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What Europe's Stimulus Means For U.S. Investors

Six years after the global Great Recession began, most European economies remain in a very deep funk.

And the continent's bankers are growing nervous. Chronic high levels of unemployment have already been a long-standing concern, and now the European Central Bank (ECB) is struggling with another mandate: price stability.

Europe may be on the cusp of falling asset prices, which can lead to a series of negative ripple effects. The eurozone inflation rate slipped to an annualized 0.5% in April, and Goldman Sachs' economists estimate that figure fell to just 0.3% in May. Fears are rising that prices may start to shrink, and once price deflation takes root, it is hard to reverse it.

That fear is bringing out a rarely used arrow in the quiver: negative interest rates charged by the ECB on the money that banks park on their balance sheets, which can strongly encourage banks to step up their pace of lending. Higher lending often leads to higher spending, by both businesses and consumers alike.

The ECB is lowering its main refinancing rate from 0.25% to 0.15%, and the rate it pays to banks for their deposits from zero to minus 0.1%. (The ECB is also freeing up $550 billion in fresh funds for banks to use in loans (outside of mortgages), which is a good thing, because the amount of idle cash on bank balance sheets has dropped from $1.1 trillion in 2012 to a recent $140 billion, according to The Washington Post.)

To understand why it's so crucial that businesses and people start spending, just look at Japan in the 1990s. That country had been coming off a period of soaring real estate prices a decade earlier, but a sharply slowing economy hurt demand, so the value of real estate started to steadily fall. And falling asset prices led Japanese citizens to feel financially weaker, and they moved into hibernation, trimming spending on many luxury items and even some necessities. That led to a multi-decade economic slump from which Japan may only now be exiting.

The other goal of lower rates: a cheaper currency as foreign exchange traders shift their assets toward countries that offer higher interest rates. By lowering the value of the euro, these central bankers aim to boost exports, but economists doubt that the rate shift will alter trade balances to any great extent. Outside of Germany, many European countries remain inefficient in the global marketplace.

Let's look at all of this through the prism of the Italian leather goods industry. Italian craftsmen, traditionally employed by small, family-owned businesses, were considered to be among the most capable in the world, creating shoes, handbags and other accessories that were beautifully designed and durably built.

Yet over the past few decades, craftsmen in Asia have learned the trade and can produce goods of reasonably high quality at far lower prices. It is unclear how a reduction in interest rates (or other stimulus measures) will help restores Italy's industrial positioning.

If European central bankers really wanted to help these economies, they would help them to develop world-class infrastructures and labor force skills. Only Germany has maintained a top-tier infrastructure and invests heavily in training of its workforce, which explains why German businesses always seem to be globally competitive.

Here's the real problem with lower interest rates: The move is designed to encourage major banks to lend more and businesses to borrow more. Trouble is, many businesses are already heavily indebted, the real risk emerges that loans start to default at a rising rate. That could set off an even deeper cycle of layoffs and spending woes.

As it stands, Europe's economies are not nearly feeling the rebound that many economists had predicted only a year ago. And that means unemployment remains an intolerable 12% (though in Southern Europe, that unemployment rate is well higher). Chronic high levels of unemployment are corrosive as an entire generation fails to learn the trades and skills that their parents had before them. The fact that Europe is rapidly aging as families produce children below the replacement rate will create yet another drag on growth.

The real solution to this whole mess is one that few are publicly pondering right now...

Break up the economic union.

It's almost impossible to see how countries like Greece, Spain, Italy and Portugal can build a head of steam while they are sharing the same currency with more powerful economies to the north. A return to their native currencies would likely lead to a rapid 20% or 25% drop in the cost of doing business. And though there are costs associated with a fracture of the economic union, a lower currency would likely lead to much more robust job creation, which is the real long-term goal of citizens and central bankers alike.

If and when this option takes root in the public psyche, it could mark the beginning of the end of this very painful chapter of European history.

Risks to Consider: A rapidly aging workforce, increasingly uncompetitive industries, persistently high government debt loads and pull-out-all-the-stops central banking moves make up the interlocking risks that Europe now faces.

Action to Take --> The ECB's moves are unlikely to deliver a dramatic jolt for the European economy, or deliver gains for U.S. investors that have exposure to the continent. But Europe's central bank is expected to follow up these moves with some sort of bond-buying program, modeled after our own quantitative easing (QE) programs. That's likely to be a clear positive for investors, as markets love liquidity. A QE-style program may not juice growth but could stave off further erosion, which is precisely the scenario that led investors to bid up U.S. markets in recent years.

It's time again to closely track events in Europe, which is still a key source of trade for many U.S. firms. If Europe's troubles deepen even further, then it's bound to spill over into our markets and economy as well.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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