Eurozone Stocks Don’t Need an Ever Closer Union

Last week, French President Emmanuel Macron shared his grand vision of a stronger, more unified Europe and called on newly re-elected German Chancellor Angela Merkel to back him.^[i] We won't bore you by belaboring one politician's speech about things that may never happen, but it did resurrect several long-running questions, such as: Will the eurozone survive without a common fiscal policy, common debt and the like? Would voters support such reforms? What would they look like? There are many options, and even if folks agree on goals and principles, the specifics are messy. We don't have all the answers and suspect no one will any time soon. Regardless, we wouldn't overstate their importance for markets. Whether or not Macron's push for a eurobond or fiscal union is successful, the last seven years have proven such long-term structural issues don't materially impact stocks.

To see this, let us take our time machine back to the 2010 - 2012 European debt crisis, when the prospect of eurobonds became a going concern. Greece, Portugal and Ireland, drowning in high sovereign debt and unable to tap capital markets, had to take bailouts. Spain and Italy were teetering. Most pundits worried the euro would splinter if any of these nations defaulted and bombed out of the common currency. While each nation had its own reasons for being in trouble, many (then and now) blame the eurozone's incomplete nature for the broader crisis: Member states share a currency and monetary policy, but taxing, spending and borrowing are country-level matters, and the rules outlaw fiscal transfers. In fiscal transfer unions like the US and UK, the strong states or constituent countries subsidize the weak, helping less competitive members skate through tough times. If the eurozone had a similar arrangement, whether through outright fiscal transfers or common borrowing via eurobonds-which would reduce borrowing costs for less competitive nations-perhaps there would be no need for bailouts.

Debate over this preoccupied eurocrats for much of 2010 - 2013. "Europe can't last without figuring this out," said many. Others feared trouble arising if the eurozone did become more fiscally integrated: What of spendthrift nations free-riding off responsible taxpayers elsewhere? One country's (think: Greece) much-needed fiscal transfer is another country's (think: Germany) bailout-unpopular! Similarly, why should more creditworthy countries back riskier debt just because peripheral nations ruin their finances and fudge budget numbers? At the time, we spent quite a lot of pixels covering the debate-not because it had high stakes for markets but because it was sort of an interesting conversation. As we wrote in 2014 following Greece's not-so-triumphant return to international bond markets, disputes over which reforms could have sidestepped the debt crisis and how to prevent future ones stalked European markets for years-but didn't end the bull. To quote:

Greece's successful [debt] auction is a clear indication the market's fears of a disorderly eurozone breakup have all but completely dissipated. Officials are still haggling over longer-term issues like the banking union, but like Greece's big debt, these issues likely simply fade into the longer-term backdrop of the eurozone. With yields across the periphery approaching historic lows, countries seem quite capable of staying afloat while that squabbling plays out.

More than three years since we wrote that, said squabbling is still playing out-nothing new. A banking union is closer to reality, but fiscal union remains distant. This matters: Markets move most on surprises, and glacial shifts in the eurozone's architecture won't happen quickly. If you think Brexit is moving slowly, you ain't seen nothin' yet.

While the eurozone remains incomplete and its long-term architecture unknown, eurozone stocks have done just fine. So has the economy. The eurozone recovery began in 2013. Since then, GDP has grown for 17 straight quarters. A new eurozone bull market began in mid-2012 before the recession's end. Eurozone stocks did lag US markets for several years but have outperformed this year on the back of falling political uncertainty and broad-based economic growth.

Exhibit 1: Eurozone Stocks Power Past US in 2017

Source: FactSet, as of 10/2/2017. MSCI European Economic and Monetary Union (EMU) Index in USD with net dividends and S&P 500 Total Return Index, 12/31/2016 - 9/29/2017. Indexed to 100 at 12/31/2016.

Lesson: Markets move on cyclical, not structural factors. Whether or not a eurobond or common fiscal policy ever happens is far less important to markets than their ability to see them coming and gradually price in potential changes. The same principle applies to countries with supposedly weak demographics (aging societies like Japan), those with poor institutional stability and those located right near rogue states (think South Korea). These features are effectively always part of the backdrop-and stocks are pretty well aware of them.^[ii] Hence, stocks' direction in the here and now depends far more on transient factors like the economic cycle and ongoing political dynamics. The allegedly incomplete eurozone economic union cycling from regional weakness to strength is just one example.