Investors' Outlook July 2018

Investors Outlook, Multi Asset 7/1/2018 by Christophe Bernard
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Europe is on the brink of an existential crisis

"People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them."
Jean Monnet, Mémoires, 1976

After a prolonged period of continuous geographical expansion, the European Union (EU) is contracting for the first time with the UK leaving its ranks. However, Brexit is just one of a series of deep-rooted challenges which eventually may threaten the EU’s existence. 

Migration has exposed the divide between a technocratic institution and people afraid of losing their cultural identity as a result of uncontrolled immigration. The inability of the EU to act on this issue has contributed to the rise of "anti-system", populist parties such as Lega in Italy or AFD in Germany, which claim to truly represent the people's aspirations, in contrast to discredited political elites. The issue is acutely straining the governing German coalition putting the future of Angela Merkel at risk.

Even the core liberal, open trade agenda of the EU is facing rising protest from voters feeling vulnerable to the fallout of global competition. Rising income inequality is grist to the mill of rising populist parties, which typically advocate the instauration of trade barriers.

On the geopolitical front, the annexation of Crimea by Russia has broken a post-WW2 taboo while the U.S. under Trump’s leadership are not exactly behaving like a reliable ally, to say the least.

Finally the euro, a symbol of European integration, remains fragile as the monetary union remains incomplete. In particular, the rising Target2 imbalances between European core countries and those of the periphery give reason for concern. Target2 (Trans-European Automated Real-time Gross Settlement Express Transfer System) balances  represent the claims and liabilities of euro-area national banks vis-à-vis the European Central Bank arising from cross-border payment flows that are executed through Target2. These show that capital is flowing into the core without adequate reinvestment into the periphery (see chart). This is because economic agents and investors act as if they did not truly believe in the irreversibility of the monetary union and understandably so: there is no common bank deposit insurance scheme, no mutualized safe euro zone bond, and the current European Stability Mechanism is not designed to address big system threats such as a potential Italian sovereign crisis.

Without some form of a euro zone budget - an anathema to Northern countries that fear being held accountable for their spendthrift Southern counterparts (a worn-out, but still vivid cliché) - it is difficult to hope for a reduction of the current, growing imbalances. Even though it is a small step, France and Germany are proposing the creation of a euro zone budget (outside of the European Commission budget) by 2021. The size and scope are not defined yet and the proposal must first overcome resistance at the EU summit on 28/29 June.

To paraphrase Jean Monnet, a founding father of European institutions, the proliferation of trouble spots within the EU might sharpen the minds of European leaders and push them to take decisive action to safeguard its long-term survival. However, for the time being fundamental disagreements stand in the way. As a result, investors might be prone to underestimating the probability of an eventual euro crisis. Such a potential outcome, however, should be accounted for in long-term strategic portfolio positioning.

Target2 balances reveal liquidity imbalances between core European countries and the periphery

In euro billion

Source: ECB (Eurosystem), Thomson Reuters Datastream, Vontobel Asset Management

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Investors' Outlook