainly ugly across the larger exchanges and indices. Examination of the 'ugly' so as to identify immediate divestment and 'break-up' scenarios for cross-border sector consolidation.

Professional investors will be critically assessing their portfolios relative to these prime criteria:

- corporate home country
- its non-EU business exposure
- western hemisphere sector dynamics
- overall balance sheet structure

All normative assessment criteria not so subtly re-jigged, now with added opportunity and threat.

But what of the broader, global picture?
What are the ramifications of this tough period in EU relations?

As previously stated, investment-auto-motives suspects Germany is using this period to as quietly as possible restructure itself from top-down.

Efforts such as Volkswagen AG's efforts to build its truck empire via the capture of remaining shares in MAN AG and absorption of Scania are well reported and obviously grab the headlines. Yet the family-led members of the massively broad, inter-connected and powerful Mittelstand are almost certainly re-aligning themselves either structurally through M&A, through mutual share-base capture and thus have the protection and synergies of 'chaebols' (so as to repel 'hostile' private equity) or via greater financial interweaving with specific T&C's which effectively act as pseudo 'poison-pill'.

The 2008 financial crisis effectively put Germany on 'amber alert', the problems created for its financial sector having major ripples for the country's bastion of its industrial sector. The EU soveriegn debt crisis will ratcheted that alert level higher. An outcome has been closer relations to Russia to ensure oil and gas energy supplies (with probably a reassessment of its own clean coal supplies) and closer relations with China as demonstrated by the Sino-German trade pact worth E15bn (to take effect after the present Chinese slowdown). Germany then is quietly re-plotting its contribution to, and part in, mid and latter term global growth.

In recognition of the 2008 financial crisis and its long-term effect on Europe, some years ago investment-auto-motives presented the notion of the 'Eco-Rainbow', a collaborative meeting of government minds in the realm of automotive eco-tech that could span from the UK across Scandanavia and to Germany, creating a trade-pact between those nations that had both advanced engineering capabilities, scale and (global-leadership) credibility.

The notion was to try and replicate the eco-credentials of Japan, through both the development of independent solutions and the use of Japan-linked solutions via absorbing the best of its own 'transplant'-available technologies.

To ensure the eventual need for manufacturing cost-reduction, that 'Rainbow' was adjoined to a 'reverse S' chicane, that ran from Germany into Poland & Russia across the Balkans and into Turkey.

This trade path would not only allow for lower production costs, as is typically the case, but also importantly provide a host of other mutual advantages:

Eastern Europe would provide:
- direct access to commodities and input materials required for production.
- a younger, incentivised & flexible labour-force
- agro-products for 'Rainbow'homeland food production

In return Western Europe would provide
- advanced eco-engineering solutions across various sectors (auto as pioneer)
- educational opportunities via universities, R&D centres etc
- financial centres to service nest-generation eco-companies (production & retail)

However, since the notion of the 'Rainbow ' & 'Chicane' were formed the ultimate depth of the EU sovereign debt crisis, the strained relations and indeed now the questionable will of western financial markets & corporates to ensure a productivity push even in the mid-term – given concerns about necessary deleveraging – potentially means that any technological gain that north-west and northern Europe may have over other regions (esp Japan and S.Korea) could be lost without effective encouragement from collaborating governments.

Moreover, the time has arrived for the UK, Scandinavia and Germany to form closer cultural and business relationships with the Near and Middle East; both those re-shaped countries in North Africa and those more sensitively royal ruled countries of the GCC. As investment-auto-motives highlighted just before the emergence of the 'Arab Spring' the MENA region was set for medium pace growth of 4-7% annually, but since the dynamic changes some local observers believe that growth potential sits toward the higher-end. Demands made by the populace for a broader education which builds upon Islamic foundations (ie deploying basic tenants into Sharia-type Finance so as to underpin ethically orientated CSR commerce and thus links to eco-solutions business) indicate that new opportunity has arisen as part of the MENA region's need and desire to broaden its historical industrial base beyond rigid petro-centric planning and infrastructure. Of course 'petro-centricity' must remain given its importance but should also offer greater spin-off potential that perhaps is the case today, which in turn link to eco-tech and advances possible across the board in automotive, transport and other arenas. The MENA dynamic then highlights mid & long-term opportunity for eco-tech players in NW & N Europe, as both an eventual supply region in parallel to the Balkans and as an eventual large and culturally more uniform market which still has a very close affinity to nature and enjoys the kudos of advanced-world credibility.

Hence, the British-Scandinavian-Germanic 'Rainbow' and Russian-CEE-Turkish 'Chicane' should be coupled to MENA by the Arabic letter 'dād' (which when overlaid the region circumscribes arab unity - see graphic).

Through this template and process an eco-tech based economic affiliation can be explored and co-created, thus creating a vital geo-economic chain of interests that fosters both progress and stability.

The 'German locomotive' previously pulled the ever enlarging EU up-hill through the 1990s and 2000s, yet once past its true private-sector productivity peak that train 'over-ran' on the downward slope laden with the weight of unsustainable credit. It had morphed into a region-wide version of the legendary Brussels 'gravy-train'. Today the German locomotive has momentarily "decoupled, stopped at its home-station station and considers a set of points on the line. The German machine is being assessed for condition, re-serviced, re-fuelled and presently re-orientated, and the country's economic engineers could well be seeking alternative routes.