One of the striking features of the European economy, since the start of this year, has been the dislocation between financial markets and the real economy. For all that they give misleading signals, the Purchasing Managers’ Indices (PMIs) suggest that euro area countries have remained firmly in recession so far this year,Â and this is borne out by more reliable indicators such as the sentiment indices from the European Commission. Official statistics on unemployment, trade and production also suggest that the economy remains mired in decline.
In contrast, financial markets have been bullish. Major equity indices have risen strongly during 2013, and the cost of borrowing for struggling peripheral euro area governments has fallen further, with Italian ten-year interest rates falling below 4% even before a coalition was agreed. At first glance, this divergence looks odd.
In truth, the reaction of financial markets is less of a puzzle than is often claimed. The story of the past three years is of banks and governments struggling to get their balance sheets and borrowing under control; in contrast, European companies – and in particular the larger businesses that are much more likely to be listed on equity markets – have performed rather well.
Many of these larger companies are sizeable precisely because they do not rely solely on domestic markets but are plugged into faster-growing economies as well. They also acted fast when the recession hit to contain costs and slash discretionary spending on things like investment and hiring, shoring up their balance sheets. Taken as a whole, the corporate sector has been running a financial surplus for some time now – literally, saving money and building up cash stockpiles. With the macroeconomic picture unlikely to change significantly, there is no reason to think this pattern won’t persist. But sooner or later, something has to happen to this money – and with companies not really looking to grow domestically, the smart bet at the moment is that they will choose to return it to shareholders, either buying back shares or offering special dividends. Equities may have risen for good reasons.
In contrast, if we believe that the threat of outright euro breakup is now negligible, thanks both to the ECB’s commitment and the ongoing relaxation of the austerity targets by the European Commission, then a continuation of the current depression should imply low market yields, as we already see in the UK. Clearly investors still see more credit risk for peripheral countries, as yields have not converged completely. But unless the ECB threatens to kick a country out of the euro (as it did to Cyprus), this expectation of a long depression – where large companies continue to perform as well as they have recently – would be consistent with markets being roughly where they are now.
Of course, all this would change if the crisis flares up again, as it may well do. But for now, markets seem to be betting that depression and stagnation will continue across most of the euro area, but that large companies are pretty well placed to cope. Sometimes, things aren’t as odd as they first seem.