Two decades after inception, the eurozone countries’ arranged marriage-type of union looks shaky at best, and now it is even more challenged by ongoing, global disruptive forces.
The hope in an arranged marriage is that people marry, and then fall in love. Sometimes that works, other times it doesn't. Two decades after inception, the eurozone countries' arranged marriage-type of union looks shaky at best, and now it is even more challenged by ongoing, global disruptive forces.
PIMCO's Secular Forum recently highlighted that these disruptive forces, including Populism, Technology, Demographics and a slowdown in China, could challenge our view that over the next three to five years the global economy will stay on a New Normal path, characterized by low growth, low inflation and low interest rates.
Unfortunately, a New Normal baseline is probably the best that the eurozone can hope for. With public and private debt levels elevated, a rapidly aging population and evidence that inflation expectations are being anchored at depressed levels, we believe that Europe could be prone to a Japanification effect, essentially a state of long-term stagnation. What's more, the eurozone's fragile economy and half-hearted unity suggest that the monetary union could be more vulnerable to disruptions than other economic areas. Let's see how each of the five disruptive forces identified by PIMCO could threaten the eurozone and whether investors can still find opportunity in the region:
- China: The economic slowdown in China and rising global trade tensions are particularly damaging for the eurozone. Its current account surplus of about 3% of gross domestic product (GDP) makes it highly exposed to the global trade cycle. This is especially true in Germany, Europe's largest economy, which runs a current account surplus of over 7% of GDP, among the world's highest. Extra-eurozone exports constitute about 28% of the eurozone's total GDP, far exceeding the 12% and 20% figures for the U.S. and China, respectively. In 2018, China was the eurozone's third-largest goods export destination, and the largest source of goods imports in Europe, according to the European Union's (EU) data agency Eurostat. China and the eurozone trade on average over €1 billion a day - mostly machinery and equipment, motor vehicles, aircraft, and chemicals.
- Populism: The rise in populism is of particular significance in the eurozone, as it often contains elements of EU and euro skepticism. Granted, most populist parties have scaled down their anti-European rhetoric recently, but contempt towards EU institutions is part of most of these parties' DNA. These parties might resurrect a more antagonistic attitude towards the EU and the currency union if the region is hit by an economic crisis. Already, the proliferation of more extreme parties has increased political fragmentation in countries such as Spain and Italy, leading to difficulties in government formation, political instability, and the challenge of squaring competing populist policies.
- Demographics: The eurozone's working-age population, now stagnant, looks set to contract over the next decade, according to the UN. The old-age dependency ratio (the number of those above 65 as a share of the working-age population aged 15 to 64), stands at just over 30%, and looks set to move to above 40%, according to European Commission projections. Amongst major regions, the eurozone is second only to Japan in terms of how rapidly the population is ageing. This presents many challenges: First, fewer working age people may find it harder to finance an increasing number of retirees; and secondly, aging populations tend to save more and consume less, fueling the already large savings glut in the region. More savings, among other factors, have helped push down bond yields, a drag for many pension plans as they are not earning enough interest to meet future obligations. In Germany, for instance, highly regulated insurance companies are suffering as yields on all of the country's sovereign debt are now negative. Arguably, excess savings have also contributed to a mispricing of capital, disrupting an efficient allocation of resources.
- Technology: Once home of leading technology companies, Europe has lost significant ground to the U.S. and China, where tech giants have grown exponentially. Investment growth has lagged in the eurozone and productivity growth, at just under 1% a year over the past decade, has remained subdued. According to Organisation for Economic Co-operation and Development (OECD) data, the 28 European Union countries spent 2% of GDP on research and development, below the U.S.'s 2.8%, Japan's 3.2%, and marginally below China's 2.1%.
- Financial market valuations: The European Central Bank (ECB) policy rate, 10-year German yields, and now even 30-year Bund yields are negative, well below the level of their equivalents in the U.S., the U.K., and even below Japan's. Negative yields have pushed investors to reach for yield, but have failed to lift growth or inflation in a sustained fashion. With nominal growth remaining stubbornly low, asset valuations look increasingly expensive, which poses the risk of sudden corrections ahead.
To find out more about these disruptors and how they affect the global economy, please read our full 2019 Secular Outlook: Dealing with Disruption.