Our thesis through most of the post-crisis (2008+) period has been that Europe would trail behind the United States economically by about two years, following in our policy footsteps, as well as consumer and investor footsteps. Many of the same forces have been propelling each economy forward, and similar headwinds have been holding each back. One of the most significant factors has been central bank policy. The US Fed moved aggressively to stop the bleeding by employing extraordinary measures to hold back rates and make access to capital cheaper. Fiscal hawks in Europe chose the path of austerity, and the ECB and member countries did not finally come around until the US had lapped them in terms of recovery and growth.
We took for granted that many of the same catalysts would drive economic progress forward in the short- and long-term; Education, innovation, immigration, worker mobility, a single currency, and free trade. The two largest looming threats we saw to the bullish case were a major and abrupt economic policy reversal and the idiosyncratic effects of global terrorism. Looking to the present, while central banks remain accommodative, there has been a lurch toward political conservatism and isolationism, not unsurprising in a period of recovery that has inured to the benefit of the wealthiest few while leaving the middle class and the working poor behind. We are in a season of conservative retrenchment globally, bookended by Brexit and the election of President-Elect Donald Trump.
This retrenchment has been fueled in no small part by terrorist acts globally, from the Bataclan in Paris to Zaventem Airport in Belgium to a holiday party in San Bernardino and the Pulse nightclub in Orlando. The root of these acts is for a different kind of blog, but the effect has been chilling in terms of societal attitudes toward openness. Austria came close to electing a hard-line conservative, Marine Le Pen’s prospects in France’s upcoming elections are not insignificant, and Angela Merkel’s power base has eroded considerably since the immigration crisis began, punctuated by the Christmas village truck attack this past week in Berlin.
Here is where we are finding divergent paths between the US and Europe. Both economic zones are wrestling with the same challenges and reacting the same rhetorically and in reality. But, the structural differences between the US and Europe now become critical. If the US tightens border controls, renegotiates or terminates global trade alliances, and enters a period of isolationism, we still have the benefit of a single currency, free trade and worker mobility across all 50 states, extensive natural resources, farm production that exceeds our ability to consume and a vertically integrated economy. An isolated US may grow more slowly or even not at all, but it benefits from self-sufficiency.
Europe, if critical individual nations such as Germany follow the UK’s path toward “independence”, has no similar backstop to the US. The Schengen Agreement covers a zone of 26 nation-states and more than 400 million people. These permeable borders have facilitated trade, a mobile workforce, pan-European consumerism and tourism, and addressed demographic challenges in the aging societies of Western Europe with an infusion of younger, aggressive and upwardly mobile individuals from the periphery. If the member states begin closing borders, and particularly if the common currency is dismantled, Europe becomes a mediocre array of smaller markets with only France and Germany having sufficient scale and diversity to be stand-alone integrated economies. As the UK is learning, it is no simple task to establish new trade accords either. Multiply that challenge by two dozen countries and the outlook is not encouraging.
A negative outcome is by no means certain, or investors would already be aggressively trading down Europe. We believe though that these systems-level threats to the European story mean that owning Europe monolithically is increasingly challenging. Investing in discrete parts of Europe, whether individual countries or industries may provide a clearer ownership case. To the extent we continue to hold Europe as a group, hedged or unhedged, it is with the understanding of the risks and a belief in the opportunity to be rewarded in the fullness of time commensurate with those risks.